As cryptocurrency is reaching more adoption and utilization as a method of payment, some people are left wondering how to invest or obtain this wild new and fascinating asset. We will focus on Bitcoin in this review because it is the dominant cryptocurrency with the most established and secure network for making transactions. Bitcoin is the digital equivalent of gold and can be considered as a store of value. There are mining operations that are established to mine the coin which are more cost efficient and safe than your traditional gold mining operations. For this reason we think it is comparable to gold but in a digital format.
Comparably, when we observe bitcoin returns and price fluctuations over a longer term horizon, we see that historically they have been uncorrelated with other more traditional asset classes.
Source: Morningstar Data
Considering the very low correlation coefficient, this makes it a lucrative option to include into portfolio diversification strategies. Bitcoin is still a pioneer in the digital currency space, and for that reason we consider it as a speculative investment class with higher than average volatility.
When considering how to allocate your portfolio to include Bitcoin as an option, we can use the methods of Modern Portfolio theory to maximize portfolio returns in accordance with the risk tolerance of an individual or organization. We can run simulations using the expected return and annualized volatility of our asset classes to understand what is the optimal allocation to a portfolio when incorporating BTC. For example, a company holding bonds and equities like the SPX can be assessed in incremental additions of BTC to find the optimal Sharpe Ratio. Here is an illustration of incorporating BTC with equities and bonds, but this exercise can be extended to a portfolio of any amount of asset classes assuming you have historical performance.
Modern Portfolio Theory has it’s own limitations, but is an incredibly useful tool to help optimize your particular portfolio for the inclusion of BTC to maximize returns. I only illustrate the simple concepts here, but a portfolio management strategy can be set by allowing the historical returns to update and find the best parameters as the market conditions evolve.
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