D IVERSIFICATION CAN BE BOTH observed AND sane; a rule of behavior that does not imply superiority of diversification should be rejected both as an hypothesis and as a maxim. Harry Markowitz was a young, prodigiously gifted economist who wrote in the Journal of Finance 1952. This paper helped Markowitz win the Nobel prize for economic science in 1990. It laid the foundations of modern portfolio theory, a mathematical framework that allows for optimal asset distribution.
According to this theory, a rational investor should maximize his or her returns relative the risk (the volatility of returns) that they are taking. Naturally, assets that have high returns and are reliable should be a large part of a prudent portfolio. However, Markowitz’s genius was not in demonstrating that diversification can reduce volatility while not sacrificing returns. Diversification is the financial equivalent of the idiom “the whole is more than the sum of its parts.”
Investors looking for high returns and low volatility may not be attracted to cryptocurrencies like bitcoin. They often plummet in value, then soar in price. Buttonwood was writing this column when bitcoin plunged 15% and then bounced back. However, Markowitz’s insight revealed that an asset’s riskiness is not what matters to investors. It is the contribution it makes towards volatility in the overall portfolio. This is primarily due to the correlation among all assets. Investors who have assets that are not correlated or weakly correlated can feel more secure knowing that even if one asset falls in value, the other could still hold its ground.
A sensible investor may have a mix of assets, such as bonds, stocks with different geographical distributions, listed real estate funds and precious metals like gold. Stocks and real-estate are the assets that offer the highest returns. They also tend to move in the exact same direction. Stocks and bonds are not correlated (between 0.2-0.3 in the last ten years). This allows for diversification, but bonds also tend to be behind when it comes returns. Although investors can reduce volatility through the addition of bonds, they also tend to have lower returns.
This is where bitcoin excels. Although it is volatile, the cryptocurrency has experienced high average returns over its short lifespan. It also tends not to be dependent on other assets. Since 2018, the correlation between bitcoins and stocks from all geographies was between 0.2 and 0.3. It is even less weaker over longer time periods. Similar to bonds and real estate, it has a weak correlation. This makes it a great source of diversification.
This could explain why it is attractive to large investors. Paul Tudor Jones, a hedge fund manager, stated that he hopes to have about 5% of his portfolio in Bitcoin. This is a sensible allocation for a portfolio that is highly diversified. Buttonwood randomly chose four periods in the past decade to test and found that an optimal portfolio had a bitcoin allocation between 1-5%. This is because bitcoin has rocketed. Even if one picks a volatile few years, such as January 2018 and December 2019, when it plummeted steeply, a portfolio with a bitcoin allocation of 1% still showed better risk-reward characteristics that one without it.
There are many factors that go into choosing the right assets. Investors want to make money, but not just to be successful with their investments. Bitcoin isn’t environmentally friendly. An investor must also gather information about the potential behavior of securities before selecting a portfolio. The past performance of an asset can be used to predict future returns and volatility. This method is not without its flaws. Past performance is not necessarily indicative of future returns. The history of cryptocurrency is not long.
Although Markowitz provided a detailed explanation of how investors should optimize asset choices, he stated that ‘we haven’t considered the first stage: The formation of the relevant beliefs. Investment in equities yields a portion of the profits of the firm; bonds return the risk-free rate and credit risk. Other than speculation, it is unclear what causes bitcoin’s returns. It is reasonable to assume that it may not yield future returns. Many investors believe that bitcoin is either salvation or damnation. Both sides are unlikely to invest 1% of their assets into it.