The Modern Portfolio Theory includes Bitcoin

Anthony Ferrenbach
Dec 3, 2018 · 5 min read

The reasons why institutional investor want/should get in

Bitcoin has been praised a number of things, from “internet money” to “digital gold” and has proved to be a real revolution in the tech scene. Even the bear market has not stopped the trend, with 1.3 billion already invested in 2018, blowing 2017 totals and a 300% increase in the number of jobs related to cryptocurrencies in the US.

The number of market where Bitcoin could be applied to is very broad. From the remittance market (584 billion annually), the gold market (7 trillion), the offshore deposit market (16,7 trillion), to the e-commerce market (2.3 trillion annually) etc. Capturing a fraction of those markets, and this is plausible given Bitcoin advantages over gold for portability, its privacy and security for offshore deposit market and remittance market, and convenience for the e-commerce market, would make Bitcoin value increase much higher than it is today.

The risk around Bitcoin

On the other hand, many risks have been sited around Bitcoin and why it value should actually be 0. Here are some of the main ones:

Notably, the possibility that Bitcoin will be replace. People have been saying that bitcoin is slow and expensive, so most probably other * better * options will take over. Options that are much faster like Litecoin, Bitcoin Cash and the likes. However, this hypothesis has not materialized so far. This is because Bitcoin offers the best consensus, prioritizing security over rapidity. More importantly, Bitcoin enjoys a much higher network effect than any other cryptocurrencies out there. Metcalfe’s Low stipulate that “the value of a telecommunications network is proportional to the square of the number of connected users of the system (n2)”. Bitcoin has undeniably the highest number of wallet (around 20 million) and users by far, making it very difficult (or would take years) for any other digital assets to compete on that scene.

Plus, Bitcoin also benefits from the highest Lindy effect, against its other counterparts. The Lindy effect is a concept that the future life expectancy of some non-perishable things like a technology or an idea is proportional to their current age, so that every additional period of survival implies a longer remaining life expectancy.

Furthermore, the possibility of a hard fork, which has long been feared. In August 2017, many concerns were raised around the potential catastrophic outcome of the hard fork. However, we now know that Bitcoin community has be resilient enough. If anything, bitcoin has rallied after the hard fork.

Moreover, some have stated the possibility of a bug on the software code. Indeed, Bitcoin being the first cryptocurrency, it cannot be possible that Satoshi Nakamoto have thought of everything, right? Well, in September 2018 a bug was find, one that would have given the possibility to print un unlimited number of new bitcoins, above the 21 million hard cap. Instead of taking advantage of the bug, the anonymous developer who find it reached to the Bitcoin Core developers, which then handled the project. This again, has shown that, given the open-source aspect of Bitcoin and it strong community, the software has been kept safe and secure.

All of those factors combined have allowed Bitcoin to maintain the top position on CMC since inception, and represent more than 50% of the total market of cryptocurrencies today.

The allocation strategy of portfolio manager depends on their investment policy statement and customers preferences, risk aversion and style. However, even for a risk averse investor, putting a small amount of their overall portfolio would make them benefit from diversification.

The risk around traditional asset classes:

To further put that into perspective let’s take a look at what assets classes are available out there and their risk-reward profile.

Fixed Income: Government bonds are usually thought to be very secure and giving a stable return over time. However, the interest rate policies of the last 10 years have created a very unstable environment, where governments have taken too much debt and can no longer pay their principal. From that outcome, the government and central bank have two options. One, it let the government default and the bond is worthless. Second, it will print more money to pay the bondholders. Which in reality only leave us with one real options. Unfortunately, this option is the one where money is devaluated and is getting subject to inflation. The same dollars you have today will be worth less tomorrow.

Equities: The stock market has seen an incredible rise in the last 10 years, partly due to low interest rate and the money printing machine as well. The equation is simple, there is a higher supply of money for almost the same demand of stock (Amazon, Google, Microsoft, Facebook…), which shoots the price up. Again, this is all based on the assumptions that interest rate will stay low, and the availability of credit. Moreover, these debts are very concentrated among a handful of companies. Creating a very high systemic risk if anyone of them default. (aka too big to fail). At those current valuation, there is a high probability that the percentage downside is much greater than the percentage upside.

Real Estate: The same assumptions can be made here around the effects of interest rate and availability of credit. The difference is the liquidity, which makes housing price drop for longer time periods if no artificial growth is created.

Currencies / Cash: The potential risk of increased inflation due to quantitative easing makes your cash worth less over time.

So where does bitcoin fit?

Thus, not being with any risk, Bitcoin offers an enormous potential for future value and thus a risk-reward ratio that has not been seen for a while on any investment asset classes. Which is why including Bitcoin in a diversified portfolio might increase it risk-reward characteristics

While Bitcoin’s correlation with other asset class is certainty not negative, it averages toward zero, which is much better than traditional hedges that are mid-positive. Plus, it has appeared to be an uncorrelated alternative not as impacted by the macroeconomic factors that influence more traditional asset classes. Meaning that Bitcoin could potentially increase the risk-reward characteristics of an investment portfolio and the Sharpe ratio of managers.

Considering the current investment landscape and its risks, the benefit of diversification cannot be over-looked. Adding this new asset class would add even more diversification to a portfolio. If not bought for its enormous potential upside, it should at least be bought for diversification. Diversification is the only free lunch that exist, since it free up a portfolio from unsystematic risk (company specific risk).

Forecasting the behavior of Bitcoin during time of economic and/or political stress is very hard given that the asset has never gone through a recession.

One thing to note is that assets’ correlation tends to increase in downturns, so they might as well follow the same trajectory, but to what extent? Moreover, during periods of market uncertainty, funds tend to fly to safe heaven assets, thus, since bitcoin is thought to be a risky asset, it value would decrease. However, the only political * stress * events that Bitcoin has lived through in its history were Brexit and Trump’s election, which in both case it has increased in value.