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About the author: Nannette Hechler-Fayd’herbe is chief investment officer of international wealth management and global head of economics and research for
Speak to anyone younger than 25 about investing and the conversation will quickly turn to crypto assets. That generation’s enthusiasm and perception of making big profits with a relatively small investment builds on the past decade of experience with Bitcoin and Ethereum, to name but two prominent examples. In addition, the prospect of earning much lower real returns on traditional bonds and equities than previous generations shifts young investors’ focus to any alternative that helps grow their capital sufficiently to fund what is expected to be longer life spans.
However, now things look set to take a different turn, as the world’s central banks, first and foremost the U.S. Federal Reserve, plan to start raising interest rates in their battle against the diminishing purchasing power of cash. Except for an episode in 2018, not much is known about how cryptocurrencies fare in rate-hiking cycles. Back then, the price of Bitcoin fell from $19,511 in December 2017 to $3,136 in December 2018. It subsequently climbed a steep peak, hitting a high of $64,870 in April 2021 before falling back to $28,824 in June 2021. That volatility continued in the past week, with Bitcoin seeing dramatic swings up and down.
Where cryptocurrencies are headed over the next 12 months is anybody’s guess, and beside the point. In the long term, what really matters from an investor standpoint is how much return and decorrelation one gets for every unit of risk taken in a portfolio. Decorrelation and diversification provided by crypto assets are unequivocal. Since 2010, Bitcoin, for example, has had a correlation of only 15% with U.S. equities, 4% with U.S. government bonds of medium maturity, and negative 1% with gold. Returns have also been compelling, averaging about 150% annually. However, volatility is what makes crypto assets challenging for investors.
Most investors would consider emerging market stocks volatile and to be added carefully to portfolios. In fact, the volatility of cryptocurrencies is a multiple higher than emerging market equities (an average 200% annually for Bitcoin, for example). A mere 2% allocation to cryptocurrencies in an otherwise well-diversified portfolio of bonds, stocks, and alternative investments of medium risk would account for 25% of overall portfolio volatility. Instead of a typical portfolio volatility of about 7.6% annually, volatility would rise to 9% by switching 2% of alternative investments, such as hedge funds, into an equal allocation to Bitcoin, according to Credit Suisse estimates. Increasing the cryptocurrency allocation to 5% or even 10% of the portfolio would eventually triple overall portfolio volatility to nearly 23%.
Along with high volatility comes the degree of drawdowns. Since 2010, Bitcoin has had three instances when losses amounted to 80% from the previous high over periods up to 18 months. In a balanced portfolio, adding Bitcoin would take the maximum portfolio drawdown (losses) from about minus 13% (without crypto holdings) to some minus 18% in the case of a hypothetical 10% allocation to Bitcoin. Portfolio optimizers calibrated to minimize the impact of extreme events and penalize assets with large downsides would actually require an average annual return of 350% to retain Bitcoin, for example, in a portfolio.
Thus, investors pay a steep price in terms of volatility for the promise of outsize scarcity returns and diversification. This is why professional wealth and asset managers are wary of including cryptocurrencies in structured portfolios. A recent survey that Fidelity conducted of institutional investors finds that the most significant barriers to adoption of digital assets among professional investors are price volatility, concerns around the lack of tested valuation methods, the security of asset custody, regulatory classification, and market manipulation.
The moral of the story is that there is no free lunch, only tough decisions and transparency about portfolio impact. High returns come alongside high volatility, and it is up to investors to assess how much risk they should be taking to achieve their investment objectives, always keeping in mind their investment horizon, specific needs, and constraints. Up to a 2% portfolio allocation, digital assets as part of the allocation to alternatives keep the nature of portfolios broadly unchanged. Higher allocations increase portfolio risks materially and alter the nature of the entire portfolio. That is why Credit Suisse doesn’t include digital assets in its advised asset allocations.
That said, the technology behind crypto assets—distributed ledger technology, or DLT—may still have a bright future. It can be applied in numerous cases ranging from trading and exchanges to payments and logistics, and any form of smart contracts. Even central banks are accelerating digital-currency projects. Hence, DLT does offer the potential to become the technological backbone of future monetary and financial systems. Thus, we expect that the inclusion of companies that have either direct revenue or operational exposure to DLT in portfolios will be rewarding for investors going forward.
Investors should always go back to the basics of investing: focus on an asset’s return, volatility, drawdown, and correlation properties to determine its suitability in robust and well-constructed portfolios. Especially for the next generation, this must be a priority.
Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to [email protected].
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