Bitcoin’s high volatility is often interpreted as an unreasonable risk to traditional investors and it has been one of the key issues preventing established investment firms from considering it as a consistent investment vehicle. However, volatility is one of the primary reasons Bitcoin is able to generate phenomenal gains to investors.
Bitcoin was the best performing asset of the decade according to a recent report by Cointelegraph and earlier this week Morgan Creek Capital CEO, Mark Yusko, said that every investment portfolio should have a minimum 1% Bitcoin allocation.
Yusko made the comments during an interview with Max Keiser on the Keiser Report, published on Jan. 30. Keiser also noted that portfolios with a 1% allocation to Bitcoin have also outperformed nearly all other investments of the past five years.
Over the past 6 years, due to its volatile nature, many investors have taken advantage of Bitcoin’s wide price movements. Hence, it has been suggested that a diversified crypto portfolio doesn’t offer the advantages that an investor could expect from the application of traditional diversification principles.
Nevertheless, we’ll look further into the matter and for those looking to take advantage of Bitcoin’s behavior without exposing themselves to the risk presented by its volatility we will analyze how several investment baskets composed of Bitcoin and traditional assets such as stock indices and treasuries perform.
Defining diversified investment baskets
To determine whether diversified crypto portfolios provide a return that is above the average produced by traditional markets but also does not expose investors to untenable levels of risk, we have analyzed the diversification power of traditional stocks indexes (S&P 500 and Nasdaq Composite), and the Treasury Bill (10 Year Government Bond) in comparison to investing only in Bitcoin or in a Bitcoin-indexed trust like the Grayscale Bitcoin Trust (GBTC).
We defined the following investment baskets:
Basket Nº1: 50% of Bitcoin and S&P 500;
Basket Nº2: 50% of Bitcoin and Nasdaq;
Basket Nº3: 50% of Bitcoin and T-Bill;
Basket Nº4: 33% of each Index (S&P500 and Nasdaq) and 33% of Bitcoin;
Basket Nº5: 33% of Bitcoin, S&P500 and T-Bill;
Basket Nº6: 33% of Bitcoin, Nasdaq and T-Bill;
Basket Nº7: 25% of each asset (BTC, S&P500, Nasdaq and T-Bill).
Analyzing the period from Jan. 2017 until Dec. 2019, Bitcoin alone offered the best cumulative return (293%) from all the investment options. The asset was followed by a 270% gain from the Grayscale Bitcoin Trust.
From a risk-adjusted perspective, Bitcoin shows a 0.98 ratio and Grayscale a 0.67 Shape ratio – considered low values – meaning investors are taking up too much risk for the return they get from investing in these two assets.
January 2017-December 2019 Cumulative Return for Bitcoin and Grayscale Bitcoin Trust
These two assets will be used as the reference investment options when comparing the performance of the diversified investment baskets.
Diversification basket performance
Looking at the cumulative returns for each basket, we conclude that basket Nº2 (composed of 50% Bitcoin and 50% Nasdaq Composite) offers the best investment option (222%) for the sample period. This was followed by basket Nº1 which was composed of 50% Bitcoin and 50% S&P 500.
The third best option consists of investing 33% in each stock index (S&P 500 and Nasdaq Composite) and 33% in Bitcoin (basket Nº4), resulting in a 192% cumulative return. From a purely return-based point of view, all the diversified options give investors a worse performing strategy than investing solely in Bitcoin or Grayscale’s GBTC security.
Interestingly, the worst cumulative returns from the baskets is the one with more diversification (basket Nº7). This basked consisted of 25% of each asset (BTC, S&P500, Nasdaq and T-Bill) and provided a 164% return.
We could be tempted to reconfirm previous reports citing the lack of value in diversified crypto investing, but in order to reach that conclusion, one would need to analyze the risk-adjusted performance using the Sharpe ratio. This would allow an investor to comply with its risk aversion level.
The data shows that 5 out of the 7 available diversified baskets offer a better risk-adjusted performance than investing in either Bitcoin or Grayscale’s (GBTC) trust. Moreover, the best option is provided by basket Nº4 which has a 1.32 Sharpe ratio and consists of investing 33% in each index and the remaining 33% in Bitcoin. The options consisting of 50% Bitcoin and 50% of the other stock indexes offer also acceptable Sharpe ratios at 1.20 and 1.14.
Diversification power for investors
It is worthwhile mentioning that in order to develop this analysis, weekends and holiday returns were taken out of the sample in order to construct diversified portfolios as stock indexes are not traded during those days, unlike the cryptocurrency market which is always open.
Despite that adjustment, this analysis shows the benefits of applying traditional diversification principles into the crypto space.
Looking forward, investors have the chance to take advantage of high-gain assets like Bitcoin and offset their risk exposure by investing in traditional stock indexes to generate superior performance.