Portfolio theory and Bitcoin: The risk/return profile

Bitcoin, a “very attractive value store” – Stanley Druckenmiller
Blackrock and Vanguard indirectly rely on Bitcoin

Crypto currencies like Bitcoin Trader belong into each Portfolio. But how is it ordered around their net yield-risk profile and how high is the correlation to traditional Assets? The Iconic getting thing from Frankfurt took up this topic and wrote a report in addition.

The following report was written by Iconic Holding from Frankfurt, an asset manager specializing in digital assets. The company was founded in 2017 by Patrick Lowry and Max Lautenschläger. In regular analyses they provide the necessary know-how to better understand digital assets.

One of the basic principles of portfolio theory is diversification, which aims to minimize risk – measured by standard deviation – without reducing the expected return. This is because each individual asset class has its own risk/return profile, as can be seen in the chart below.

The optimal investment would be located in the upper left-hand corner, i.e. a high expected return with a low standard deviation. Normally, a riskier investment also provides a higher expected return.

Correlations are measured with the so-called correlation coefficient, which can be between +1 (perfectly positive) and -1 (perfectly negative). In terms of risk diversification, both values are not desirable, since either the entire portfolio rises or falls with an event, or half of the portfolio rises while the other half falls. Diversification is mainly achieved by adding an asset that ideally shows no correlation with other asset classes. The lower the correlation between the assets in a portfolio, the more risk can be eliminated. An uncorrelated asset is considered the holy grail of portfolio construction.

In the context of this article, strategic asset allocation is assumed, not tactical asset allocation. Thus, the focus is on long-term allocation to different asset classes and not on short-term earnings opportunities in certain industries or which asset manager is selected.
Correlations of traditional and alternative asset classes

Let’s first take a look at traditional asset classes such as equities, bonds, commodities and real estate.

As can be seen in the upper left quadrant, equities correlate very positively with each other worldwide, and are therefore only suitable for risk diversification to a certain extent. Gold is very well suited for inclusion in an equity portfolio, but correlates relatively strongly with other commodities and real estate. In particular, bonds with a long lifetime are excellent for diversification into stocks, commodities and real estate.

What about other alternative asset classes?

Here it can be seen very clearly that hedge funds, private equity and venture capital are excellently suited for diversification compared to all the aforementioned asset classes with values between 0.05 and 0.35.

From the results so far, we can conclude that shares, commodities, real estate and bonds belong in a diversified portfolio just as much as hedge funds and private equity or venture capital. It is therefore less surprising that the most successful investment concept of the last decades is the so-called endowment model, which is rather aggressively designed. Unfortunately, not every investor has access to certain asset classes. Investing in private equity funds, for example, is only possible for professional (EU) or accredited (US) investors and the minimum investment amount is often more than 1 million Euros. In my previous article I already discussed the effect of allocating cryptoassets to different types of portfolios.
Bitcoin and other asset classes

How do cryptoassets fit into a portfolio? I have already shown in my last article (here the Research Report) that they not only generate a good deal of alpha, but also have a positive effect on the Sharpe Ratio (risk/return profile). But what about correlations? Do they legitimize crypto as an addition to a diversified portfolio?

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