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Why Should 10% of Your Portfolio be Diversified in Bitcoin?

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As a kid, my weekly Friday routine was a trip to Macdonald’s. I loved it!

I still remember the happy meal with hot fries, crispy chicken McNuggets, ice-cold coke, and a surprise toy inside. I remember the yellow & red theme, the clown Ronald Macdonald, and many choices or burgers I could select.

It shouldn’t come as a surprise, that I was an unwilling member of my primary school’s Trim And Fit Club (TAF Club).

Being in my 30s now, I tend to go Macdonald’s (a lot) less.

I think there was a season, where I didn’t visit the fast-food chain for years until an interesting documentary caught my attention.

It was called “Super-size me” and follows a 30-day period during which the filmmaker ate only McDonald’s food. He gained about 11kg by the end of the 30 days, telling the world something everyone already knows: “Fast food is bad for you.”

Obesity in the United States is viewed as a major health issue. It is believed to result in numerous diseases, specifically increased risk of certain types of cancer, coronary artery disease, type 2 diabetes, stroke, as well as significant increases in early mortality and economic costs.

What would be the smartest thing for a fast-food company to do next?

They diversified their products.

Macdonald’s started offering healthier options like grilled chicken wraps and cup corn. According to reports, by CNBC and business insider, sale of McMuffins are soaring after a switch from using margarine to butter.

Macdonald’s diversifying into more wholesome food offerings, as taste around the world, is getting healthier. Even for myself, when I buy Macdonald’s these days, I often swap my fries for cup corn instead.

The importance of diversification applies to your investment portfolio as well.

Most investment professionals agree that, while diversification doesn’t guarantee against losses, it is the most important component to minimise risk and achieve long-term financial goals.

Diversification is a method that allocates investments among various financial instruments, industries, and other categories with the agenda of reducing risk and maximizing returns. This is done by investing in areas that would react differently to the same event.

Investopedia gives a great example of this.

If we have a portfolio of only airline stocks, and it is announced that airline pilots are going on an indefinite strike and that all flights are cancelled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable decline in value.

However, when we balance out the airline stocks with some railway stocks, only part of our portfolio would be affected. In fact, there is a chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.

We could diversify even further potentially since both rail and air is involved in transportation. An event that reduces any form of travel hurts both companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.

The more uncorrelated our stock investments are, the better.

Thus, when you diversify, it follows the age-old wisdom of not putting all your eggs in one basket. In fact, the de facto standard in traditional finance is to allocate 60% to stocks and 40% to bonds.

The two different assets, behave in the opposite manner to adverse events. Generally, bond and equity markets move in opposite directions, so a 60/40 portfolio is diversified across both areas. Any unpleasant movement in one asset will be offset by positive results in another – unless we encounter black swan events like the 2008 Global Financial Crisis.

During 2008, no one expected the highly rated securitized mortgages (in the form of securities known as mortgage-backed securities (MBS) and collateralized debt obligations (CDO), to ever default.

When it did, no one was spared from the ensuring ripple effects.

There are talks, on how the next black swan event is around the corner, and how it could potentially be related to corporate debt, shadow banking in China, or a global currency crisis – caused by a decade of low-interest rate and governments printing money out of thin air. But well, that can be a whole new topic for another day.

So Why Do I Have 10% of My Portfolio In Cryptocurrencies?

Is there something that can diversify against stocks, bonds and even currency?

The answer might lie in alternative investments.

These are investments that are “non-correlated” which means that their return is not correlated to that of stocks and bonds. This allows such vehicles to excellent diversification in a 60/40 portfolio that is primarily invested in stocks and bonds.

Including a small percentage of high risk and potentially high reward assets into your retirement portfolio, has been advocated by investment firms and professionals for years.

Image result for nassim taleb barbell strategy
Stocks/Bonds on the left. Cryptocurrencies on the right.

The concept works like this – a small percentage of your overall asset allocation (from 5 to 10 percent) into these assets potentially provide high returns, with minimal impact on your portfolio if the risk becomes too great.

Hedge funds, private equity, gold, currencies and real estate are the most common forms of alternative investments.

For cryptocurrency investors like myself, the answer is Bitcoin.

I would classify Bitcoin under the category of Alternative investments. Since it is not controlled by a government or a single company, the nature of BTC ( short form of Bitcoin ), is that it is decentralised. Anyone around the world can set up a BTC node, and “mine” for new Bitcoin while contributing to the Bitcoin ecosystem.

This means that Bitcoin is not concentrated in a geographical location, nor a single government. The price is determined by exchanges that is likewise distributed all around the world as well.

Also, for alternative investments like PE, real estate or angel investing, it may get difficult to determine the current market value of the underlying investment.

The investment might be illiquid, and difficult to sell when you need to funds (just like it takes months to sell property). With bitcoin, you can see the price in real-time through the various tickers and online exchanges now available.

In Singapore alone, there are 3 exchanges that would allow the buying and selling of Cryptocurrencies like Bitcoin via SGD.

How well does Bitcoin diversify against other main asset classes? I included a screenshot from Portfolio Visualizer.

This is the asset correlations for time period 06/01/2015 – 09/30/2019 based on monthly returns. Singapore stocks, S&P, Dow Jones, US Bonds, Commodities and a Bitcoin trust were compared.

We can see that the Bitcoin trust has a low correlation to all the other Asset classes presented. This is also supported, based on research done by Coinfi.

“Adding any portion of Bitcoin to the 60/40 portfolio has generally yielded better results in many measures, and that around 5% allocation seems to yield the best risk-adjusted returns. “ If you are interested, you use their Bitcoin investment calculator to find out how Bitcoin could have impacted your traditional portfolio here.

Since January 02, 2015, if you allocated 10% Bitcoin to your traditional portfolio, your portfolio would have returned 267.99% more, with a max drawdown size of 41.58% more than your traditional portfolio.

Here is a screenshot of the returns and drawdown would look like. The left is the traditional 60% equity 40% bonds portfolio, while the right “Enhanced” portfolio, contains 10% of Bitcoin and the remaining 90% in the (60/40) portfolio

Of course, Bitcoin investors must be aware of the consequences for a currency that does not feature any central bank or supervising authority.

Bankruptcies of Bitcoin exchange and wallet services can happen, and if investors do not know how to properly store their Bitcoin, it could be lost forever. Knowledge of IT security is critical as well since hackers could steal Bitcoins via various spyware or malicious methods.

After being in the cryptocurrency market for years, I can discern that mainstream investors do not yet realized the opportunities that Bitcoin provide.

You see, while investors of Bitcoin need to pay attention to the risk associated with this new alternative asset, they can also experience potentially high returns in a short period of time. Most importantly BTC has low or even negative asset correlations which makes it a very good instrument to diversify a portfolio consisting of stocks/bonds.

Remember how we used Macdonald’s as an analogy? The 1990’s MacDonald’s used to sell only unhealthy fast-food. But the 2019 MacDonald’s, had to produce healthier alternatives. 

It’s time that investors did the same. We need to add in the Cup Corn option, to an all fries menu.

In a time where Trump is being impeached and rising quantitative easing, I think now more than ever, investors should allocate a tiny portion of their portfolios into Bitcoin to reap the rewards and to shield themselves from massive drawdowns.

If you’re interested in the specifics on how to invest in Bitcoin, you can register for a seat here.

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