Time to Allocate Bitcoin in Your Portfolio
Relative to other alternative assets, the low weighting of Bitcoin has a large positive impact on risk-adjusted returns and diversification.
Bitcoin's lack of correlation with other assets makes it a useful alternative asset, which helps reduce the risk of economic cycles.
Rebalancing Bitcoin to its original weight in the portfolio on a quarterly basis can help reduce the impact of volatility and increase returns.
Bitcoin's journey over the past decade has been well documented, with supporters and skeptics alike vying to comment on the price of the most valuable coin. However, for investors with a long-term investment horizon, a fundamental question remains largely unanswered: How effective is adding bitcoin to a portfolio?
We believe that a thorough analysis of Bitcoin's performance in a typical "60/40" stock/bond portfolio is warranted to determine whether it actually improves or decreases overall performance and diversification.
The result of our analysis is that whenever an investor decides to invest, Bitcoin not only enhances returns but also improves portfolio diversification.
What the data tells you about Bitcoin's impact on your portfolio
To test the impact of Bitcoin on investment portfolios, we created a database of daily returns from 2015, when Bitcoin was first traded as a product. We created a traditional balanced portfolio, 60% stocks and 40% bonds, and then added the appropriate amount of Bitcoin, reducing the proportion of stocks and bonds equally.
Since Bitcoin is an asset in an early growth stage, most investors will accept that their portfolio weights are somewhat off. We decided to do quarterly rebalancing (despite the potential negative impact on yield gains) because we believe rebalancing helps moderate the impact of volatility.
Bitcoin Improves Portfolio Performance
Despite Bitcoin's volatility, a 4% Bitcoin allocation in the above portfolio increases annualized returns from 9.3% to 18.8%.
A portfolio's Sharpe ratio tells us how likely the return is relative to the risk an investor is taking. Typically, any Sharpe ratio above 1 is considered positive for a portfolio.
In this portfolio we created, we see a Sharpe ratio of 1.69, while the correlation with the underlying portfolio has dropped by a whopping 15%.
Data comes from a "60/40" balanced stock/bond portfolio minus Bitcoin, Gold, SOCL or CRB with equal weight. Using XBTUSD, Gold, SOCL and CRB indices. Rebalance every quarter.
Performance of Bitcoin vs. Various Asset Classes in Portfolios
Over the past three years, Bitcoin has been a diversifier to the standard "60/40" portfolio. However, there are other alternative assets that can serve as diversifiers. We sought to understand how Bitcoin performed relative to these other alternative assets.
We used in our analysis:
Gold, as Bitcoin is often considered digital gold.
SOCL Index, which is a social networking index (including companies such as Facebook and Google), because Bitcoin has been more closely correlated with this stock index than other indexes in recent years.
The CRB index is a representative indicator of today's global commodity market because of its similarity to commodities.
Notably, no other comparable asset or index offered the same diversification benefits over the same period. What also makes Bitcoin stand out is its asymmetric rate of return, the upside versus downside it offers. Despite Bitcoin's high volatility, a 4% portfolio weight does not significantly increase the maximum possible loss relative to other assets, while its annualized return is nearly double that of other alternative assets.
backtest
A major weakness of this type of analysis is that it looks backwards. It is very likely that investments will perform differently in the future than in the past. This may be especially relevant since we believe Bitcoin's identity is steadily changing.
This does not mean that we should dismiss this analysis. The chart below shows that we can see what impact Bitcoin will have on our portfolio regardless of an investor's entry point. For example, a backtest of 675 days means that investors decided to add Bitcoin to their portfolios when Bitcoin reached nearly $20,000 at the end of 2017.
Different backtest days are highlighted in the figure, ranging from 290 days to 1100 days. We are pleased to see that the correlation of a Bitcoin portfolio relative to a standard "60/40" stock/bond portfolio remains consistently lower than comparable assets such as gold or commodities, highlighting that Bitcoin is a better portfolio diversification tool. Consistency in Bitcoin is also important. Even during periods of unusual volatility for Bitcoin, its correlation and annualized returns have remained remarkably consistent.
Bitcoin is effective portfolio diversification
Interestingly, even adding Bitcoin to a portfolio at the high price in December 2017, when the price fell sharply, Bitcoin still lifted the portfolio relative to other portfolio diversifications such as gold or commodities s return. Bitcoin's return from its December 2017 price high is currently -46%, so it should reduce the overall portfolio's Sharpe ratio. Historically, this has been mitigated by quarterly rebalancing, which helps limit the impact of Bitcoin volatility. We have seen similar results from monthly rebalancing, suggesting that regular rebalancing has been an effective way to reduce overall portfolio volatility.
All in all, Bitcoin's investment properties have historically made it attractive as a yield-enhancing allocation and portfolio diversifier. Compared to other common alternatives and diversification varieties, Bitcoin has a huge positive impact on returns, Sharpe ratio and diversification, even at extremely low allocation sizes. Given these benefits, Bitcoin may well be suitable to fill the gap in existing diversification that currently plagues investors and portfolio allocators, and to help mitigate the risks posed by economic cycles.
