How Bitcoin fits into a pension portfolio

Crypto has a low correlation with equities. What does it mean?

Stocks, bonds, real estate, commodities. Bitcoin.

Bitcoin? Is cryptocurrency an asset class that deserves a place in every capital and pension portfolio?

A modern portfolio theory of bitcoins is now being built on Wall Street: detailed demonstrations that a dose of virtual currency will improve returns or reduce the risk of a portfolio. Be prepared to be bombarded with Sharpe ratios, correlations and optimal distributions.

It may be that all this fine arithmetic is a proof of the legitimacy of virtual currency. Or it may just be a sign of a peak.

Here I will present the cases for and against an allocation to bitcoin in an investment account, while I strive to take a neutral position on where the price of this asset is going. It is a 50-50 proposal. Virtual currencies can prove that they are worth competing against declining fiat currencies and sending bitcoin for $ 400,000. Or they may be destined to go the way of the South Sea Bubble.

Bitcoin has seen three phases in its 12-year life. The first was Silk Road: a payment mechanism, a Western Union for drug trafficking. The second phase was speculation. Speculators bought for $ 570 and sold for $ 5,700 for another group of speculators who bought for $ 5,700 and might have sold for $ 57,000 if the opportunity had not been so fleeting.

Now we are in the third phase: institutional. August units such as Fidelity, BlackRock, JP Morgan and MassMutual join as guardians, portfolio managers or cheerleaders. In fact, we might include Coinbase in our list of venerable institutions. The ten-year-old cryptocurrency trading venue has over $ 90 billion in assets and is about to be announced at a valuation that competes with Charles Schwabs.

The institutional fans are equipped with statistics. At heart, modern portfolio theory is just the old egg-in-a-basket saying clad in mathematical terms. The reason for diversification, says MPT, is that you can get the same return as on a less diversified portfolio but with less volatility, or, equivalent, keep the volatility constant while you get an increased return via some leverage.

One of the statistics that despite this exercise is a relationship that is popular by economist William Sharpe. It compares returns with volatility. The higher your Sharpe ratio, the more you earn at a certain level of risk. What do you know? Cryptocurrency has an amazing Sharpe.

Bitcoin is terribly volatile, but it has more than made up for it with appreciation. The Coin Metrics Bletchley Index watches bitcoin’s Sharpe ratio over the past five years at 1.6. It compares (per Morningstar) to 1.1 for the Vanguard Balanced Index Fund, which is about as diversified as you can get with the help of stocks and bonds.

If you could invest in the future, you would go back in time, put 100% of your money in crypto and stick to the roller coaster. In five years, you would have multiplied your money 105 times (see chart).

No institution, at least not those mentioned above, advocates a 100% allocation to crypto for a pension portfolio. So now we go into the next round of MPT statistics, correlation coefficients. These are used to make it possible to put some bitcoin in a portfolio that largely consists of a calmly balanced fund.

The correlation between two series of historical returns measures the extent to which the two assets track each other. A correlation of 1.0 means that they are marching in lockstep. A reading of 0.0 means that they are not connected. The whole point of diversification is to put together a mixture of different assets that have low (or negative) correlations with each other. The case for throwing some management stocks into the real estate mix is ​​based on correlations: If inflation kills your bonds, it can help your capital Reits.

This is why you hear sellers of various alternative assets, such as hedge funds, boasting of low correlations to the stock market. Sometimes this correlation game overlooks a crucial assumption that the other asset has a good expected return. If all you want is a low correlation, you can still put half of your money in the S&P 500 and half in lotteries.

At this point, bitcoin is working great. Or, to be a little more careful with our language, that has performed fantastic. For a long time, it has, unlike lotteries, delivered a positive return, and for the most part it goes its own way, unaware of the stock market.

VanEck Associates, a provider of exchange traded funds hoping to get approval for a bitcoin fund, estimates the long-term correlation between bitcoin and the S&P 500 to be a small 0.01. If that relationship continues, bitcoin would be a major diversifier in a portfolio that includes stocks. One of VanEck’s white papers concludes: “A small allotment for bitcoin improved significantly [hypothetical] cumulative return on a 60% equity and 40% bond portfolio allocation mix while minimally affecting its volatility. ”

To put it in MPT terms: You can increase a portfolio’s Sharpe ratio by adding crypto to it. But there are two reasons to hesitate.

One reason is that the history of bitcoin is short. It is one thing to look back at a century of equities and bonds and draw conclusions about how much return and how much volatility you can expect from them. It’s a whole other thing to extrapolate everything from the freakish first decade of a virtual object.

Bitcoin appears on the 6-cent mark at the starting point in August 2010 in Bloomberg’s price chart. Since then, it has estimated 80 million percent. It was to repeat that rise for a decade, the market value of all bitcoin now circulating would be $ 370 quadrillion.

Billiards? That is more than the market value of the entire solar system. And yet it is the feverish story, not a probable future, that goes into the formulas for Sharpe relationships, correlations and optimal portfolios.

The second question comes to the nature of wealth. Most assets are productive, and their value is related to how much they spend. A bond or a share is a requirement for the production of things such as cement mills and restaurant chains and vaccine patents. A bitcoin produces nothing. When you own one, you only have one row of numbers. It’s only valuable because other people want it.

To be sure, you can almost compare the same accusation against gold, whose value in jewelry and manufacturing is peripheral to its current price. You can really do it against the US dollar, which produces nothing when it’s not moving. Bitcoins are also by nature limited in quantity. Dollars are not; the government is printing 1.9 trillion of them to make people feel better.

Finally, I will quote comments from the two opposing camps. Nikolaos Panigirtzoglou is a global marketing strategist at JP Morgan. Says a Morgan research note: “He believes that the adoption of bitcoin by institutional investors has only just begun compared to holding gold.” He may be right; bitcoins spurt since september seems to have removed the shine from bullion.

And then there’s this one, from James Grant, who writes in his Interest rate observer: “The The bitcoin bubble, one of the largest in history, has, of course, anchored who is who is the established economy. That is the problem. ”

Like I said, it’s a throw up that has better arguments here. Maybe you should own some of these number strings. But do not let wishful thinking – I would have bought it five years ago – obscure your mind. Here, more than anywhere, apply another Wall Street saying: Past performance is not an indicator of future success.

Related story: Guide to cryptocurrency taxes