On Bitcoin, Risk, and Portfolio Allocation
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Bitcoin recently hit new highs after the Securities and Exchange Commission approved various spot Bitcoin exchange traded funds (ETFs). Now wealth managers have the option to include Bitcoin exposure in portfolios alongside financial securities.
Generally, I am skeptical of Bitcoin as an investment because after more than 15 years into its development, the technology has yet to demonstrate a viable use case. Bitcoin is rarely used in transactions with merchants, which leads me to question its utility as an alternative to traditional fiat currencies.
Absent any adoption as a medium of exchange, I view Bitcoin as having no intrinsic value, which differentiates it from other risk assets such as stocks, bonds, leveraged loans, options, or venture investments. Nonetheless, with a market capitalization of over $1 trillion, Bitcoin has established itself as a store of value, and as a vehicle for trading and speculation.
Following the approval of Bitcoin ETFs, I’ve had conversations with clients interested in adding Bitcoin exposure to their managed portfolio. While I will not be proactively recommending Bitcoin as an investment, my general advice regarding crypto investments is the same as it’s ever been: size risk appropriately, limit exposure to less than 5% of total assets, and do not invest more than you’re willing to lose.
Bitcoin is significantly more volatile when compared to stocks, bonds, and other publicly-traded financial assets. As shown in the graph below, Bitcoin has experienced three drawdowns in excess of 70% over the last ten years, compared to a maximum drawdown of 34% for the S&P 500 and 21% for a 60% stock/40% bond portfolio during the same timeframe.
Drawdowns of Bitcoin, the S&P 500, and the 60/40 Portfolio
Moreover, the cryptocurrency market has unique risks when compared to regulated financial markets. Blackrock touched on these risks in its recent prospectus, in which it pointed out that the opaque nature of the digital asset market “gives rise to an increased risk of manipulation and fraud, including the potential for Ponzi schemes, bucket shops and pump and dump schemes.”
A recent Morningstar study examined the impact of adding Bitcoin to a traditional 60/40 portfolio. As shown in the graph below, a 5% allocation to Bitcoin would meaningfully increase overall volatility as measured by standard deviation, and according to Morningstar would account for nearly 45% of portfolio volatility.
Portfolio Standard Deviation Based on Various Allocations
Source: Morningstar Research
However, my sense is that with ongoing portfolio management, risk can be mitigated. A recent Bitwise report suggests that overall portfolio volatility nearly doubles when adding a 2.5% allocation to Bitcoin in a 60/40 portfolio; however, almost all of this incremental risk can be reduced by rebalancing at regular intervals.
As your investment advisor, my goal is to help you grow your wealth, while managing risk to a level that is appropriate based on several unique factors, including your personality, financial goals, and comfort with volatility. If you're interested in holding Bitcoin, either through ETFs or in a separately managed account, I recommend that we have discussion regarding the impact of Bitcoin on overall portfolio returns and volatility, and the various paths for mitigating risk.
Please reach out anytime to discuss your positions in crypto assets and how we can evaluate them in the context of your overall portfolio allocation.
Best,
Peter Hughes, CFA, CEPA®