The current issue of the prestigious 178-year-old weekly magazine The Economist explains why having Bitcoin as part of an investment portfolio is “a Nobel Prize winning diversification strategy.”
In an excellent article published earlier today, John O’Sullivan, who writes the Button wood column for The Economist, began by reminding us that economist Harry Markowitz had an article published in the Journal of Finance in 1952, which won him (jointly with Merton H. Miller and William F. Sharpe) the Alfred Prize Nobel Memorial in 1990 in Economics. According to the press release issued on October 16, 1990 by the Nobel Prize Organization, Markowitz received the award for “developing the theory of portfolio choice.”
According to O’Sullivan, in this article, Markowitz had the following to say about diversification:
“Diversification is both observed and sensitive; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.“
The Economist columnist then added that “modern portfolio theory” says that “a rational investor should maximize his returns relative to the risk (the volatility of returns) he takes” and that “Markowitz’s genius was to show that diversification can reduce volatility without sacrificing returns.
O’Sullivan says Markowitz realized that “it is not necessarily the inherent risk of an asset that is important to an investor, as much as the contribution it makes to the volatility of the overall portfolio – and c ‘is mainly a question of correlation between all of the assets it contains.
He explains that you want to have asset classes in your investment portfolio that have the potential to provide high returns and that have little or no correlation with each other. For example, while stocks and real estate can generate hefty returns, unfortunately they are also highly correlated with each other. In contrast, in the case of stocks and bonds, the correlation between them is “weak”, but unfortunately “but bonds also tend to lag behind in terms of yield”.
O’Sullivan goes on to say that this is why Bitcoin is such a good tool for portfolio diversification:
“Cryptocurrency can be very volatile, but over its short lifespan it has also had high average returns. Importantly, it also tends to evolve independently of other assets: as of 2018, the correlation between bitcoin and stocks in all geographies is between 0.2 and 0.3. Over longer time horizons, it is even lower. Its correlation with real estate and bonds is also low. This makes it a great potential source of diversification...
“In the four time periods over the past decade that Buttonwood randomly selected to test, an optimal wallet contained a 1-5% bitcoin allocation. It’s not just because cryptocurrencies have exploded: even if we choose a few particularly volatile years for bitcoin, say from January 2018 to December 2019 (when it fell sharply), a portfolio with an allocation of 1% to bitcoin was always a better risk. reward the characteristics that one without it.“
The views and opinions expressed by the author, or anyone mentioned in this article, are for informational purposes only and do not constitute financial, investment or other advice. Investing or trading crypto-assets carries a risk of financial loss.
Image by “petrre_barlea from Pixabay