A small dose of skepticism is a healthy quality. Skepticism keeps us from investing into scams or trusting a stranger with our children.
It makes us leery when it comes to new foods or diets, and prevents us from experimenting with untested remedies for a variety of maladies.
But skepticism can also keep us from moving with the times, opening ourselves to new opportunities or in some cases, life-saving vaccines.
As evidenced by the abundance of misinformation surrounding coronavirus vaccines and the vaccine hesitancy of millions of people in the rich world, skepticism it appears, is alive and well, with sometimes disastrous consequences.
Even when it comes to portfolio management, too much skepticism can have long term consequences on investment performance.
In 1952, Harry Markowitz, a prodigiously talented young economist wrote in the Journal of Finance,
Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.
Markowitz would go on to win a Nobel Prize for his work in 1990 and lay the foundations for Modern Portfolio Theory, a mathematically-founded framework for the optimal distribution of assets in an investment portfolio.
Life, is by its very design, an exercise in the management of risk and opportunities.
Whether we take one job over another, marry one partner over another, or live in one city over another, the choices we make have a significant impact on how we end up.
Unfortunately in life, most decisions which we make are binary, meaning that choosing one option necessitates the elimination of another.
For the most part, there’s no way for us to work two jobs in two cities simultaneously.
And while some have attempted to marry more than one partner, that endeavor is certainly not one for the faint-hearted.
Fortunately when it comes to investment portfolios, the increasingly lower barriers to entry in a variety of asset classes is making it easier than ever to diversify portfolios.
But why should you diversify anyway?
According to Modern Portfolio Theory (“MPT”), a rational investor should seek to maximize returns relative to the risk (the volatility in returns) that they are taking.
Following that logic, sensible portfolios should be heavily weighted towards assets that deliver both high and dependable returns.
Markowitz’s genius was demonstrating that diversification can reduce volatility, without sacrificing returns, the very definition of what in investment circles is known as a “free lunch.”
Why “free lunch”? Because when presented with such an ex gratia meal, the only reasonable thing to do is eat.
But given that in the decade and a bit after the 2008 Financial Crisis, yields have steadily been eroded, the prospect of both high and dependable returns has become increasingly elusive — investors have had to contend with a landscape that has been able to provide either one or the other, but not both.
Returns can either be dependable or high, but they will not do two things at once.
Instinctively, the rational investor seeking high returns without volatility might not gravitate towards cryptocurrencies, given that they often plunge inexplicably, and soar on what can often seem like a whim.
But the magic of Markowitz’s MPT is in making a distinction between an asset’s inherent riskiness and a portfolio’s.
What matters, according to proponents of MPT, is not how risky (volatile) an asset is on its own, but the contribution it makes to the overall portfolio and that is primarily a question of the correlation between the rest of the assets in such a portfolio.
Take the last week of September 2021 for instance.
While equity investors were nursing wounds from a challenging landscape, from the threat of China Evergrande Group’s debt default, to soaring energy costs, rising inflation, central bank interest rate hikes and tapering, cryptocurrencies rebounded sharply.
The goal of MPT is to reduce overall portfolio volatility, as opposed to that of a specific asset.
An investor holding two assets that are weakly correlated, or better yet, uncorrelated, can rest easier knowing that if one plunges in value, the other might not just hold its ground, or better yet, gain.
When one considers the scope of assets a typical rational investor might hold, from geographically diverse stock indices, listed real-estate funds and perhaps even a precious metal like gold, the assets that yield the juiciest returns, stocks and real estate, also tend to move in the same direction at the same time — which is otherwise known as correlation.
While the historical correlation between equities and bonds is weak (around 0.2–0.3 over the past decade) making them natural complements in a portfolio, their more recent correlation has been far stronger.
During the course of the pandemic (which still rages on) stocks and bonds moved almost in lockstep, with yields declining (yields fall when bond prices rise) even as stocks rose.
The main reason recently strong correlations between stocks and bonds has been the unprecedented fiscal and monetary stimulus that governments and central banks have flooded the financial system with, in an effort to stave off the worst economic effects of the pandemic.
Which is where Bitcoin has an edge.
While no one is suggesting that Bitcoin is not volatile, during its short investment history, it also has had high average returns and more importantly, moves independently of other assets.
Since 2018, the correlation between Bitcoin and the MSCI All Country World Index (a measure of global stocks) has been between 0.2–0.3, with 1.0 representing a perfect correlation, and -1.0 a perfect negative correlation.
Bitcoin in other words, has very little, if any, correlation with global equities.
Over a longer period, the correlation of Bitcoin with global stocks gets even weaker, and its correlation with real estate and bonds is virtually non-existent.
This makes Bitcoin an excellent potential source of diversification, regardless of what it costs to buy today and helps to explain why it appeals to some of the biggest macro investors.
Take Paul Tudor Jones, a macro hedge fund manager and early proponent of Bitcoin who publicly declared that he aims to hold about 5% of his portfolio in the cryptocurrency — an allocation that would have gained the approval of Markowitz.
But not all calculations on what goes inside an investment portfolio can be based so simply on correlation.
To select what goes into a portfolio assumes an investor has amassed relevant information about the assets within that portfolio and how they might behave relative to one another.
Unfortunately, expected returns and future volatility are usually gauged by observing how an asset has performed in the past and given the relatively short history of Bitcoin, can require some degree of abstraction.
Additionally, because past performance does not always translate to future returns, investors looking to allocate a portion of their portfolios into cryptocurrencies will need to contend with a dearth of empirical data relative to other more established asset classes.
And while Markowitz suggested how investors should optimize asset choices vis-à-vis each other, he did caveat,
We have not considered the first stage: the formation of the relevant beliefs.
Bitcoin specifically, and cryptocurrencies generally, are of the class of assets which are unconstrained, meaning that they are not tied to any specific supply or demand factors outside of narrative.
Being of the class of unconstrained assets, it is not immediately clear what drives Bitcoin’s projected returns outside of what the market agrees that its price ought to be.
With equities, investors expect a share in a company’s profits and from bonds, the risk-free rate plus credit risk, but Bitcoin and cryptocurrencies enjoy no such clear calculus.
Given how many investors hold fiercely philosophical and ideological beliefs about Bitcoin, how much is held in any given portfolio may have more to do with conviction than correlation, but at the very minimum are worth more than some consideration (within a portfolio that is).
Patrick is an innovative entrepreneur and a lawyer passionate about cryptocurrencies and the business world. He is the CEO of Novum Global Technologies, a cryptocurrency quantitative trading firm. He understands the business concerns of founders and business people helping them to utilise the legal framework to structure their companies to take advantage of emerging technologies such as the blockchain in order to reach greater heights. His passion for travel, marketing and brand building has led him across careers and continents. He read law at the National University of Singapore and graduated with Honors in the Upper Division and joined one of Singapore’s top law firms, Allen & Gledhill where he was called to the Singapore Bar as an Advocate & Solicitor in 2005. He created Purer Skin, a skincare and inner beauty company which melds the traditional wisdom of ancient Asian ingredients such as Bird's Nest with modern technology. In 2010, his partner and himself successfully raised $589,000 from the National Research Foundation of Singapore under the Prime Minister’s Office. He has played a key role in the growth of Purer Skin from 11 retail points in Singapore to over 755 retail points in Singapore and 2 overseas in less than a year. He taught himself graphic design, coding, website design and video editing to create the Purer Skin brand and finished his training at a leading Digital Media Company.