Modern Portfolio Theory and Your Crypto Investments

What is the ideal combination of traditional investments and cryptocurrency investments?

While bitcoin and other cryptocurrency investments offer the potential for huge returns, they also carry enormous risk. In Bitcoin Market DiaryOur goal is a balanced investment strategy that minimizes risks as much as possible.

To help us find the ideal portfolio, we turned to Modern Portfolio Theory (MPT).

MPT is about achieving the optimal balance between risk and reward through diversification. Instead of going "all in" on bitcoin, we balance the wild fluctuations of cryptocurrencies with more traditional investments. MPT helps us find the right combination.

In this article, we will explore two types of investor people: the balanced inverter and the crypto bro. Who is the winner? Spoiler: it's the one using the MPT approach.

What is modern portfolio theory?

Simply put, MPT suggests that Diversification is the key to maximizing returns and minimizing risks..

You can think of it as preparation for a long trip where you need to be prepared for all types of weather. You would bring an umbrella, sunscreen and a warm jacket.

Similarly, diversifying your investment portfolio using the MPT strategy means preparing for various economic “climates,” from crypto bull runs to frigid crypto winters.

By allocating between different asset classes, you can take advantage of the returns of volatile assets like bitcoin, while protecting yourself against an expected market decline.

Who created MPT?

Modern portfolio theory was introduced by the American economist Harry Markowitz in 1952 in a article titled "Portfolio Selection." Markowitz later received the Nobel Prize for his work on this investment approach.

He called for a diversified portfolio that gave exposure to different asset classes, such as corporate stocks, bonds, real estate, commodities and hedge funds.

If you knew about cryptocurrencies, you'd probably allocate a portion of a diversified portfolio to this new asset class. This is because cryptocurrencies' low correlation with traditional investments helps reduce risk.

Take, for example, BTC's correlation with the S&P 500 Index, NASDAQ Index, and Gold:

Pearson correlation shows the strength and direction of correlation between variables (S&P 500: black, NASDAQ: red, Gold: teal). Fountain: The block

In the chart above, we see that the S&P and NASDAQ are highly correlated, so they offer little diversification. Gold, however, is not correlated with stocks, so it can serve as a hedge: when stocks go down, gold can go up (and vice versa).

Markowitz argued that diversification methods could vary. For example, a portfolio may rely on asset allocation models, sector allocation models, industry allocation models, or geographic allocation models.

The main objective of MPT is Maximize profitability while mitigating risks..

Many mutual funds in the US follow MPT guidelines to maximize the returns on their portfolios.

Our view of a balanced portfolio with a small amount allocated to cryptocurrencies is based on modern portfolio theory.

Modern portfolio theory in action

Let's explore two investor examples and see who wins in the long run:

The balanced investor

Imagine Alice, the balanced investor. She is an experienced captain who navigates calm and stormy seas with a well-equipped boat.

For example, she uses our "Blockchain Believers”Portfolio strategy, which allocates traditional stocks (65%), bonds (32.5%), and a small portion of bitcoin (2.5%).

This combination allows you to take advantage of the growth potential of digital currencies while anchoring your portfolio with the stability of traditional assets.

This approach has many benefits, such as:

  • Stability amid high volatility and turbulence in the crypto market.
  • Smooth out portfolio volatility.
  • Focus on long-term growth.

The Crypto Brother

On the other hand, we have Bob, the crypto brother who speculates on the price of crypto assets, trying to find the next big coin. While his portfolio is diverse, it includes many risky assets: almost a third is dedicated to memecoins such as DOGE, Shibu Inu, and dogwifhat. So while the assets are varied, the risk is not, and aside from the large chunk of ETH, there isn't much to absorb the volatility.

At best, your wallet allocates most of it to Ethereum. However, many cryptocurrency investors chase quick profits, betting on riskier crypto assets, such as meme coins, that have no utility or fundamentals to back them.

Who wins in the long term?

Alice's diversified portfolio experiences lower volatility. The stability of traditional investments offsets your losses during crypto market crashes. Meanwhile, your exposure to cryptocurrencies provides a substantial advantage during market recoveries and bull runs.

On the other side, Bob faces a roller coaster. The value of his portfolio rose during the cryptocurrency market boom, but eventually plummeted during the bust cycle, erasing earlier gains. This illustrates that there may be better long-term strategies than putting all your eggs in one basket like cryptocurrencies.

Applying MPT to Crypto Investments

The cryptocurrency market has provided enormous opportunities to early investors who simply "hodled" rather than speculate.

For example, bitcoin has gained more than 10,000% over the last decade.

However, it has gone through huge price fluctuations and most investors have been tempted to sell for profits or exit during multi-month downtrends. It's not easy being a hodler.

On the contrary, traditional markets have also increased in value, but they have been much more stable and balanced. The S&P 500 Index (SPY) is up more than 150% during the same period.

Fixed income investments, such as government bonds, have mostly generated negative returns over the past decade, but still offer stability to a diversified portfolio. For example, SPDR Portfolio Long-Term Treasury ETF (SPTL) It has decreased by 15% during the same period but does not show extreme volatility.

We believe the best approach for risk-averse investors is to consider the principles of MPT and create a diversified portfolio exposed to crypto assets. Our preferred approach:

  • About 2/3 in a stock index ETF
  • About 1/3 in a bond index ETF
  • Only a portion (between 2 and 10%) of bitcoins or crypto assets.

This combination seeks to capitalize on the growth of the stock market, the safety of bonds, and the explosive potential of bitcoin.

Modern Purse Theory and the Purse of Baby Believers

We tried our own version. Believer Baby Portfolio like an experiment. We use data from the last five years for SPY (stocks), SPTL (bonds) and BTC (bitcoin) to find the "optimal" portfolio, using the MPT formula to balance risk and return.

risk-return correlation of bond stocks and bitcoin
The three data points (SPTL, SPY, BTC) show the risk/return correlation of bonds, stocks and bitcoin, respectively. The blue line shows the calculated efficient frontier, and the red X shows the optimal asset allocation based on past performance.

In the “optimal allocation” (shown by the red X), we have:

  • Expected annual return: 32.6%
  • Annual volatility: 2.3%
  • Sharpe ratio: 13.34

By any measure, a 32.6% annual return is stellar, particularly when only exposed to 2.3% annual volatility in the portfolio. It's a very good risk/reward ratio, as evidenced by the relatively high Sharpe ratio: generally, the higher the Sharpe ratio, the more attractive the risk-adjusted return.

However, let's look at the portfolio allocation recommended by this MPT model:

  • BTC: 72.5% of the portfolio
  • SPY: 27.5% of the portfolio
  • SPTL: 0.0% of the portfolio

This is very different from our standard approach, with almost three quarters allocated to cryptocurrencies! However, the annual volatility of this BTC-heavy portfolio would have remained reasonable.

Remember: this is a retrospective model based on historical performance, and past performance is not indicative of future results.

Most investors simply do not have the conviction to invest 75% of their savings in bitcoins, which is why our Blockchain Believers The models present an alternative to help you sleep better at night.

The investor's conclusion

Modern portfolio theory is a strategy that works with various asset classes, especially for long-term investments. It highlights the power of diversification to achieve an optimal balance between risk and reward.

While the "optimal" portfolio over the past five years might have been 75% bitcoin and 25% stocks, we are sticking to our most conservative investment strategy of only a small portion of crypto assets, which still outperforms the traditional investor. with much.

Subscribe to the Bitcoin Market Journal Newsletter to receive regular updates on the performance of our Blockchain Believers portfolio.

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