Research Analyst at Amberdata
We're wrapping up the first month of the new year and Bitcoin's YTD performance is up +20%, along with a +287% increase since the past 6 months when institutional movement started to kick off. Although Bitcoin has suffered a minor Black Monday reaching a low of almost $30,000, reports show Bitcoin whales have been buying the dip which helped the digital asset from suffering further losses. For any new investors, they might think of buying the dip but when the dip occurs, some tend to be greedy waiting for a further drop or have doubts about future performance and don’t invest at all. Now that bitcoin prices are substantially higher you’re wondering if it’s worth adding a few coins or even as little as $100 to your liquid portfolio for the long term(Investing Bitcoin at its highest spot price in 2019 would result in a +214% return on investment today).
Although it's nothing more than a theory, modern portfolio theory states that it's possible to design an ideal portfolio with optimal risk through diversification to avoid unsystematic risk. With the addition of digital assets into a modern portfolio filled with traditional stocks and bonds, there may be significant returns that might catch one's attention.
Now that several large institutions and prominent investors and executives have taken a second look at the exploding digital asset space, public adoption is slowly, but surely rising. Nonetheless, there are still conflicting opinions about whether or not bitcoin really has value and can it replace gold.
A statement made by Eric Peters, CIO of One River Asset Management, points out the power of collective faith and how people in agreement can create value out of anything. "Money is not real. It never has been. It never will be. It is our collective faith in the meaning of money that gives it value. Not even gold is real as a form of money. But for thousands of years, people have had collective faith in the useless yellow metal as a store of value, and at times, a medium of exchange. Naturally, something else equally useless could have served the purpose. But gold is scarce and for reasons we may never fully understand, we placed our collective faith in it." Gold has been around for centuries and so it is fair to say that collective faith in precious metals is far more stable than emerging digital assets. But as technology advances and both public and institutional adoption rises, digital assets could very well compete with modern day assets and commodities.
It would be foolish (but lucky during this time) to think digital assets should be the primary source for capital gains. Instead, we should be looking at these assets as alternative investments that can be added to diversify risk and reduce exposure to one’s investment portfolio. Investors must acknowledge limitations such as reduced liquidity, accessibility and high fees to benefit from increased returns and diversification on alternative investments like real-estate and artwork. If we look at Bitcoin as an alternative investment for portfolios, we know that liquidity is not a problem as digital assets trade 24 hours of the day with little to no barrier to entry for anybody unless they have to comply with KYC(Know Your Customer) guidelines. Rebalancing, short-term strategies, and unanticipated liquidity needs are present with trading Bitcoin.
Bitcoin as an alternative investment is accessible to anybody who has internet connection and a digital wallet to store digital assets. Other alternative investments such as real estate puts investors at a disadvantage based on an individual's profile and credentials which implies they aren’t accessible to anybody and not as many investors. Using the example of an alternative investment like real estate, there are additional fees with managing the property, commission fees, and other factors for maintenance. With Bitcoin, the only fee required is the cost of trade and cost to hold your asset in a custodial wallet on CEX (Central Exchange) platforms such as Bitfinex, Binance, and Coinbase to name a few.
A typical well-balanced investment portfolio allocates assets and bonds in a 60/40 ratio, respectively. Historically, stocks have a higher rate of return than bonds. A portfolio that allocates more stocks than bonds allows investment returns on bonds to serve as a hedge against potential exposure that comes with investing in stocks that return higher rewards for higher risk.
An article published on Forbes used Vanguard's data on historical risk and return of several portfolios showing average yearly returns over 90+ years. A portfolio that consists of 100% bonds showed an average yearly return of 5.3% while a portfolio with 100% stocks showed an average yearly return of 10.1%. Take note that the data collected includes the stock market crash of 1929 where returns fell by 43.1% in a 100% stock portfolio. The stock portfolio lost value in 26 of the 90+ years while the bond portfolio lost value in 14 different years. This indicates stocks are much more volatile and if there was a 50/50 allocation of bonds and stocks to the portfolio, there would be less exposure to risk.
The 60/40 rule has been useful in the past few decades and is still considered a good reference for investing but there are critics like Bob Rice, Chief investment strategist of Tangent Capital, who states that 60/40 is not as viable and investors need to seek other options. He states that stocks and bonds cannot cover the whole spectrum of providing income, growth, inflation protection, and downside protection. Instead, he has suggested other alternatives such as private equities, venture capital, hedge funds, timber, collectibles, and precious metals. Something is missing from this list and its digital assets.
Early last year, Bitwise Asset Management published a paper on bitcoin allocation to traditional diversified 60/40 portfolios of stocks and bonds. The study was conducted over a 6 year period from January 1, 2014 to March 31, 2020 and all Bitcoin allocated portfolios include quarterly rebalancing. A traditional 60/40 portfolio showed a return of 26.2%. A traditional portfolio with a 1% Bitcoin allocation showed an increase of ~8% cumulative return compared to a portfolio without any digital assets. With more bitcoin allocation there is an upward trend in returns with the study showing a 5% Bitcoin allocation showing a 65% cumulative return in investment.
Another study was done to show the effect of different bitcoin allocation rebalancing strategies. Where there was yearly, quarterly, monthly, or even no rebalancing strategy used, all Bitcoin allocated portfolios showed greater cumulative returns compared to a traditional 60/40 portfolio. An almost miniscule portion of bitcoin allocation in a portfolio shows superior cumulative returns for an investor.
The rise of digital assets have only begun so there is still more research needed than simply looking at hypothetical graphs and charts of what could and should be the next option of alternative investments such as Bitcoin for allocation in an individual’s portfolio.
Bitcoin was currently trading around $12,742.17 when PayPal announced crypto trading services. Investors would have a staggering +174% return on investment without any rebalancing from the start of institutional movement. Investing a small amount now may very well result in larger returns than your stock portfolio in the near future. Seeing prices violently jump up and down every second indefinitely causes doubt on whether to invest in the digital asset but it is inevitable until global adoption is achieved and utility of the digital asset is proven during rough economic periods.
The information above is not to be used as financial advice but rather supplement curiosity in understanding the potential impact of emerging alternative investments.
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