• Marcus P. Miller, CFP®

Bitcoins place in a diversified portfolio

What is Bitcoin really? A digital asset that we can own, like an MP3? True, somewhat. The actual technology can be uncovered in an incredible lecture series by MIT and Current SEC Chairman Gary Gensler found here: https://youtu.be/EH6vE97qIP4


Bitcoin is indeed an asset, although it's underlying value is hard to pin down. For gold we can use historical prices, the cost of digging it from the ground, or perhaps it's commercial and industrial uses. Bitcoin has none of that going for it. It's short history makes it seem like just another hot fad. The cost in equipment and energy baffles some and angers others. It has few uses outside the store of (perceived) value.


So why own it? Perhaps because someone in the future will think it's worth much more than it is today. Perhaps it becomes the staple of our future economy, with everything being valued in Bitcoin. In that future, the money supply would be Bitcoin, and everyone purchasing Bitcoin with USD and other fiat currencies would push its price through the roof. Some values for Bitcoin in the millions because of this possible future.

Others believe the asset will go to zero when a better option becomes available. And some believe that governments around the world will begin to ban the asset or tax it heavily. This is largely due to the fact the cryptocurrencies remove the ability of the central government to control that money within the banking system.


So where does it belong in a portfolio? In the event of a hyperinflation, it's expected that it would perform like gold, or any other asset which has a perceived value. Unfortunately, we do not know how it will perform. Given the inherent liquidity and lack of historical performance, it may very well be the first asset sold. Additionally, the crypto market currently has a large amount of leverage. The weak hand theory would indicate that any bear market would likely cause the weak hands to fold and the leverage they are currently employing to create a snowball effect. The recent drop in Bitcoins price of ~50% appears to be a symptom of this highly leveraged market.


Bitcoin may also perform as a safe haven asset. In this instance the other assets like stocks and bonds would be sold as all liquid cash is used to purchase the "safe" asset, Bitcoin. This argument comes largely from proponents of Bitcoin, and again, there is no historical example to point to.


This speculation (and that's what this is) has most wondering exactly where this belongs in a portfolio. Should it be avoided? Should it be a large position? That depends on your personal view. Keep in mind that these assets are not currently regulated by the SEC. The exchanges are slightly regulated, but even there we have major issues.


For private (non-institutional) portfolio's, it may be a healthy form of speculation in a future that may come to realization. If your currency hyper-inflates like many in South America, or 1920's Germany, you'll likely be glad you owned a bit of cryptocurrency like Bitcoin. If the entire world adopts Bitcoin around us and they begin to buy it like hotcakes you'll be glad you owned a bit. With speculative price estimates ranging from $0 to $1-million this is likely the most volatile asset available (aside from the joke cryptocurrencies). Volatile assets with a limited confidence interval should be a very small portion of any diversified portfolio. A target of 1-3% is reasonable, although a professional approach would include evaluating its effects on your portfolio's volatility and potential return.


Measuring the period of 2012 through 2020, Bitcoin's correlation to the US Stock and Bond markets is almost zero. The same is true for Bitcoin's correlation to gold, oil, real estate, and emerging markets. (https://www.etftrends.com/tactical-allocation-channel/bitcoins-correlation-to-markets-hits-a-record-in-2020/)


However, this period includes many years when Bitcoin was not a major assets. In the last year measured (2020), it's correlation values increased dramatically. 0.22 correlation with the S&P, 0.25 with emerging markets, and 0.07 with bonds. These numbers are still low, but more data is needed before the "uncorrelated asset class" argument can be used to evaluate the increased benefit of having this in your portfolio in any large amount.


Cryptocurrency lending is a major new phenomenon made available by companies like Blockfi. The ability to purchase Bitcoin and then immediately loan it to someone else for a 5% APR is incredible to say the least. It's nearly created an alternate base rate for what is considered a reasonable rate of return. Compared to the 10 year treasury yield of 1.4%, it's gold (pardon the pun). Unfortunately it has created the aforementioned leverage in the cryptomarket, increasing volatility.


If Bitcoin ends up having a true uncorrelated return with minimal risk, and lending it to others produces a reasonable return, this will become a true major asset class. For now, it's place in the portfolio is likely right next to gold, oil, and the other price-sensitive, volatile, non-income producing assets. As you may assign a very low % to those assets to harness a personal view or non-correlated price increase, you might want to do the same with Bitcoin.