Why Diversify With Crypto?

“Don't put all your eggs in one basket”: this popular piece of advice also applies to finance. Smart investors strive to build diversified portfolios that are made up of a variety of financial products, such as stocks or bonds. Crypto can be an interesting asset to further diversify one’s portfolio - we will explain why, and how, in this article.

“Crypto” refers to digital currencies that rely on cryptography to secure transactions. The first Bitcoin (BTC) was mined, i.e created, in 2009, followed in 2015 by Ethereum (ETH). Bitcoin and Ethereum adoption has grown steadily ever since, as illustrated by the charts below. They show the number of BTC & ETH unique addresses. Also known as wallets, they enable users to make transactions with or store BTC/ETH. As of December 2022, there are over one billion BTC addresses, and over 150 million ETH addresses.

Today, there are thousands of cryptocurrencies available on the market. Most investors focus on BTC and ETH, which are considered to be major players in the crypto ecosystem, and are referred to as “blue-chip” coins. BTC in particular is the most popular crypto, with a market capitalization of $435 billion as of March 2023, and it is often the first crypto asset traders invest in.

More and more investors are turning to crypto. In this section, we will focus on Bitcoin to explain why.

Diversification is a way to limit risk by investing in assets that are not fully correlated. Correlation is a statistical measure that tracks how two assets move in relation to each other. Let’s say a trader invests in two assets: A and B. If A and B’s correlation is 100%, it means they are perfectly correlated: their value rises and falls at exactly the same pace. As a result, the investor’s portfolio is not diversified at all: any adverse event affecting A is reflected in B’s value. On the contrary, if A and B’s correlation is -100%, the assets are negatively correlated, and move in opposite directions. 

Investors aiming to effectively reduce their risk are looking for assets with as low correlation as possible. This means assets are moving independently from each other, and makes for a diversified portfolio. 

Bitcoin’s correlation to other assets has historically been quite low, as reflected in the table below.

The S&P 500, an index tracking the stock performance of 500 large companies listed on stock exchanges in the United States, is often used as a benchmark. Its correlation with BTC from 2019 to 2023 stands at a pretty low value of 34%. This makes BTC a good candidate for portfolio diversification.

However, Bitcoin’s correlation to traditional assets tends to increase as the asset matures. In addition, Bitcoin can also react to major macroeconomic events, such as interest rate hikes. Head over to our 2023 Bitcoin Outlook report for more information on why Bitcoin is increasingly viewed as  a rate sensitive asset. 

Those investing in Bitcoin also appreciate its volatility - and are prepared to book a seat in a roller-coaster ride, as shown in the graph below.

Past market phases have seen Bitcoin move from $4,000 to $20,000 in 3 months (in 2017), or from $5,000 to $60,000 in barely a year (2020-2021). However, while investors often think of volatility as an opportunity, it also comes with higher risks, and BTC’s price is currently trending down, below the 20k$ mark. 

In addition, predicting what BTC’s price would be ten years from now is no easy task: there is still room for price exploration. Surveyed in early 2023, a panel of 56 industry specialists estimate BTC will be worth US$26,844 by the end of 2023 before rising to US$77,492 by 2025. 

Adding a volatile and decorrelated asset like BTC to your portfolio increases its diversification, therefore potentially modifying its risk profile. This can lead to a potentially enhanced risk-adjusted return portfolio. 

Having said that, how much BTC should you welcome into your portfolio? And how should you manage it? 

Let’s compare 3 portfolios to see if adding BTC is beneficial:

1. Standard portfolio is made of stocks (60%) and bonds (40%). This is the “standard” asset repartition in traditional finance. 

2. This portfolio introduces 4 percent of gold vs the standard one. 

3. This one adds 4 percent of Bitcoin in the portfolio instead of gold. Its rounded composition is therefore stocks (57%), bonds (39%), and BTC (4%).

All 3 portfolios were active from October 2015 to November 24, 2022, and their assets were rebalanced every quarter. This means that assets were weighted over time to match defined values (4% for gold or BTC in our example).

• Performance: a 4% BTC allocation improved annualised returns from 6.9% to 14.4%, compared to portfolio 1.

• Risk: despite BTC’s volatility, the portfolio as a whole is not significantly more volatile (10.4% vs 9.3% for portfolio 1). Its maximum drawdown (the maximum drop from a peak to a low) stands at 22.9%. However, portfolio 2 (gold) had lower volatility and drawdown, as gold was a steadily rising asset on the period.

• Decorrelation: with as little as 4% of Bitcoin in the portfolio, correlation to portfolio 1 is reduced by almost 8%. This is a further indication that Bitcoin is a suitable asset for diversification purposes.

   

This analysis shows 4% was efficient, as it achieved higher returns by slightly increasing risk. But this is only an example: it’s up to investors to build their personalised portfolio, based on the risk level they are comfortable with. The more BTC there is in a given portfolio, the riskier it becomes. Diversifying with BTC should therefore be part of a wider strategy, in conjunction with other assets. 

Whatever the chosen percentage, rebalancing is key. Rebalancing is the process of adjusting the allocation of assets within a given portfolio to achieve a preferred level of risk and returns. Concretely, it means that BTC should remain at the predefined weight within the portfolio (4% in our example). 

Should this percentage swing too widely over time, investors will be exposed to more volatility, drawdown, and hence risk, that they had initially forecasted. To prevent this from happening, investors should regularly monitor their portfolios’ performance and buy/sell assets accordingly. 

Thanks to its decorrelation, crypto can be an interesting addition to your portfolio. ​​Based on our simulation, holding 4% of Bitcoin improved the portfolio’s risk/return trade-off, compared to a “standard” 60/40 stock/bond portfolio. 

However, keep in mind that investing in crypto comes with risks, in particular of volatility and loss of capital.

The easiest way to add crypto to your current portfolio is to invest in crypto ETPs. Crypto ETPs slot straight into your existing investment portfolio, making analysis of your investments and activities like asset rebalancing a straightforward operation. They also free you from the complexity and security risks of self-custody. 

We explain it all in our article outlining why crypto ETPs are the best way to invest in crypto.

Please remember, there are still risks associated with the XBT Provider’s ETPs, such as counterparty and volatility risks, that they are complex products, may be difficult to understand and have a high risk of capital loss.