Should Bitcoin be added to the portfolio?

Should Bitcoin be added to the portfolio?

In the past ten years, which asset has the best return? If Bitcoin can be considered an asset, the answer is Bitcoin.

From December 31, 2010 to December 31, 2020, the price of Bitcoin has risen from 26 cents to more than 28,000 US dollars, with a cumulative return of more than 11 million and an annualized return of 217%, far exceeding the same period. The S&P 500 Index (13.9%) and U.S. dollar bonds (AGG, 3.8%) returned. If we count the price increase in the first month of 2021, Bitcoin’s return is even higher.

So the question is, is such an excellent performance enough to make Bitcoin an asset class like stocks and bonds that investors will take seriously and be included in the asset allocation portfolio? If Bitcoin is added to the portfolio, how much weight should we allocate?

Let’s look at the first question first. What are the reasons to support Bitcoin as an asset choice?

The biggest reason for support comes from the supply limit of Bitcoin, which is a total of 21 million. Since the total supply is capped, Bitcoin is like gold: no one has the ability to make more Bitcoin out of thin air, and dig a little less. This feature is completely opposite to the banknotes issued by the central banks of all countries.

In the paper currency era, the central bank of any country can print and issue banknotes without restrictions to meet its monetary policy goals. The 2008 financial crisis made the world feel the power of quantitative easing of money printing up close. The central bank’s money supply in the form of hundreds of billions of dollars has firmly held bond yields near zero, while pushing up the prices of assets such as stocks and real estate.

More than 10 years after the end of the financial crisis, everyone thought that the global central bank would gradually resume normal monetary policy and bring the benchmark interest rate back to a more reasonable range. Unexpectedly, the new crown epidemic in 2020 completely disrupted the original plan. The central banks of major countries have successively lowered their benchmark interest rates to zero or even negative ranges. At the same time, governments of various countries have introduced trillion-level stimulus policies that are larger than the 2008 financial crisis.

Every time there is a financial crisis, the response strategy of the government and the central bank seems to be nothing new. It is nothing more than printing money to solve the problem, and the scale is getting bigger every time. Will such an operation trigger a higher price level or even hyperinflation? Will it cause systemic risks? The limited supply of Bitcoin is very special in this context, providing an effective hedge to deal with investment risks caused by the government’s abuse of currency. From the data of the past three years, Bitcoin price does have a negative correlation with the value of the U.S. dollar, showing that when the U.S. dollar depreciates, Bitcoin can provide a certain hedging function.

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In addition to the value of inflation hedges, Bitcoin also provides the value of cross-border payments and capital transfers. If more people and institutions accept Bitcoin, then we may achieve zero-cost cross-border payments and transfers, and a disruptive revolution to the global banking system. The prospect of this use alone is enough to make Bitcoin a hot asset. Since Bitcoin is not a stock or a bond, in a diversified and diversified investment portfolio, Bitcoin can reduce the volatility of the investment portfolio and increase the Sharpe ratio of the investment portfolio.

In fact, Bitcoin has indeed been favored by some institutions and companies and has become their investment target. For example, BlackRock, the world’s largest asset management fund group at present, announced in 2020 that its three public funds will include Bitcoin in the investment scope. MassMutual of the United States bought Bitcoin worth $100 million in 2020. In January 2021, Tesla purchased $1.5 billion worth of Bitcoin and announced that it would accept Bitcoin as a payment for its electric cars.

Having said that Bitcoin can be accepted as an investment asset, let’s talk about the objection.

The biggest objection is actually similar to the one against gold becoming an investment asset, that is, Bitcoin itself does not generate cash flow, so it cannot be valued by traditional financial methods. Assets such as stocks, bonds, and real estate all generate cash flow, including corporate free cash flow, dividends, interest and rent. Based on these cash flows and capital costs, we can make a reasonable valuation for them and calculate their intrinsic value. But should a bitcoin be worth 10 dollars, 10,000 dollars, or 500,000 dollars? Reasonable value seems to depend entirely on market supply and demand and sentiment. This is precisely the difference between speculation and investment: without the support of fundamentals, the price of assets is determined solely by market sentiment, which looks more like speculation than investment.

