LENSELL EDUSeries: Episode 3 - Cryptocurrency

At LENSELL, our team strives to make financial literacy accessible to everyone so that you can make informed investment decisions and grow financially. In our last blog, Alpha & Beta, we discussed the two indicators that will help you understand portfolio performance and see how they can assist in making better informed investment decisions. This time, we will explore the question: Should you include Cryptocurrencies in your Portfolio?

Cryptocurrencies have taken the world by storm and as of today Bitcoin makes up 45% of the total value of cryptocurrencies in terms of market capitalization. Are the Aussies left behind or have they picked up on this exciting asset class? A Finder survey of 1,004 Australians conducted in January 2021 revealed that 1 in 4 people invest in or plan to invest in cryptocurrency. That's equivalent to 5 million digital currency investors. 

Cryptocurrencies can be used as a diversification tool to boost the potential return of your portfolio but it is only recommended if you understand the risk that comes with it. 

 

The issue of volatility

To keep things simple let's take the example of Bitcoin. If you glance through the price charts (see below) you will see that the popularity of Bitcoin kicked in during 2017 when the price went from $1,000 to almost $20,000 by the end of the year. That's a 2000% increase in only one year. When has an asset in your portfolio done that? 

Bitcoin price chart from Jan 2017 to December 2020. Source: CoinMarketCap

Bitcoin price chart from Jan 2017 to December 2020. Source: CoinMarketCap


Any reasonable investor would have understandably argued that that was a singular behavior that could not be repeated. However, in 2020 the price of Bitcoin went from $7,500 to $27,500 - a change of about 275% in a calendar year. So we can safely assume that exceptional growth may return at some point (it’s definitely possible as we see the current 52 week high of Bitcoin at USD 64,895). 

By now, you are probably calculating the return you could have made - but hang on, return is not everything you should consider.

What's the catch?

The problem comes with analysing and accepting the risk, or the downside involved while aiming for those incredible returns. After Bitcoin hit a high of $20,000 in 2017, it saw a low of $3,600 by the end of 2018 which is a fall of almost 80% - imagine the psychological impact of that change on the investors. 

How do you move ahead with this analysis?

The bitcoin volatility time series chart shows us the standard deviation in daily returns of Bitcoin from 16th August’10 to 15th June’21. Built with highcharts.comThe bitcoin volatility time series chart shows us the standard deviation in daily returns of Bitcoin from 16th August’10 to 15th June’21. Built with highcharts.com


Volatility is a measure of how much the price of a financial asset varies from the mean, over time. The figure above shows us the standard deviation of daily returns of Bitcoin (BTC) over the past decade. As it can be seen, at its highest the daily standard deviation was a whopping 14.4%.  To compare, the volatility of gold averages around 1.2% per day, while major currencies average between 0.5% and 1.0% per day. 

This highlights the importance of understanding the risk and impact on your portfolio beforehand. We show how Diversiview can help to do that, with a few examples, further down.

 

With all this volatility, does it make sense to diversify into cryptocurrency?

Other people (we mean, big players) invest in crypto, so why wouldn’t you?

“Smart money” is the name given to capital that is being controlled by institutional investors, market mavens, central banks, funds, and other financial professionals. Sometimes retail investors are able to make good returns when they follow the smart money flow.

In recent times we have seen a number of financial institutions and big banks getting involved in the cryptocurrency space. Some examples are:

  • Citibank: One of the most significant observations in their recent report (March 2021) regarding Bitcoin is that because an increasing number of businesses are accepting Bitcoin, it means that the flagship cryptocurrency is already breaking into the mainstream. The report also states that Bitcoin’s base is markedly different from 2017 when Bitcoin was trading almost exclusively as a retail asset; 
  • Morgan Stanley: In March 2021, the bank announced plans to offer its wealthier customers access to Bitcoin funds, with three choices on offer. This was no surprise because a March 2021 report by the bank asserted that cryptocurrencies are on the threshold of becoming an investable asset class.
  • Goldman Sachs: New York-headquartered Goldman Sachs, one of the oldest banking firms, is due to open a trading desk for cryptocurrencies in 2021 for Bitcoin futures, specifically, according to reports.
  • JP Morgan Chase: In December 2020, JP Morgan Chase strategists suggested that insurance companies and pension funds around the world could invest $600 billion in Bitcoin, following the example of MassMutual. 

These are just some examples of ‘smart money’ flowing into the cryptocurrency market.

It seems that cryptocurrencies like Bitcoin can be an amazing diversification asset class for your portfolio - with the condition that their impact is analysed correctly and accepted beforehand so there are no surprises.

 

How much crypto for diversification?

The key to reducing portfolio risk through diversification is to combine investments whose market returns do not move together and therefore are not positively correlated. The lower the correlation between the returns of the investments in your portfolio, the greater the benefit of diversification. This means the correlation between cryptocurrency and other portfolio securities has to be very low, zero or even negative for you to reap the benefits of diversification - let us see if that is the case for crypto, with two examples.

Example 1

Consider a portfolio of 6 investments (5 ASX stocks and 1 cryptocurrency). These investments are spread across 6 industry groups and consist of 70% blue chip stocks, 20% mid and lower caps and 10% Bitcoin (BTC). 

Selection of graphs from the Health & Allocation section in a Diversiview analysis for the example portfolio.Selection of graphs from the Health & Allocation section in a Diversiviewanalysis for the example portfolio.


Some investors may think this is a well diversified portfolio. Is that the case?

