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ON HOLD - DRAFT COMPLETE//Portfolio Diversification and Cryptocurrency: Are We There Yet?

Does bitcoin have a place in your diversified portfolio? Learn about the risks and possible opportunities of trading cryptocurrencies.

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5 min read
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Key Takeaways

  • The cryptocurrency market is maturing, although still volatile 

  • Cryptocurrencies could potentially be considered as a viable alternative investment for portfolio diversification

  • Understand the risks and how bitcoin may fit in with your goals and risk tolerance

According to legend, it was about 10 years ago when a person or group operating under the pseudonym Satoshi Nakamoto logged the first entry into the bitcoin ledger. Fast-forward to today, and more than 2,300 other cryptocurrencies have joined the markets, with a collective market cap of $240 billion as of mid-Novmber 2019.

The technology behind bitcoin and cryptocurrencies looks adaptable to numerous industries, including banking, retail, legal, health care, and others, leading to billions of dollars of investment in research and infrastructure.

Meanwhile, the financial community has taken note, building platforms and exchanges for cryptocurrency products. This continues even as many cryptocurrencies saw their trading volume and value drop steeply from a late-2017 peak as some market experts questioned the concept, viability, and stability of the industry. But after bottoming out in late 2018 and staging a resurgence in 2019, the message looks to be clear: Cryptocurrency may be down, but it appears far from out.

As the crypto market continues to mature, perhaps it’s time to ask: “Does crypto have a place in my portfolio? Might it help me pursue investment diversification?” These questions remain relevant even with bitcoin still down over 50% from its highs.

What Is Cryptocurrency? By Definition and Philosophy

Before deciding where cryptocurrencies might fit into a diversified portfolio, let’s take a step back and define what we’re talking about.

Bitcoin and other cryptocurrencies are digital assets, typically obtained through the calculation of complex math problems (aka “mining”). Once a unit has been mined, it appears on a ledger that’s shared by all users and updated in real time. This distributed ledger, which is called a blockchain, becomes a virtually irrefutable point of integrity. That’s a fancy way of saying that because everything is transparent and shared, it’s nearly impossible to fake an entry or hack your way into a blockchain.

The certainty built into distributed ledgers has attracted widespread attention from industries that see it as a way to do things more quickly and efficiently. Banks, exchanges, credit card companies, and other financial players have been investing in distributed ledger technology in hopes of making global payment systems faster and more efficient. Others see it as a way to facilitate the transfer of ownership through what’s called a smart contract, which can verify legal documents and other agreements in real time. Any firm or government entity that manages a supply chain or stores large volumes of data might stand to benefit from cryptocurrencies and the blockchain technology that underpins them. 

So that’s cryptocurrency defined. But what about from a philosophical standpoint? Much depends on your perspective. Plus, some cryptocurrencies are built for different purposes. But here are a few crypto possibilities:

Currency. Cryptocurrencies can function as a store of value and medium of exchange. Bitcoin has gained some prominence in recent years as a facilitator of transactions, but as a store of value, it may have a ways to go. The price has been quite volatile over the last few years. In late 2017 it spiked to nearly $20,000 versus the U.S. dollar, then down to around $3,000, up to $13,000, and then back below $10,000. That’s quite a bit of volatility compared to a stable, developed currency. If the dollar showed this much volatility, for instance, it likely wouldn’t enjoy its reputation as a global currency people can trust. (See figure 1.)

Inflation hedge. Many analysts have compared crypto assets to gold and other precious metals as a way to hedge against runaway inflation. The rationale is that because the control of bitcoin and other cryptocurrency supplies lies outside of any central bank, cryptos may be less susceptible to currency devaluation, hyperinflation, and other such risks.

Industrial commodity. Cryptocurrencies are mined, and the tokens created from this mining process have tangible value. The mined cryptocurrencies help to power payment systems, smart contracts, supply chains, and so on. How is that any different from, say, crude oil, aluminum, or silicon? It’s true that you can't hold a digital asset in the palm of your hand, and you don’t store it in a warehouse or storage tank. But again, this is a philosophical argument.

FIGURE 1: VOLATILE CRYPTO VERSUS ESTABLISHED ASSETS. Although Bitcoin futures (/BTC - candlestick chart) have made inroads over the last few years as a viable product, the price has been quite volatile relative to markets such as the dollar, Japanese yen (/6J - purple line) and gold (/GC - blue line). Data source: CME Group. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

The World of Alternatives

What do foreign currencies, precious metals, and commodities have in common? They’re all part of a subset of investment choices called alternative assets, meaning they’re outside the traditional world of stocks and bonds. The allure of these “alts” is that they’re often uncorrelated to traditional assets, potentially adding a layer of diversification for investors and sometimes helping to offer superior risk-adjusted returns. But many alts come with their own risks, such as higher fees and periods of volatility. They can also be difficult to liquidate quickly during times of stress. In other words, they’re not for everybody, but when structured properly, they have the potential to enhance a diversified portfolio.

If you do decide to allocate a bit of your portfolio to alternatives, you’d need to decide how much. Of course, it depends on your objectives, investment horizon, and risk tolerance. Suppose, for example, you have a portfolio mix of 60% stocks and 40% bonds, and you’d like to allocate as much as 10% to alts. You might then dial back your stocks to 55% and bonds to 35%. 

But what about cryptocurrencies? For investors interested in alts, should cryptos be part of the choice set? In the early days of bitcoin, the market was more geared toward traders and speculators with an appetite for risk. Bitcoin was frequently used for illicit transactions. And the largely unregulated platforms were rife with accusations of price manipulation.

Today, tens of billions of dollars in notional value change hands each day in the top cryptocurrencies such as Bitcoin, Tether, Ripple, and Ethereum. Blockchain applications have moved to the mainstream. But there’s work to be done; it’s still early days. Although the market in the top coins is typically liquid, many of the 2,300+ are thinly traded and don’t have a clear use case from an economic standpoint. Some might be run by charlatans. Although there’s an established futures market, other derivative products such as exchange-traded funds and options have been slow to come online.

So, does crypto have a place in your portfolio? Again, it’s not a strategy for everyone. Cryptocurrencies are new and not fully understood. They’ve been risky. But if you’re the type who wants alts as part of a diversified portfolio, a compelling case can be made for potentially adding crypto to the mix. 

Investing Basics: Bitcoin and Blockchain
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Key Takeaways

  • The cryptocurrency market is maturing, although still volatile 

  • Cryptocurrencies could potentially be considered as a viable alternative investment for portfolio diversification

  • Understand the risks and how bitcoin may fit in with your goals and risk tolerance

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