- As more investors eye cryptocurrencies such as bitcoin, it's key to keep in mind that many asset classes once thought too volatile for average investors are now common.
- Some recent research finds small weightings of bitcoin have an outsized positive impact on risk-adjusted returns and diversification relative to other alternative assets.
When a financial advisor discusses the appropriate asset allocation for a portfolio, they are essentially trying to construct a plan that maximizes expected returns based on a given level of risk.
The advisor pays less attention to the behavior of an individual security and instead focuses on how different asset classes work together as a group.
So, what is bitcoin's role in an investment portfolio and does it make sense to incorporate it?
Conventional wisdom suggests that while bitcoin has delivered great returns, it will add substantial risk to a traditional stock/bond portfolio.
With that said, it's important to remember that many asset classes that are now commonplace in a portfolio were at some point considered far too volatile for the average investor. We don't give it a second thought to include emerging markets or technology stocks into an allocation today, and yet there was a time when the pundits believed they were far too risky.
Their concerns were justified.
Since the 1988 inception of the MSCI Emerging Markets Index, there have been seven drops of 25% or more. Moreover, Nasdaq stocks collapsed by 79% during the dot-com bust as technology companies fell at a stunning pace.
Nevertheless, they both rebounded and paid off handsomely when included in a diversified portfolio that considers time horizon and risk tolerance.
It seems that the same arguments have been made about digital assets, even as a long-term study by VanEck found that bitcoin had exhibited lower volatility than 112 stocks of the S&P 500 in a 90-day period and 145 stocks year-to-date as of Nov. 13, 2020.
This begs the question about the impact bitcoin has on a well-constructed portfolio and whether it is suitable for the average investor to have some exposure.
Many may recall the bell curve that assesses the number of potential outcomes. When a portfolio is constructed, each additional possibility on that bell curve increases the volatility. If the objective is to receive the greatest returns with the least amount of risk, the addition of an asset class that serves that purpose is worth considering.
Some recent industry research found that small weightings of bitcoin have an outsized positive impact on risk-adjusted returns and diversification relative to other alternative assets. Additionally, the research concluded bitcoin's lack of correlation to other assets make it a useful alternative asset that can actually help reduce exposure to economic cycles.
To that point, the RIA Digital Asset Council reports that when investors allocate 1% to a balanced portfolio, the returns increased with little to no impact on the volatility or maximum drawdowns when the market got dicey. Likewise, rebalancing a portfolio that includes 1% bitcoin each quarter increased the long-term return of a balanced portfolio, even though the volatility and maximum drawdowns for the same time frame barely budged.
Suffice it to say, having an open mind and using the risk-management tools already at our disposal makes a great deal of sense.
— By Ivory Johnson, founder of Delancey Wealth Management