One of the elements that Bitcoin investors cite is the cryptocurrency’s performance when the stock market is doing poorly. These coins are then often described as a «flight-to-safety» investment: an asset that rises in value when the rest of the portfolio goes down. Is this really the case?
Is Bitcoin an interesting investment to diversify a portfolio? To answer that question, investors (and academics) often use various measures, think of a return-risk measure such as Sharpe ratio or Alpha. The problem with those measures is that they are subject to different assumptions (e.g. Sharpe ratio does not distinguish between a rising or falling market, volatility is volatility or Alpha depends on the risk factors chosen). What if we answer the question in a simpler way?
I compare the returns on Bitcoin and the S&P500 between July 2014 to May 2023 on a scatterplot (see Figure 1):
- For equity investors, there should be many observations in the top left quadrant (= a negative return on the S&P500 and positive return on Bitcoin).
- For Bitcoin investors, there should be many observations in the bottom right quadrant (= a negative return on Bitcoin and a positive return on the S&P500).
To see how good diversification can be, we then count the percentage number of observations in the two quadrants. What do we see? For equity investors, 13.44% of observations are in «the desired quadrant» (= Bitcoin rising as the stock market falls in value). For Bitcoin investors, the situation is better: 26.89% of observations are in the desired quadrant (= the stock market rising in value as Bitcoin falls). However, when taken together, these two investments move in the same direction 60% of the time. This is not what we are looking for when looking for a diversification investment.
If we compare this to gold, we see similar figures. Pim Van Vliet and Harald Lohre calculated, between 1975 and 2022, that gold can be a diversifier for equity investors (= gold rising in value when the stock market falls) in only 19% of cases. What the study does find for gold is the decrease in overall portfolio risk when added to a more traditional portfolio. This is negligible when it comes to Bitcoin. This is because the currency’s volatility is systematically higher than the stock market (See Figure 2). When the stock market goes down, the crypto currency’s volatility is often even higher. Not what you want when thinking about diversification.
So Bitcoin is not the (new) gold in an equity portfolio. There is no denying the nice returns the currency has put down in 2023 (or any further past). But whether classical investors should jump on the bandwagon to get a piece of the pie, the data is very clear: the crypto currency is moving too much in the same direction as the stock market. This is both in a positive and negative sense. For this reason, it is not an interesting investment when diversification is the goal.
Gertjan Verdickt is a lecturer in investment theory and Investment Officer knowledge expert. This column originally appeared on Investment Officer Belgium.