July 24, 2019
In our previous post below we shared some investors’ views relating to crypto in the context of one’s portfolio. In short, many believed that crypto should be at least a small percentage of an investment portfolio - those views ranged from around 1% to as high as 20%.
While the obvious argument towards inclusion of crypto in one’s portfolio is for the potential upside, the less obvious benefit is overall risk reduction. This may seem counter-intuitive; after all, crypto’s price fluctuations are generally more volatile than those of traditional investments (i.e. equities and debt). If that’s the case, then why does adding crypto to one’s portfolio potentially lower the overall risk? The main reason is that crypto’s correlation with traditional assets has historically been quite low - see below for more detail.
According to Investopedia, "a perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all."
Imagine a hypothetical portfolio consisting of two equities, A and B. Let’s assume the correlation between these assets is exactly 1. One day, asset A decreases by 50%; given the perfect positive correlation, B will also decrease by 50%. Now let’s add a new crypto asset to the portfolio, asset C, with -1 correlation to both A and B. In the above example, while A and B decrease by 50%, C would have increased by 50% (given its perfectly negative correlation), increasing the return, and lowering the portfolio’s overall volatility.
In reality, it is rare to find assets that are perfectly positively or negatively correlated. So historically, what has BTC’s correlation been vs. traditional assets? According to Blockforce Capital, Bitcoin’s correlation with the S&P 500 from Jan 2015 through Oct 2018 did not exceed 0.25 (see image below). Interestingly, the correlation was negative for approximately one year in such time frame.
Similarly, according to The Block, Bitcoin’s correlation with the S&P 500 during January 1, 2017 through April 17, 2019 was 0.08, with EOS having an even lower correlation.
As you can see, by adding crypto to your portfolio, it may reduce overall volatility, and potentially increase returns.