Cryptocurrency: a risky asset or a new investment opportunity?

The allure of cryptocurrencies has continuously kept us fascinated. Virtual currencies are a frequent topic of discussion among everyone from retail investors to general members of society, this accelerating market - a subset of a market named “digital assets”. 

The tormenting financial crises of the previous two decades has driven regular investors, traders, stakeholders, and policymakers to seek alternative investments that help them with diversification benefits. 

In my last blog, we observed that bitcoin cannot currently be used as a hedge against inflation, but let's see if other cryptocurrencies, in addition to bitcoin, can be used as asset diversity to boost portfolio performance. 

Cryptocurrency’s privileges of high return and minimal correlation with conventional assets have piqued investors’ excitement but at the same time, its excessive volatility often scares them away. 

 

In the thirst of perceiving if digital currency is a new investment opportunity or just a false alarm, researchers have experimented extensively with various investment strategies and conducted tests by pairing cryptocurrency with traditional assets. 

 

The correlation of cryptocurrencies with traditional assets; and diversification benefits of cryptocurrency are inversely proportionate to each other. 

Until 2017 the virtual currencies showed strong signs of diversification but they began to diminish by the start of 2018 due to various reasons, one of which being there were crypto hacks like the Coincheck hack in January 2018 in japan.

The versatility reward of cryptocurrency is highly susceptive to external events like government bans on cryptocurrency operations, financial shocks and crypto hacks. When there is a significant degree of uncertainty investors seek to impersonate investment techniques of other markets players, which increases equicorrelation and hence, reduces diversification advantages. 

Even though the diversification merits were reduced at the start of 2018, portfolios inclusive of cryptocurrency attempted to perform better and offer a higher return than a portfolio solely inclusive of stock. Amid all the cryptocurrencies, bitcoin is the best diversifier followed by Ethereum.

 

“The co-founder of macro hedge fund Brevan Howard has emerged as one of the highest-profile European fund managers to throw his weight behind digital currencies like bitcoin” as per financial times.

As per existing academic research, cryptocurrencies prices vary across exchanges, to analyse the benefit of cryptocurrency they use portfolios consisting of stocks and bonds, and test portfolio models with bitcoin prices from the CoinDesk site and Bitstamp (highly liquid) site. 

The result showed a low relationship between bitcoin and conventional portfolio which states that there is the possibility of diversification benefit. But note that this test excluded transaction cost which means the transaction cost was deducted from the returns. 

To determine an asset's true profit, we need to add the transaction cost to the return. 

So, what happens if we include the transaction cost with the return? 

Well, again bitcoin wins, it adds value to the performance by increasing the risk-adjusted return of the portfolio once it is included. 

It was simple up to this point, but now let’s make it tough for bitcoin to show us its worth, shall we? 

Adding commodity index (mostly industrial metals, followed by energy) to a multi-asset portfolio can also improve portfolio performance, so let's examine what happens if we add bitcoin to a stock-bond-commodity portfolio? 

Bitcoin remains consistent and shows that it’s better to include bitcoin rather than using only a stock-bond-commodity portfolio, on the other hand, the allocation of bitcoin in a portfolio varies depending on the individual; if you are risk-averse, you will lower the percentage of bitcoin in your multi-asset portfolio, reflecting the riskiness of bitcoin. 

Ultimately, how will bitcoin perform beyond a portfolio consisting of global assets? 

One of the best ways to diversify our portfolio can include international assets. Even if the global asset portfolio is already very well-diversified, tests conducted by the researchers prove that a marginal contribution to cryptocurrencies may yield a better benefit. 

Finally, keep in mind that bitcoin is highly volatile, it has the diversifying benefit which boosts the investor’s portfolio performance but this benefit has no role in reducing its irregularity. 

So, if one’s aim is to lessen the risk in a box of a risky asset then funding in cryptocurrencies is probably a bad idea. 

Given bitcoin's market fluctuation, investors continue to support it; thus, is cryptocurrency a threat to central banks, and why are they launching CBDC? Which country will be the first to introduce CBDC? 

STAY TUNED!!

References:

Demiralay, S., 2020, ‘ Should stock investors include cryptocurrencies in their portfolios after all? Evidence from a conditional diversification benefits measure’, URL: https://onlinelibrary.wiley.com/doi/epdf/10.1002/ijfe.2116?saml_referrer 

Platanakis, E. and Urquhart, A., 2020, ‘Should investors include Bitcoin in their portfolios? A portfolio theory approach’, URL: https://www.sciencedirect.com/science/article/pii/S0890838919300605?casa_token=QSBUAQXb7qMAAAAA:cQPx_pJsPg3hgMJBkLCY7kIAjxTv4Vh5q7_466z9ULpWqVh9iRsVXUUUpNeqZij4yy3AqRXp8g 

Colombo, J., Cruz, F., Paese, L., and Cortes, R., 2021, ‘ The Diversification Benefits of Cryptocurrencies in Multi-Asset Portfolios: Cross-Country Evidence’, URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3776260 

Oliver, J., 2021, ‘Alan Howard makes fresh investment in crypto start-ups’, Financial Times, URL: https://www.ft.com/content/2fc6f620-2872-41d6-8b63-7cd8d3e33b4d 

Cryptocurrency HD Wallpaper, URL: Image: https://wall.alphacoders.com/big.php?i=888104