A Few Tips on Diversification and the Correlation of Assets in Your Portfolio
What's one of the big benefits of investing in crypto? If you talk to a lot of folks, two really big benefits are routinely offered. First, big price appreciation. Folks who buy Bitcoin, Ethereum and other digital assets are all highly confident that the price of these assets are going to rise dramatically over the next several years. There's another argument as well called non-correlation. This is an important conversation, something that most folks are not terribly familiar with.
Non-correlation. What on earth does that mean? It all comes down to the conversation of diversification. Investors are always trying to accomplish two things simultaneously. We're trying to grow our assets and simultaneously we're trying to lower our risks. Right. It's not about how much money did you make? The real question is how much risk did you take to get there?
And we know that diversification helps us lower our risks. In other words, if we put all of our money onto one stock, well, that's a big risk. What if something goes wrong with that stock? But if we buy two stocks, we have lower risk. I mean, what are the odds that they both go broke at the same time? And if we add hundreds of stocks, we further diversify, we further spread out our risk. And then if we go even beyond stocks, we add bonds, we add real estate, we add gold, oil, commodities, the more different investments we have and the more of them we have, the more diversified we are. And that helps lower our risks.
Lowering risk without lowering returns: That’s Modern Portfolio Theory
Here's the fascinating thing. If you do it right while you're lowering your risks, you aren't necessarily lowering the returns, even though different assets have different return potential. We know stocks have a higher potential than bonds. Just because you buy bonds doesn't mean that you necessarily lower the potential for the returns. This is called Modern Portfolio Theory. It won the Nobel Prize in 1991. It was invented back in 1952.
Modern Portfolio Theory simply says that if you obtain the proper mix of investments, you can have the Holy Grail. Higher returns and lower risks. The key is to own investments that zig when others zag. This is called correlation. I don't want investments that are correlated with each other. When I go up, I don't want them to go up. When I go down, I don't want them to go down. I want them to do different at different times. If everybody did everything all the same, all at once, there wouldn't be any diversification. They would be all the same. And this is why I want to have assets that are negatively correlated or non-correlated to each other.
Enter Bitcoin – which can also lower portfolio risk
Bitcoin in its 12-year history has shown itself to be the first non-correlated asset, meaning its price movements have been totally independent of all other asset classes. This means it's a wonderful addition to a diversified portfolio. It helps to lower the portfolio's risk, even though Bitcoin itself is risky. Adding it to the portfolio lowers the overall risk of the portfolio. It's counterintuitive. I know it's hard to get your head around this. That's why it's a Nobel Prize winning strategy.
But everything that I just said has been true about Bitcoin until about nine months ago. Starting last fall, Bitcoin has begun to move in sync with the stock market. It has no longer been non-correlated. It's no longer negatively correlated. It is now positively correlated. Which means as the stock market has gone up, so did Bitcoin. And over the last nine months, as the stock market has crashed, so has Bitcoin. This is raising questions. Gee, one of the big benefits I thought I was getting from buying bitcoin seems to have disappeared. Seems to have gone away. Is that true or not? Well, to answer that question for you, I need to help you understand why the correlation conversation has changed so dramatically. Something happened to Bitcoin in the last year and a half that is totally new and different compared to Bitcoin's 12 year history.
Techies, anarchists, and computer geeks
In the beginning, when Bitcoin was invented back in 2009, it was invented - to be honest, quite frankly, to be blunt - by anarchists. The people who invented Bitcoin were excited about it because it was digital money that was not issued by any government. Their goal was to have it replace all government money around the world. The people who are investing in Bitcoin in the early days were these anarchists, these techies, these computer geeks who were really into this, almost as a cult like thing. That was 2009, 2010, 2011, 2012. And then as Bitcoin's price started to skyrocket, retail investors started to take notice. They began investing, too.
There's now 300 million people around the world who own Bitcoin, but they were all individual investors until about two years ago. Year and a half, two years ago, something changed. We now have the inclusion, the adoption, the engagement of institutional investors, pension funds, endowments, billionaires, hedge funds, venture capital and private equity funds, major multibillion dollar portfolios managed by some of the biggest, best, brightest Wall Street money managers. And what we've noticed since they've gotten involved in crypto is that they are treating Bitcoin and Ethereum and the others as simply another sleeve within their stock portfolio. They consider it part of their emerging markets. They consider it part of their high growth positions, part of their thematic investing positions.
They're not treating it like a totally different, separate new asset class. They think it's just part of the overall asset class of equities. And over the past nine months, as the stock market has fallen and these institutional investors have been selling and running to the safety of cash, they've been selling indiscriminately, they've been selling stocks, they've been selling bonds, and they've been selling their crypto. Institutional trading has been bigger than retail trading in the crypto space. And because of this, they aren't treating it as a non-correlated or negative correlated asset. They're treating it like all the other assets and it's raising the question: is the non-correlation argument gone?
My answer to you is this. It's too early to tell. It's quite possible that these institutions will soon recognize they'll wake up and realize, Oh, we've been treating Bitcoin all wrong. We've been treating it like it's a stock, but it's not. We should be treating it like a separate, distinct asset class with its own features and benefits. We shouldn't be selling it simply because we're selling out of our stock portfolio and they will begin to treat it the way it has always been treated for the past 12 years, or the institutions will continue to dominate, they'll persist in their behavior and the non-correlation argument will simply not return. It's too early to tell. We're going to have to wait and see.
Bitcoin and the price appreciation argument
But the one thing that does remain is the other argument for buying Bitcoin, the price appreciation argument, the notion that Bitcoin's price at $30,000 is very, very low compared to where it is headed over the next five and 10 years. And this argument is still very strong within the institutional marketplace. So we're going to have to wait and see. My message to you is very simple. If you bought bitcoin because it is non-correlated, you have to recognize that that theory is being tested right now for the very first time in Bitcoin's 12 year life. You're going to have to decide if you continue to believe in this argument and whether you think it's going to return to the way it was or whether you need to reevaluate the value proposition for this asset class.
For me, I remain very bullish, but we do have to recognize that when it comes to non-correlation and diversification, the story is not yet over. Stay tuned. I'll be keeping you updated. And if you want to learn more about this entire conversation, read my book, The Truth About Crypto, which has two entire chapters on this very subject of the investment strategy and correlation and diversification. Read The Truth About Crypto.
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