In 2018, the price of Bitcoin fell from around 18 thousand to 3,000 USD, a drop of more than 80% of its market value. In January 2021, the price of Bitcoin fell by more than 30% in just one month. Have the fundamentals of Bitcoin changed so much in a month? I’m afraid not. So why does its price fluctuate so sharply in a short period of time? It may only be explained by speculative changes in market sentiment.

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If we look back at the price changes of Bitcoin, we will find that it has not played the role of spreading risk that everyone expected. For example, in the fourth quarter of 2018, global stock markets fell, and the S&P 500 index fell by about 14%. During the same period, Bitcoin’s decline was even greater, falling by about 44%. In the first quarter of 2020, the S&P 500 index retreated about 34% due to the new crown epidemic, while Bitcoin fell by about 38% during the same period. A good asset that can diversify risks is best kept from falling when the stock market falls, or even rising in price. But Bitcoin does not provide such value convincingly.

Another reason for opposing investment in Bitcoin mainly stems from the attitudes of governments around the world. As I mentioned above, one of the values ​​of Bitcoin is that it can realize free cross-border payments and capital transfers. But the prerequisite for realizing this value is that governments allow Bitcoin to grow and be accepted by more and more merchants, institutions and banks. At least so far, there is no sign that Bitcoin will be recognized by mainstream governments and financial institutions. This also increases the transaction cost of Bitcoin. Whether you want to buy or sell bitcoins or invest in bitcoin funds, you have to pay relatively high transaction and friction costs, and bear certain credit risks. These factors are enough to make investors think twice before buying bitcoin on a large scale.

So after comparing support and opposition, what attitude should we hold toward Bitcoin?

We might as well use the data to analyze. Research (Arnott, 2021) shows that in the past 10 years, Bitcoin’s return is much better than that of stocks, but its price volatility is also very large, with a maximum drawdown of 82%. In other words, if an investor buys 100 yuan of bitcoin, in the most extreme case, the market value of the bitcoin on hand is only 18 yuan. Due to the high volatility of Bitcoin prices, even if only a small amount of Bitcoin is purchased, it will greatly increase the volatility and drawdown of the investment portfolio.

If you replace 1% of Bitcoin in a pure stock portfolio, then the investment portfolio containing 1% of Bitcoin will increase the annual investment return by about 7.3%, but at the same time the maximum drawdown will increase to about 33%. If you replace 5% of stocks with Bitcoin in your portfolio, the annual return will increase by about 30%, but the maximum drawdown will also increase to 62%. And if you replace 10% of the stocks with Bitcoin in your portfolio, the maximum drawdown will increase to 71% while the annual return increases by about 50%.

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Here, we can see a clear trade-off relationship: If you want to increase the return of your investment portfolio through Bitcoin, you have to accept higher risks. Even if only a small amount of Bitcoin is included in the investment portfolio, the market value fluctuation of the entire investment portfolio will depend on the rise and fall of the price of Bitcoin. For most individual investors, such a rise or fall is obviously too great to be accepted calmly.

In summary, Bitcoin has achieved amazing price increases in the past ten years. Bitcoin has a certain hedging value against the depreciation of the U.S. dollar and inflation risks, but it does not produce endogenous cash flow, price fluctuations are highly speculative, and the government and financial institutions have an ambiguous attitude towards it. These factors limit Bitcoin. The investment properties of the currency and the future price increase space. Because the price of Bitcoin fluctuates too much, individual investors should invest with caution. If you really want to include Bitcoin in your investment portfolio, its allocation ratio should also be controlled at a relatively low level to ensure that the risk and drawdown of the investment portfolio are within an acceptable range.

Author/ Translator: Jamie Kim
Bio: Jamie Kim is a technology journalist. Raised in Hong Kong and always vocal at heart. She aims to share her expertise with the readers at Kim is a Bitcoin maximalist who believes with unwavering conviction that Bitcoin is the only cryptocurrency – in fact, currency – worth caring about.