Some investors scoff while others completely embrace the recent momentum in major cryptocurrencies. Since about 2018, I have taken a mostly agnostic view on cryptocurrencies and their hypothetical role in our economic future. As time has gone by, I have slowly dipped my toe into this new world. I started by initiating a very small investment in a handful of the largest coins, only increasing my holdings slowly and periodically as new information became available. Today, about 5% of my portfolio is held in cryptocurrency; a number that I’m happy with, neither eager to increase or decrease.
But now that it has been four years since I first entered the crypto market, I’ve become curious about how cryptocurrency would fit into a general portfolio of investments. The return you receive on an asset is not the only measurement you should be interested in. The risk adjusted performance of the investment in question, as well as it’s correlation with your existing portfolio are also very important.
To simply illustrate this key point; tell me which portfolio you would rather have:
Most people would rather have Investment 1 because it offers the same return as Investment 2 with less uncertainty.
This is the idea that I wanted to evaluate with cryptocurrency; does it make my portfolio more like the red line or the blue line? To do so, I used Portfolio Visualizer for the backtest and analysis. The data analyzed is constrained from January 1, 2016 to March 2021 as that is the earliest complete data becomes available in Portfolio Visualizer.
How Does the Addition of Bitcoin and/or Ether Affect Risk Adjusted Performance?
The base portfolio used in this analysis is 60% Vanguard Total Stock Market Index and 40% Vanguard Total Bond Market Index. This mix chosen to approximate a simple 60% stock 40% bond investment portfolio. The portfolios were rebalanced annually, meaning the investments were annually bought or sold to stay in line with their original % allocation. Without rebalancing, the cryptocurrencies would have quickly grown to dominate the portfolios.
The chart above requires little interpretation; clearly adding BTC to a portfolio increases return; and adding ETH even more so. Let’s take a closer look at the risk adjusted performance of the three portfolios.
|Portfolio||Beta||US Mkt. Correlation||Sharpe Ratio|
|55/40/5 BTC/5 ETH||.68||30%||1.31|
Beta tells us how volatile a security or portfolio is compared to the market as a whole. The S&P 500 has a beta of 1 because it is a good proxy for the entire US stock market. A beta of less than one means that your portfolio is less volatile than the US stock market and a beta of greater than 1 means your portfolio is more volatile than the US stock market. The addition of BTC and/or ETH has reduced portfolio volatility. We can find the reason why if we look at the portfolio’s correlation to the US market in column 3.
The addition of BTC and/or ETH has reduced the overall portfolio’s correlation to the US market substantially. A 5% allocation to BTC alone has dropped the portfolios correlation to 69%. Remarkably, the addition of ETH to the portfolio has dropped the correlation even further to 30%.
The sharpe ratio is a risk-adjusted measure of return for a security or portfolio. It’s calculated by subtracting the risk free rate of return, in this case the 3 mo. T-bill, from the return of the portfolio and dividing the result by the standard deviation of the portfolio. Generally, the higher the sharpe ratio, the better the risk-adjusted return. We can see over the last 5 years the addition of BTC and/or ETH increases a portfolio’s sharpe ratio. It’s important to note that this is not simply because BTC and ETH have done really well over that time period. Instead what the sharpe ratio is telling us is that the return on these investments was well worth the added risk (as measured by standard deviation).
You can see from the table above that the 5% BTC portfolio has a higher sharpe ratio than then BTC/ETH portfolio. On the other hand the addition of ETH increased the return of the portfolio. What this tells us is that while ETH increased the return of the portfolio, it didn’t increase the risk-adjusted performance of the portfolio. I.e. the added return came with more standard deviation.
We know that usually if we want more return from an investment we must accept a higher risk. But the same return on two different investments doesn’t mean they have the same risk.
Below is the first chart we looked at earlier. The two investments have the same return, but investment 1 is going to have a higher sharpe ratio than investment 2 because there has been almost no deviation from it’s annual returns.
The simplest takeaway here is that over the last 5 years, the addition of BTC and/or ETH has increased the risk-adjusted returns when compared to a general portfolio of 60% stocks and 40% bonds. This is not a call to action to dump your retirement savings into cryptocurrency. The younger you are, and the higher your capacity for risk, the more reasonable it is for you to invest a small percentage into cryptocurrency. The older or closer you are to living on your retirement savings, the less ideal it is for you to expose yourself to cryptocurrency. At the end of the day, no amount of backward looking number crunching is going to tell us what the future looks like and that goes for this analysis as well. In other words, cryptocurrency remains extremely speculative. All we can conclude is that so far, on a risk-adjusted basis, it has performed well.
Erik Goodge is a CERTIFIED FINANCIAL PLANNER™ and the President of uVest Advisory Group. He holds a B.S. in Economics and Cognitive Science from the University of Evansville. Erik is a Marine Corps veteran of the Afghanistan campaign and Purple Heart recipient. He is from Evansville, Indiana, and currently lives in near-by Newburgh with his wife and daughter.