No alt text provided for this imageGranular Diversification diagram in a Diversiview analysis.

 

Diversiview’s granular diversification diagram shows that there are 12 positive correlations and no strong positive correlations between the securities in this example portfolio, giving a rating of 3.3 out of 5.  The best diversification is achieved when as many correlations as possible are very low (close to zero) or even negative. Moreover, we can see from the granular diversification diagram that Bitcoin is not correlated with the ASX listed securities in the portfolio. Considering these observations, one can say that the portfolio in this example is well diversified and it makes sense to diversify in cryptocurrency. 

At the same time, the total risk of the portfolio increases significantly with the addition of cryptocurrency - let us understand the impact by looking at the same example. 

The portfolio risk, also known as Portfolio Volatility, shows the potential fluctuation of the expected returns. For our example portfolio (with a 10% Bitcoin allocation) the risk due to portfolio volatility is very high at 101.11% while the expected portfolio return is 29.55%.

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Indicators from the Performance & Benchmark section in a Diversiview analysis.

 

What if no cryptocurrency was included in the portfolio and the other stocks were maintained with equal percentages? As it can be seen below, the portfolio risk would fall sharply by 76.61% (to 24.5%) showing the significant impact of including cryptocurrency. The return would not be significantly impacted, with a potential decrease of only 7.17%.

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Given the very high volatility of the original mixed portfolio in our example, many investors may want to reduce risk. Two questions could be raised:

  1. What is the allocation of cryptocurrency (in our example, Bitcoin) that would give the minimum portfolio risk? In other words, how much Bitcoin should we invest in in this example portfolio, to keep the risk as low as possible?

The Portfolio Balancer from Diversiview gives the following results for this problem:

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No alt text provided for this image
 Portfolio Balancer is an AI optimisation tool that allows users to calculate the optimal weights for 3 scenarios: minimum risk (Minimum Variance Portfolio), maximum return, and maximum possible return at the minimum possible risk (the Optimal Portfolio)

 

The results of the Balancer for the 'lowest portfolio risk' target (a.k.a. The Minimum Variance Portfolio) show that the optimal allocation requires a very small amount of crypto (1%) and a small amount of mid and low cap stocks (1%) to arrive at the lowest calculated portfolio risk of 16.46%. At the same time, the return for the lowest-risk allocation (18.47%) is much smaller than for the original portfolio (29.55%) which is expected. 

  1. What if we wanted to trade off some risk for the benefit of an increased return?

We can rebalance our example portfolio again, this time selecting the option to find the optimal weights that give the maximum possible return at the minimum possible risk. 

The Balancer results in this case are as follows:
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No alt text provided for this imageThe tool suggests that the mid and low cap securities weights could be increased slightly to 3.67%, but the crypto is still on a very low allocation (1%). In this scenario we can get a 4.63% increase in the expected return compared with the original portfolio at the expense of 1.39% increase in risk. The Alpha and Beta indicators are also better when compared to the lowest risk portfolio.

As it can be seen from above scenarios for example 1, there is no clear cut regarding the percentage of your portfolio that you could consider for cryptocurrency. The allocation for crypto (as it’s the case with the allocation of any other securities, stocks, ETFs etc.) is a decision that depends entirely on your risk tolerance and return expectations. Are you looking for the lowest risk for peace of mind, or are you willing to accept some level of risk for higher returns? No matter your decision, Diversiview and the Portfolio Balancer can help you find the allocation that is right for you.

Example 2

Let us look at another example of a mixed portfolio of stocks and cryptocurrencies. We will consider in this example that the investor is willing to deploy 5% of their portfolio into the two most recognised and highest market cap cryptocurrencies, i.e Bitcoin and Ether. We will keep the other 4 ASX listed securities from example 1, for the sake of comparison.

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The portfolio risk in this scenario is a whooping 206.56% for an expected return of 28.12%. When compared to a portfolio without cryptocurrency that is massive. The granular diversification diagram also shows very low or negative correlations between cryptos (BTC and ETH) and the ASX listed stocks, with a positive correlation between themselves (0.49).The portfolio's correlation rating is still good at 3.3 out of 5.

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If we run the balancer scenarios again, this time for example 2, we obtain the following results:

Allocation and indicators calculated for the ‘lowest risk’ target:

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Allocation and indicators calculated for the ‘Optimal Portfolio’ target:

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As it can be seen, the cryptocurrency allocation in this second portfolio example is still very low, while in both cases a reasonable expected return is possible. The risk is still high at 84.3% volatility but that is the lowest it can be for the improvement in return compared to the minimum variance (lowest risk) portfolio.

 

Let us summarise the key findings from this article:

  • Cryptocurrencies are seen as a suitable asset for diversification by many large institutional investors. Retail investors follow suit - in Australia, 1 in 4 people invest or plan to invest in crypto;
  • Cryptocurrencies have very high volatility which needs to be taken into account when investing. Risk and return should be always assessed together, and investment decisions should be made only after the level of risk for the expected return is accepted;
  • There is no hard rule regarding how much one should allocate to crypto investments. That figure depends entirely on the risk tolerance level, i.e. the risk investors are willing to take for the return they expect to have;
  • Granular diversification is key to calculating the optimal weights that target a particular risk and return goal for the user. Diversiview is a unique tool that can help with these optimal weights calculations.

 

We hope you find this article informative and useful.  If you have any questions about this article or about the examples included, please feel free to contact us at hello@diversiview.online

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