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When a financial advisor discusses the appropriate asset allocation for a portfolio, they are essentially trying to craft a plan that will maximize expected returns based on a certain level of risk.
The advisor pays less attention to the behavior of an individual security and focuses instead on how different asset classes interact as a group.
So, what is bitcoin’s role in an investment portfolio and does it make sense to include it?
Conventional wisdom suggests that while bitcoin has delivered great returns, it will add significant risk to a traditional stock/bond portfolio.
That said, it’s important to remember that many asset classes that are now commonplace in a portfolio were at one point considered far too volatile for the average investor. We don’t think about including emerging markets or technology stocks in an allocation today, and yet there was a time when the experts thought they were way too risky.
Their concerns were justified.
Since the inception of the MSCI Emerging Markets Index in 1988, there have been seven declines of 25% or more. In addition, Nasdaq stocks plunged 79% during the dotcom crisis, while tech companies fell at a staggering rate.
Nevertheless, they both recovered and fared well when included in a diversified portfolio that considers time horizons and risk tolerance.
It seems the same arguments have been made about digital assets, even if a long-term study by VanEck found that bitcoin had exhibited lower volatility than 112 shares of the S&P 500 in a 90-day period and 145 shares in the year to date. from November 13, 2020.
This raises the question of the impact bitcoin has on a well-built portfolio and whether it is appropriate for the average investor to have some exposure.
Many may remember the bell curve that judges the number of possible outcomes. When a portfolio is built, any additional opportunity on that bell curve increases volatility. If the goal is to get the highest return with the least risk, it’s worth adding an asset class that serves that goal.
Recent industry research has found that small bitcoin weights have an inordinately positive effect on risk-adjusted returns and diversification against other alternative assets. In addition, the study concluded that bitcoin’s lack of correlation with other assets makes it a useful alternative asset that can actually help reduce exposure to economic cycles.
Until then, the RIA Digital Asset Council reports that when investors allocate 1% to a balanced portfolio, returns increased with little to no impact on volatility or maximum drawdowns as the market became uncertain. Similarly, rebalancing a portfolio containing 1% bitcoin each quarter increased the long-term return of a balanced portfolio, although the volatility and maximum withdrawals for the same time frame barely decreased.
Suffice it to say, it makes a lot of sense to have an open mind and use the risk management tools already at our disposal.
— By Ivory Johnson, founder of Delancey Wealth Management