As Bitcoin experiences its next major bearish movement, it’s important to familiarize yourself with the major risks of investing in it. Though it’s still early for crypto’s leading asset, recent research such as Joel Coverdale, CFA’s “Bitcoin: An Asset Allocation Primer” and Coinshares’, “Volatility: The Price of Opportunity,” serve as excellent frameworks for setting the scene for future risk models related to Bitcoin in portfolios of all shapes and sizes. Below, you’ll find our thoughts on both of those reports and exactly how they do so. Consequently, if you’re interested in sticking to the forefront of how to position your portfolio with Bitcoin, read on!
Setting the Scene: How to Best Understand Bitcoin’s Inherent Risks
In January, when Joel Coverdale, CFA, published “Bitcoin: An Asset Allocation Primer,” the above number represented Bitcoin’s current volatility. However, when we consider the fact that it has reached up to 200% volatility over the course of its history, it’s easier to put its’ present volatility into context. As Coverdale states, given 9 years of data, 60% puts Bitcoin’s price dispersion “in the 20th percentile” over the course of that time period. In short, if we zoom out to a multi-year time horizon, Bitcoin’s historically extreme price movements have actually been smoothing out.
What appears even more compelling, however, is the historical movement of its’ “volatility of volatility.” If you’re not familiar with what that means, just imagine a measure of how extreme the changes in an asset’s average returns are (how extreme an asset’s volatility is % wise). So, if an asset averages 8% price movement in a month, either upward or downward, then 30% the next month, it can easily be said to have high volatility of volatility. Bitcoin’s volatility of volatility is particularly significant because it sheds further light on the question of whether or not Bitcoin’s price movements have truly been smoothing out over time.
Looking at the above data, it’s easy to see that while Bitcoin’s overall average volatility seems to have been in a long-term downtrend, its’ volatility of volatility continues to outpace that of all other major asset classes, as measured by gold, US Treasury bonds(TLT), and the S&P500 index(SPX). In fact, at the close of 2020, Bitcoin’s volatility of volatility reached its’ highest level to date. To the average investor, what that meant is though Bitcoin’s overall average volatility was at its’ lowest point in years at the end of 2020, its’ volatility of volatility during the same period indicates that it was still at risk for far more significant price swings than any other major asset in existence.
On the other hand, if we zoom out to last year as a whole, we can see that it became more in line with the volatility of the S&P500 than it ever has been, which could indicate a growing connection between the two in terms of risk. Still, to truly tell whether this is occurring, it’s important to dig further into the numbers, i.e., the actual, overall correlations between Bitcoin and the same assets as mentioned above.
Correlations and Bitcoin’s Risk/Return Profile
Last year, we examined Bitcoin’s correlations with stocks, gold, and bonds and concluded that 2020 marked the first year that Bitcoin was demonstrating true promise as a safe haven. If you consider the fact that in 2020, crypto’s leading asset was beginning to trend towards being negatively correlated with stocks and gold, while providing far more yield (as measured by ROI) than bonds, then it’s easy to see why we drew that conclusion. To bring this case forward even further, let’s continue with the data below, which expands upon Bitcoin’s correlations, both in the types of assets and the length of time measured.
Using this table from Coverdale’s report, it’s easy to put together a fuller picture of Bitcoin’s current place in a portfolio. Judging by the fact that all of its’ major correlations are nearly at zero, it’s easy to see the argument for Bitcoin being a non-correlated asset, with less systemic risk than almost anything else since it also doesn’t historically track the S&P500, for example, to any meaningful extent. Of course, in saying so, we have to address the fact that Bitcoin fell in near-lockstep with other markets during the March 2020 crash. Truthfully, however, the consensus amongst industry experts is that this was an outlier or “black swan event,” caused by an overall flight to liquidity amidst fears of COVID-19’s effect on all markets.
In other words, the general agreement is that the cause of March’s crash was all sorts of investors from all sorts of backgrounds, exiting to cash. In future analytically-focused posts, we’ll dig further into the development of Bitcoin’s correlations and possible status as a reliable diversifier with respect to them.
For now, however, if you understand that market data indicates that Bitcoin is a non-correlated asset with significant promise as a safe haven, then you’re in good stead to move on with us to how it fits into a traditional portfolio.
How does Bitcoin fit into a traditional portfolio?
As you may remember, we believe that market data and aggregated industry opinion suggest that Bitcoin’s developing value is two-fold. First, it’s becoming a revolutionary store of value when measured over a multi-year time-horizon. Next, it’s making a case for being a mainstay as a safe haven or “diversifier” for all portfolios. Since the crux of Coverdale’s further analysis lies in the former value proposition, we’ll focus the rest of our analysis on the same.
After introducing Bitcoin’s correlations with other assets and analyzing them, Coverdale went on to share the data he’d gleaned from 4 simulated portfolios, three of which held 5% Bitcoin, while one served as the “base portfolio” with none at all. Below, you can see the specific allocations of said portfolios mapped out.
As shown in the above data, of the three portfolios that held Bitcoin, one used it as a substitute for currency, while another subtracted a bit of each asset class to allow for 5% Bitcoin, and the final simply had 5% less equity. In every case, stocks and bonds were kept as the highest weighted asset classes and in all but one portfolio, commodities were kept equally weighted with Bitcoin.
