Of all the different techniques available to investors, diversification may be one of the best. By using this approach, which is touted by many investment experts, you can help manage the risk of your portfolio losing value and potentially enjoy higher returns.
The basic idea behind diversification is that you should not put all your eggs in one basket. Ideally, you will combine differing assets whose prices do not follow or correlate with each other. As a result, a decline in the price of one component will coincide with an increase in another.
Creating this ideal situation may be difficult, as assets rarely display perfect, negative correlations. However, you can still use diversification to help smooth out the price movements of your portfolio.
Bitcoin’s Key Role in Diversification
Bitcoin can play a key role in these diversification efforts due to the digital currency’s unique nature. Bitcoin is in an asset class all its own, according to a whitepaper created by investment manager ARK Invest and cryptocurrency exchange Coinbase.
When drawing this conclusion, the paper pointed to several characteristics, including the tendency of bitcoin prices to move independently of the values of other assets.
Low Correlation
By comparing bitcoin’s price fluctuations to the movements of fiat currencies, stocks, bonds, real estate, and gold, the paper’s authors concluded that bitcoin’s price movements did not follow those of other asset classes very strongly.
The chart below illustrates the correlation that bitcoin and these asset classes had between 2011 and 2016. Note the bitcoin column is almost entirely green, meaning it has low correlation with other assets, making it excellent for diversification.
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A separate paper written by academics at Paris Dauphine University had similar findings. The analysis found that:
“The Bitcoin rate of return presents statistical characteristics that differ markedly from those of other assets, including gold, oil, and hedge funds. In addition, Bitcoin investment is attractive because it delivers exceptionally high diversification benefits. This is due to low correlations not only with traditional financial assets but also with alternative investments.”
Because of these low correlations, you can potentially use the cryptocurrency to help reduce the overall volatility of your investment portfolio.
Here are some specific use cases that might help you make better-informed investment decisions. They involve scenarios with both strong-and weak-economic conditions.
Investing in Good Times
One good way to use bitcoin to diversify your portfolio is to invest in the digital currency as a hedge when economic conditions are strong. During times like these, risky assets – for example stocks, high-yield bonds and oil – tend to push higher.
While including these assets in your portfolio helps you benefit as they rise in value, including safe-haven assets like bitcoin can reduce the downside risk, or the risk of losing value, that your portfolio faces should conditions deteriorate.
A Risk-Tolerant Portfolio
For example, if you opted to create a portfolio of risky assets that included 20 percent U.S. stocks, 20 percent high-yield bonds, 20 percent oil and 20 percent real estate, you might consider using gold to fill up at least part of the remaining 20 percent.
While stocks, high-yield bonds, oil and real estate may all push higher as the economy improves, they could lose value quickly should business conditions start to turn sour.
Hedging Times of Crisis
While bitcoin can provide significant diversification when economic conditions are strong, its benefit may be even strong during times of crisis. During the financial crisis of 2008-2009, for example, many different assets suffered sharp losses.
As a result, correlations increased significantly, making it more difficult for investors to diversify effectively and protect their portfolios from downside risk. While the financial crisis took place before bitcoin was in existence, the digital currency has managed to experience significant price gains during times of crisis.
Should bitcoin behave like this going forward, you might be able to hedge against the downside risk of your portfolio by using bitcoin. If the market’s aversion to risk increases significantly, as it did during the financial crisis, the value of bitcoin could rise sharply, helping compensate for any declines in risky assets like stocks and oil.
Key Considerations
If you are planning to use bitcoin to diversify your portfolio, there are some key considerations you should keep in mind. For starters, you do not need to purchase an excessive number of securities in order to obtain effective diversification.
Once your portfolio has 20 or 30 securities, adding more will provide little benefit in terms of reducing portfolio volatility, according to research that academics E.J. Elton and M.J. Gruber conducted in the late 1970s.
Be wary of investment products that charge high fees in exchange for providing exposure to a large number of securities. Many mutual funds, for example, hold between 100 and 150 stocks, while charging fees that some critics have decried as being overly high.
Summing It Up
When used correctly, bitcoin may serve as a great tool for diversification. It may help reduce the risk of your portfolio and make its price fluctuations less volatile. However, keep in mind that bitcoin may be slightly more beneficial for smoothing out portfolio volatility during times of crisis than during times when economic conditions are strong.
Diversifying effectively can be a complicated matter, so it may be helpful to speak with a financial advisor, registered investment advisor or similar professional.
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