The Economist: Why is it wise to add Bitcoin to the portfolio?

Editor’s Note: “The Economist” recently published article “Why it is wise to add bitcoin to an investment portfolio” ( Why Bitcoin added to the portfolio is wise). The article mentioned that Bitcoin’s low correlation with traditional markets makes it a potential source of quality for portfolio diversification. This article quoted a sentence from Nobel Prize winner Harry Markowitz in a paper published in the Journal of Finance, which stated that “What is important is not necessarily the asset itself. Risk, but its contribution to the volatility of the entire portfolio’s value,” this view laid the foundation for “modern portfolio theory” to a certain extent.

The following is the original text:

“Diversity is both observable and wise. We must reject non-diversified codes of conduct, whether it’s making assumptions or treating it as an aphorism.”

This sentence is taken from an article entitled “Asset Selection: Effective Diversification” published in 1952 by the economist Harry Markowitz in the Journal of Finance. This paper helped him win the Nobel Prize in Economics in 1990 and laid the foundation for “modern portfolio theory”.


Left: Harry Markowitz

In this article, Harry Markowitz applies the two mathematical concepts of mean and variance of portfolio returns for the first time to clearly define investor preferences mathematically. For the first time, the principle of marginal analysis is applied to the analysis and research of asset portfolio. This research result is mainly used to help families and companies how to rationally use and combine their funds in order to obtain maximum benefits when risks are fixed.

The theory believes that a rational investor should maximize his returns relative to the risks (volatility of returns) they take. Naturally, assets with reliable and high returns should occupy an important position in a wise investment portfolio. But Mr. Markowitz’s excellence is that he reveals the theory that diversification can reduce risk volatility without sacrificing returns. If a common saying is used to express this financial philosophy, it is “the whole is greater than the sum of its parts.”

In view of the frequent plummeting and rising of the value of cryptocurrencies, investors seeking high returns without volatility may not be attracted to cryptocurrencies such as Bitcoin. But Mr. Markowitz’s opinion is that for investors, what is important is not necessarily the risk of the asset itself, but its contribution to the volatility of the entire portfolio—this is mainly the correlation between all assets. The problem. Investors who hold two weakly correlated or uncorrelated assets may feel more directly that when the value of one of the assets plummets, there may be no fluctuations in the other.

Considering that the portfolio of assets that a wise investor may hold includes: stocks, bonds, real estate funds in different regions, and a single type of precious metal (such as gold), the highest-yielding assets “stocks and real estate” tend to move in the same direction at the same time. Move in one direction. The correlation between stocks and bonds is weak (about 0.2-0.3 in the past ten years). But the return on bonds is also much lower. Investors can reduce volatility by increasing bonds, but doing so often results in lower overall returns.

This is where Bitcoin’s advantage lies. The volatility of cryptocurrency may be very high, but in its short life cycle, the average return of cryptocurrency is also high. The important thing is that the volatility of cryptocurrencies is often independent of other assets. Since 2018, the correlation between Bitcoin and all stocks in the world has been between 0.2-0.3, and if you go forward longer , This correlation is even weaker. Bitcoin’s correlation with real estate and bonds is also weak, which makes Bitcoin an excellent potential source of portfolio diversification.

This may explain the attractiveness of Bitcoin to some large investors. Hedge fund manager Paul Tudor Jones once stated that his goal is to hold 5% of his investment portfolio in Bitcoin. As part of a highly diversified investment portfolio, this allocation seems reasonable. In the four tests conducted by Buttonwood in the past ten years, the best investment portfolio includes 1-5% of Bitcoin, not only because of the skyrocketing cryptocurrency, even when Bitcoin fluctuates greatly, such as 2018 When Bitcoin fell sharply from January to December 2019, 1% was that Bitcoin’s investment portfolio still showed a better risk-reward ratio.

Of course, not all calculations about which assets to choose are straightforward. Many investors not only seek to make good investments, but are also committed to being environmentally friendly. They believe that Bitcoin is not environmentally friendly. In addition, to choose an investment portfolio, investors need to collect information about the expected trend of these assets. Expected returns and future volatility are usually measured by observing the past performance of the asset. But for cryptocurrencies, this approach has obvious flaws, because past performance does not always indicate future returns, not to mention the very short history of cryptocurrencies.

Although Markowitz elaborated on how investors should optimize asset selection, he wrote, “We have not considered the first stage: the formation of related beliefs.” The return on investing in stocks is part of the company’s profits, and the return on investing in bonds is The risk-free interest rate plus credit risk. For Bitcoin, apart from speculation, we still don’t know what brings Bitcoin’s return. We even have reason to believe that Bitcoin may not generate any return in the future. Many investors have strong philosophical beliefs about Bitcoin-it is either a redemption or a curse, but neither redemption nor curse can become 1% of these investors’ assets.


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