Through backtesting each of the above portfolios(using 6-year historical data to test their theoretical performance), several important discoveries were made, starting with what effect their respective weights would have had on their yearly returns.
First, a might be expected, during Bitcoin’s worst years (2014+2018), it fell behind Coverdale’s benchmark portfolio in terms of ROI. In every other case, however, a 5% allocation to Bitcoin resulted in better overall portfolio performance. In particular, the results from 2019–2020 appear to be the most telling. During that time, Bitcoin-weighted portfolios outperformed the base portfolio by 2x or more, without the influence of a speculative bubble such as 2017.
Using the data he generated, Coverdale concluded that a 5% allocation to Bitcoin appears to be advisable. It’s important to understand, however, that the heart of his argument for it relates not to the ROI it generates but the easily definable loss versus said ROI.
According to his findings, if a portfolio with 5% Bitcoin is regularly rebalanced, the downside risk will always only be a complete 5% loss, which is bolstered by the fact that Bitcoin’s correlations with all other assets are near-zero. On the other hand, its’ upside is far more significant, judging by the annual ROI it helps generate and other measures that we’ll touch on below.
Before we get there, however, let’s pause for a moment.
Just as we’ve previously discussed, as long as demand for Bitcoin continues to ramp up over the years, there’s a strong argument for Bitcoin’s value to reach progressively more impressive new heights. Even so, no one can ever reliably say what those new heights will be because there’s never been a truly decentralized, provably scarce store of value that can be traded 24/7 before.
Therefore, with Bitcoin, risk models are currently being developed on-the-go. Because of that and the fact that Bitcoin’s still in a prolonged bull market, it’s never been more important to familiarize yourself with anything and everything that could go wrong and how to effectively plan for it.
How would these portfolios perform in a future black-swan event?
With all of Bitcoin’s potential in mind, it’s also imperative that we consider how the same Bitcoin-weighted portfolios would perform in a future event like the March 2020 crash. With this idea, in mind, we can add a particular ratio into the mix that raises a further microscope to Bitcoin’s true risk.
What is that ratio, you might ask?
The Sortino Ratio.
Fundamentally, the Sortino ratio is the Sharpe ratio, with a twist. If you’re not familiar with the Sharpe Ratio, head here for a quick primer. If you are, imagine a version of the Sharpe Ratio that doesn’t consider price appreciation as a risk. Using the argument that the Sharpe Ratio doesn’t differentiate between price appreciation and price depreciation, Coverdale introduces the Sortino ratio as a better alternative.
To understand how it works, it’s important to start with the difference that splitting up volatility can make.
Historically, Bitcoin’s annual upside volatility, or upward price movement, outperforms its’ annual downside volatility or downward price movement. When the effect of annual upside volatility on Bitcoin’s overall perceived risk is taken out of the equation, we are left with only the annual downside volatility. Let’s say we wanted to measure Bitcoin’s risk from October 2015-February 2021 to set a benchmark for our future risk models. Then, we’d be left with only 54.5% as a measure of Bitcoin’s overall risk, instead of the much higher 124.1% (if the risk is understood as aggregated average annual volatility).
So, how does the Sortino Ratio use an asset’s downside volatility?
The best way to understand the Sortino ratio uses volatility to measure risk vs. returns is to look at its’ usage in practice. Recently, CoinShares published a report on the effect of a 4% allocation to Bitcoin from October 2015 to this month (a 5+ year time-horizon). What they found is particularly illuminating related to how the Sortino ratio works, why it’s a better measure of risk, and how its’ usage could help to determine the ideal allocation of Bitcoin in any portfolio.
As you can see above, a mere 4% allocation to Bitcoin more than doubles the risk-adjusted returns of a portfolio, when the Sortino ratio is used instead of the Sharpe ratio. To put it simply, this is because the misleading effect of extreme price appreciation is taken out of the equation.
Furthermore, as long as regular rebalancing is done (monthly or quarterly), it appears that the adverse effect of Bitcoin on a portfolio’s overall volatility remains minimal. Here, by rebalancing, the CoinShares’ team seems to be referring to making sure that no matter how much Bitcoin’s value grows relative to other assets, it’s always kept at only 4% of the portfolio’s total value.
Where does all of this leave us?
Because Bitcoin may be understood as an uncorrelated asset with consistently high volatility, for now, institutional investors agree that a low allocation to it is best. Whether that’s 1%, 4%, 5%, or something else entirely is where opinions begin to vary.
Overall, it’s best to consider these findings as a starting point for measuring Bitcoin’s risk, and not in any sense, a completely reliable framework. Generally, there isn’t a widely accepted model that exists yet. Even so, through applying the information you’ve learned here, we hope you’ll find it easier to work at creating your own framework and testing it in practice.
If there’s one further conclusion to be drawn from Coverdale’s research, it’s that institutions may already be putting his findings to work. Square Inc.’s recent purchase of $170 million in Bitcoin lends a bit of weight towards this possibility since it increased their Bitcoin allocation to 5% of their corporate portfolio as Coverdale’s data suggests could be done. Moreover, the involvement of Raoul Pal in spreading Coverdale’s report, speaks volumes to the potential of future institutions following suit, at least in the hedge-fund and macro-investing spaces. Therefore, as everything we’ve discussed above plays out over the long term, you can expect this series on risk modeling with regard to Bitcoin to continue.
This text is intended to inform and is not an investment recommendation.
September 22, 2022