Can Bitcoin Diversify Risks in Investment Portfolios?

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All those acquainted with investing probably known one of its basic pearls of wisdom:” Don’t put all your eggs in the same basket.” In this article, we will discuss how Bitcoin can diversify risks and why.

This old wisdom is a reference to diversifying investment portfolio risks. Much research has been done in the fields of stock markets, bonds as well as currencies, and raw materials. Traditional stock market investors recognize very well the benefits of diversification and its studies.

However, many do not know that Bitcoin’s diversifying benefits have been studied (e.g., Lehner, Carter ja Ziegler, 2018). This article will address the result of these researches.

What is portfolio diversification?

If an investor’s portfolio includes, for instance, the stocks of two listed companies from the same industry, such a portfolio cannot be regarded as remarkably diversified. This is because the industry’s problems would impact both companies, and the investor’s whole portfolio may suffer heavy losses. A good example is the restaurant and tourism business in 2020, which faced significant problems for an unexpected and surprising reason.

If the investor’s portfolio, in turn, would comprise of over 10 stocks from different sectors, whose business cycles and profits do not correlate, Then, in terms of diversity, we may consider such a portfolio to have a lower risk. If the portfolio also had bonds and different utilities, whose profits do not correlate with stock markets, the portfolio would be even better diversified.

The idea behind diversification is generally that an investment portfolio containing several different instruments would produce more profit over a longer-term than one containing fewer instruments. At the same time, such diversification would also lower the portfolio’s total risks. Therefore, the downturn of one investment would not negatively impact the portfolio’s total result, but a balanced portfolio would generate even profits regardless of cycles. (Kajtazi & Moro, 2017).

how to diversify portfolio with bitcoin
Source: https://masterthecrypto.com/4-types-of-coins-to-diversify-your-crypto-portfolio-manage-risks/

Bitcoin as part of a diversified portfolio: Can Bitcoin diversify risks?

Guesmi, Saadi, Abid, and Ftiti (2018) have, in their studies, found that Bitcoin enables diversification benefits for investors. One significant reason they present for this is that since Bitcoin is not part of the traditional financial system, it is not dependent on its actors. This means an investor can gain diversification benefits to protect against crises of the traditional financial system.

Bouri, Molnár, Azzi, Roubaud, and Hagfors also highlight the possibility that Bitcoin can provide a shield against world economy risks (2017). Burniske and White (2017), in turn, observed that Bitcoin correlates very little with traditional financial instruments, such as stocks, currencies, gold, raw material indices, and inflation bonds, which further strengthens Bitcoin’s nature as an enabler of diversification benefits.

A common theme in almost all of these studies is the notion that Bitcoin has so far historically provided outstanding profits compared to its risks. The same conclusion is reached by Carpenter (2016) as well as Briere, Oosterlinck, and Szafarz (2015), in addition to Eisl, Gasser, and Weinmayer (2015).

Newest research: BTC as part of an investment portfolio

The topic has also been the subject of research in recent studies. Newest results confirm that Bitcoin still doesn’t correlate very strongly with stocks, currencies, gold, or raw material indices. This conclusion was also reached by, for instance, Morgan Stanley’s Shalett and Galindo (2021). CFA Institute of Research (2021) has also, in its own studies, observed the existence of similar diversification benefits provided by Bitcoin.

In this study by Morgan Stanley, the portfolio’s stock share was 60%, while bonds comprised 40%. After this, the 2.5% Bitcoin allocation was added to the portfolio. The following occurred: The portfolio’s absolute and risk-adjusted profit was improved in five years out of seven in a trial period of 2014-2020.

Interestingly, the portfolio’s annual profits improved by 164 basis points without notably raising its volatility. Also, Bitcoin’s downturn periods did not increase the portfolio’s risks.

Also, the Sharpe ratio depicting risk-profit relations rose a total of 41%, while the risk-adjusted capital gains rose to 0.48. Bitcoin-allocation in the portfolio had increased its profits by 15%.

In diversification, the central point is lowering the systematic market risk. According to studies, this has historically been possible by including bitcoins in the portfolio with a 1 – 2.5% allocation.

So, can Bitcoin diversify investment portfolio risks?

Since Bitcoin does not strongly correlate with other investment instruments, it means Bitcoin as part of an investment portfolio has enabled reaching diversification benefits.

In other words, profits related to risks have historically been lucrative when Bitcoin’s portfolio share has been between 1 – 2.5%.

The risks of investing in bitcoin

Despite obvious benefits, one must consider that research has also pointed out risks related to these investments. According to studies(Cheng 2018), Bitcoin’s high volatility compared to traditional investment instruments has raised portfolio risks in reviews.

While Bitcoin has not been observed to correlate strongly with traditional instruments over a more extended period, the asset has seen a powerful correlation over a shorter interval such as March 2020. This is an important thing to remember.

As for allocation, studies (Cheng 2018. p. 11-12) also confirm the risk has risen in situations where over 2% of the portfolio has been invested in Bitcoin. Additionally, not understanding Bitcoin as an investment target can also cause risks for portfolio management. This is worth remembering, particularly with regulation and taxation in mind.

Shalett and Galindo (2021, p. 7-8) also confirm the assumption that Bitcoin’s high volatility compared to traditional investment instruments raises the portfolio’s risk-measuring numbers.

As for profits, a 2.5% allocation to Bitcoin would, according to statistical parameters, be the maximal number allocated to Bitcoin.

The research also mentions Bitcoin’s energy consumption, centralization of ownership, industry regulation such as taxation, and political risks, among other factors worth noting.

Summary: Can Bitcoin diversify investment portfolio risks?

Diversification and Bitcoin are usually not parallel with each other. People see Diversification as a conservative investor’s procedure in which they can systematically minimize risks. We can consider Bitcoin as a coffee-table cryptocurrency, which represents more speculative quick gains and higher risks.

However, diversification is ultimately nothing more than spreading out portfolio risks, which we measure with different parameters. Therefore one should choose risk-minimizing instruments to one’s portfolio.  

Studies conclude that a Bitcoin portion of 1 – 2.5 % can bring diversification benefits to a portfolio. Bitcoin can therefore provide investors safety against market risks.

Nonetheless, it is worth noting that previous earnings are unlikely to replicate themselves in the future.

There is much more research to read about the subject. You can find additional material from the sources below.

Good luck on the markets, and hopefully, these tips were helpful!

This article does not present any investment recommendations, nor should it be interpreted as such. Gaining profits on the markets often requires deep-rooted knowledge and several years of experience.

The writer is a board member of cryptocurrency organization Konsensus Ry and has years of experience in different investment fields, including cryptocurrencies.

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