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Cryptocurrency adoption is increasing. As a result, many are wondering whether they should include crypto in their portfolios. Figuring out exactly how much is the next challenge.
The increase in adoption by companies like PayPal, the investment by institutions like Rothschild Investments and the recent Coinbase listing are making it harder to deny that cryptocurrencies are becoming a common feature not only in the world but in a well-rounded portfolio.
There are several who suggest different allocations based on the typical 60/40 stock/bonds portfolio. However, by using the Black-Litterman Model, investors can allocate the amount of crypto they hold according to their confidence in its growth potential.
Institutional investors’ interest in bitcoin
Just two years ago, Shark Tank celebrity investor Kevin O’Leary called bitcoin (BTC) “garbage.” Last year, he released a video entitled, “Why I’m Not Investing in bitcoin!”
However, as the total market capitalization of crypto recently surpassed $2 trillion, it’s become almost impossible for institutional investors to ignore.
Even O’Leary has changed his tune. Last month the celebrity investor announced he would be allocating 3% of his portfolio to bitcoin. For someone with a net worth of $400 million, this allocation amounts to $12 million worth of BTC.
Other companies have been setting a similar example over the past year. In August 2020, MicroStrategy invested $250 million in bitcoin. Since then, they’ve spent a total of $2.226 billion on bitcoin.
Payments service Square Inc. followed suit in October 2020, investing $50 million in bitcoin. It recently raised this by another $170 million. Finally, Tesla made a big splash in February 2021, investing $1.5 billion in the cryptocurrency.
As with all investments, increased interest from these big players trickles down to smaller-scale investors who are interested in making smart portfolio moves.
Understanding bitcoin for your portfolio
Investors wanting to figure out how to invest in cryptocurrencies first have to understand them.
Investment firms are starting to provide explainers to potential clients. For example, Fidelity Investments released the report ‘Understanding bitcoin.’
In the report, Fidelity Head of Director of Global Macro Jurrien Timmer describes bitcoin’s growth potential and compares it with other assets to help investors understand it better.
Potential exponential growth
Timmer states that an increasing number of investors and portfolio managers consider bitcoin a legitimate and distinct asset class. Bitcoin, he explains, is a finite asset with a unique supply and a unique demand dimension. However, its distributed nature enables a network effect, which is not the case with other assets.
Specifically, Timmer refers to Metcalfe’s Law. Essentially, Metcalfe’s Law says that as the number of its users grows linearly, a network’s value grows geometrically.
Putting it another way, bitcoin’s utility, in this case, value, should grow much faster than its network of participants. Timmer notes that bitcoin’s growth curve appears to still be in its early, exponential phase—and could remain so for several years. This indicates a bullish case for bitcoin. As its demand could grow exponentially, its supply remains fixed at a total of 21 million.
Digital gold vs physical gold
Timmer then points out that some see bitcoin as a form of “digital gold.” This is because bitcoin could act as a stable store of value, potentially offering protection against inflation.
In this era, where economic stimulus against the coronavirus has seen governments all over the world printing money at an unprecedented rate, bitcoin may be stealing some of gold’s thunder when it comes to being a hedge against inflation.
Besides being easier to transfer and hold, Timmer notes that bitcoin has one unique advantage over gold — its finite supply. “Gold is scarce but not getting any scarcer,” he says in the report.
Timmer concludes with several suggestions. First, he says that some investors may want to consider bitcoin as one component of the bond side of a 60/40 stock/bond portfolio. Since bond yields are near zero or negative, he suggests replacing some of them with gold or “assets that behave like gold.”
He points out that bitcoin does have several risks, including volatility, competitors, and policy intervention. However, he also admits that:
“bitcoin is a legitimate store of value, is scarcer than gold, and comes complete with a potentially exponential demand dynamic.”
As the report suggests, the question now changes from whether you should invest in bitcoin to how much?
Varied crypto allocation suggestions
Other financial experts have also made portfolio allocation suggestions based on the 60/40 model.
Ark Invest CEO Cathie Wood said that she believes bitcoin and other crypto may become a standard part of recommended portfolios for investors.
She posited that cryptocurrencies, like bitcoin, will eventually resemble bonds. Consequently, she believes that the bond portions of these portfolio allocations may finally give way to cryptocurrencies.
Wood said:
“You think about the traditional 60/40 stock-bond portfolio, but look what’s happening to bonds right now,” she said. “If we are ending a 40-year secular decline in interest rates, that asset class has done its thing. What’s next? We think crypto could be the solution.”
Another allocation suggestion comes from a study performed by Yale economist Aleh Tsyvinski.
According to the study, cryptocurrencies enjoy higher potential returns than other asset types, despite their higher volatility. A portfolio should contain 6% bitcoin to achieve optimal construction, the study says.
Even for bitcoin skeptics, the research suggests at least a bitcoin allocation of 4%. If only for the purpose of diversification, those cautious of cryptocurrencies should have at least 1% in their portfolio.
This conservative amount is suggested by Ric Edelman, founder of Edelman Financial Engines. Replacing one percentage point of the 60% stock allocation with cryptocurrency would give investors the benefit of diversification without risking their portfolio.
“We need to acknowledge that 1% allocation isn’t going to materially harm a client,” he said. “It isn’t going to prevent them from achieving their financial goals and won’t damage their personal finances.”
Edelman lauds virtual currency for diversification, as they have little correlation with other asset classes.
The Black-Litterman Model
Although experts have various opinions of how much bitcoin one should have in their portfolio, how can an average retail investor decide?
Fortunately, there is a model that takes an objective approach while also including investors’ preferences.
The Black-Litterman Model starts with a neutral, “equilibrium” portfolio. It then provides a formula for increasing holdings based on the investor’s view of the world. It incorporates not only an investor’s growth estimation, but also the confidence in that estimate. These inputs are translated into a specific portfolio allocation.
It starts with the global market portfolio, or all the asset holdings in the world, as the neutral starting point. If bonds occupy 51.98% of the total asset market, stocks 47.03%, and crypto at $2 trillion, 0.99%, then the base portfolio should have a similar allocation.
Next, for any given growth rate in cryptocurrency, the Black-Litterman Model returns the amount an investor should hold in their portfolio. The investor can then specify their conviction level in that assumed growth rate, and the model adjusts accordingly.
As crypto increasingly overshadow investors’ interests in other assets, it is apparently worth considering the Black-Litterman Model among the many tools in determining your optimal crypto investment.