The current issue of 178-year-old weekly magazine The Economist explains why having Bitcoin as part of an investment portfolio is “a Nobel prize-winning diversification strategy.”
In an article published earlier today, John O’Sullivan, who writes the Buttonwood column for The Economist, started by reminding us that economist Harry Markowitz had a paper published in the Journal of Finance in 1952, which enabled him to win (jointly with Merton H. Miller and William F. Sharpe) the 1990 Alfred Nobel Memorial Prize in Economic Sciences. According to the press release issued on 16 October 1990 by the Nobel Prize Organization, Markowitz was awarded the Prize for “having developed the theory of portfolio choice.”
According to O’Sullivan, in this paper, Markowitz had the following to say about diversification:
“Diversification is both observed and sensible; a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.“
The Economist columnist then went on to say that “modern portfolio theory” says that “a rational investor should maximise his or her returns relative to the risk (the volatility in returns) they are taking” and that “Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing returns.”
O’Sullivan says that Markowitz realized that “it was not necessarily an asset’s own riskiness that is important to an investor, so much as the contribution it makes to the volatility of the overall portfolio—and that is primarily a question of the correlation between all of the assets within it.”
He explains that you want to have asset classes in your investment portfolio that have the potential to provide high returns and which have little or no correlation to each other. For example, although stocks and real estate can yield juicy returns, unfortunately, they are also highly correlated to each other. In contrast, in the case of stocks and bonds, the correlation between them is “weak”, but sadly “but bonds have also tended to lag behind when it comes to returns.”
O’Sullivan then says that this is why Bitcoin is such a great portfolio diversification tool:
“The cryptocurrency might be highly volatile, but during its short life it also has had high average returns. Importantly, it also tends to move independently of other assets: since 2018 the correlation between bitcoin and stocks of all geographies has been between 0.2-0.3. Over longer time horizons it is even weaker. Its correlation with real estate and bonds is similarly weak. This makes it an excellent potential source of diversification...
“Across the four time periods during the past decade that Buttonwood randomly selected to test, an optimal portfolio contained a bitcoin allocation of 1-5%. This is not just because cryptocurrencies rocketed: even if one cherry-picks a particularly volatile couple of years for bitcoin, say January 2018 to December 2019 (when it fell steeply), a portfolio with a 1% allocation to bitcoin still displayed better risk-reward characteristics than one without it.“
The views and opinions expressed by the author, or any people mentioned in this article, are for informational purposes only, and they do not constitute financial, investment, or other advice. Investing in or trading cryptoassets comes with a risk of financial loss.