Weekly Market Compass: Investors of all sizes are wondering whether cryptocurrencies are right for them. These considerations can help guide your decision.
It’s about that time again – time to write another blog about cryptocurrencies. Not surprisingly, I received a deluge of client questions on cryptos last week given the Coinbase IPO and the record highs bitcoin reached earlier in the week (followed by the steep pullback in prices over the weekend).
Of course, the most common question I get is, “Should my portfolio have an allocation to bitcoin?” This is not dissimilar to the questions I got back in late 2017 when bitcoin was on a tear and there was a lot of media coverage of it. However, what’s different this time is that not only retail investors are asking me these questions but so are institutional investors.
The critical question about cryptos
When considering the inclusion of any asset class in one’s portfolio, we must ask the simple question: What will this asset bring to the portfolio? For an alternative asset class — investments beyond traditional stocks and bonds — usually the primary goal is diversification.
Historically, bitcoin has had a low correlation with traditional asset classes such as the S&P 500 Index. For example, from Jan. 1, 2011 through March 31, 2021, the correlation between bitcoin and the S&P 500 was 0.15.1 However, as bitcoin has become increasingly popular, that correlation has increased, hitting a much higher 0.66 for the period of Jan. 1, 2020 through March 31, 2021.1 This suggests that bitcoin may no longer offer as much in the way of diversification benefits as it previously did. However, that does not mean that other cryptocurrencies will not offer diversification benefits.
Of course, capital appreciation potential can be an important goal as well, and bitcoin has had a meteoric rise from just $314.50 USD on Jan. 2, 2015, to a new high of more than $64,000 USD early last week.2 And bitcoin could potentially move far higher if more retail and institutional investors choose to include it in their portfolios. However, it has also experienced extreme volatility and major drawdowns, as evidenced by the significant drop it experienced last week — after hitting that all-time high, it quickly fell to less than $54,000 USD.2
Potential investors need to recognize this risk/reward profile. Since 2011, bitcoin has spent 93.6% of days trading beneath its highs.1 This compares favourably to gold, which over the same time period spent 98.4% of days trading beneath its highs, and compares unfavourably to the S&P 500 Index, which spent 86.6% of days trading beneath its highs.1 But importantly, on days when bitcoin was beneath its highs, it was trading on average 53.5% below its highs.1 By contrast, when gold was trading beneath its highs, it traded on average 25.6% below its highs, and for the S&P 500, that number was 3.8%.1 In other words, when bitcoin prices fall, they tend to fall hard. Other cryptocurrencies have also had strong price appreciation – and have been similarly volatile with substantial drawdowns. In other words, cryptocurrencies have historically offered significant reward and significant risk.
Other reasons for wanting to own alternative asset classes may include the ability to hedge inflation and the ability to hedge geopolitical risk. For example, some investors add gold to their portfolios in an attempt to hedge inflation, even though historically gold has only sometimes been an effective hedge against inflation. Because cryptocurrencies are relatively new, there is no long track record we can examine to determine whether any have historically offered these properties. It will remain to be seen if cryptocurrencies can provide hedges for such risks.
Four additional crypto considerations
Just a few other considerations investors should be aware of:
- Regulation. First of all, there is the potential for regulation of cryptocurrencies. Now that is not necessarily a bad thing. For example, regulation could increase confidence in investing in cryptocurrencies. However, it could also mean additional costs, which could depress the prices of cryptocurrencies. Moreover, extreme regulation could result in the shuttering of local crypto exchanges and a ban on the use of cryptocurrencies.
- The environment. Bitcoin is not the most environmentally friendly investment. Bitcoin averages around seven transactions per second, and each one requires a substantial amount of electricity: 951 KWh per transaction.3 I could envision some institutional investors coming under pressure from groups demanding divestment of environmentally unfriendly investments such as bitcoin. The good news is that other major cryptocurrencies use far less electricity.
- Competition. Other than being the first successful cryptocurrency and a pioneering invention coinciding with the birth of blockchain, there is not much that makes bitcoin special. Other cryptocurrencies share some similarities with bitcoin, and it may very well be possible that as bitcoin approaches its terminal supply amount, another cryptocurrency that is more technologically advanced and efficient takes its place. This perspective complicates the exercise of asserting a long-term value to bitcoin.
- Liquidity. Investors can be overwhelmed by the number of cryptocurrencies out there – it can be difficult choosing which ones to invest in. I suggest focusing on the largest cryptocurrencies given they are the most liquid: in addition to bitcoin, that includes ethereum, ripple, litecoin and perhaps a few others. However, investors should research the different attributes of each of these cryptocurrencies.
So, should bitcoin be in a portfolio?
And so for every client who asks me whether they should add bitcoin to their portfolio, I respond “it depends.” It depends on risk tolerance, investment goals and other factors. For those who believe cryptocurrencies are suitable for investment, I would urge them to consider a small allocation and to perhaps diversify among a number of major cryptocurrencies, since each has different characteristics. And I would favour diversification with other alternative asset classes such as gold and real estate. Regular rebalancing may also help investors to methodically take profits on upward price movements, and to take advantage of price swings lower, and active management should help as various cryptocurrencies rise and fall in investor popularity.
With contributions from Ashley Oerth, Investment Strategy Analyst
1 Sources: Bloomberg, L.P. and Invesco
2 Source: Coindesk
3 Source: XRP Ledger