Bitcoin Isn’t the Portfolio Diversifier You Think It Is
Bitcoin maximalists have been selling the value of Bitcoin as a potential investment portfolio diversifier, but increasingly there are very few, if any, assets which can effectively diversify a portfolio.
To Meghan Reid, her college application strategy made absolute sense — after all, hadn’t her Mom told her not to put all her eggs in one basket? So rather than have her hopes and dreams dashed by not being able to get into her top choice college, Reid, a senior at New York City’s Stuyvesant High School used a complex algorithm to determine how best to stretch her limited college application resources as far as possible.
Instead of focusing her efforts on writing one inspired college admissions letter, she would build a generic template and then tailor specific points for what she thought the college admissions staff would want to read.
Armed with the knowledge that the admissions rate into some of the top schools she was gunning for was around 4% to 5%, she spread her bets amongst the top colleges in the United States, calculating that the odds of at least one college accepting her were close to certain.
Reid was so confident in her strategy that she didn’t even bother with a so-called “safety school” — one whose admission rate was so high that the statistical odds of her getting in were more or less assured based on her projected GPA.
So imagine Reid’s shock and horror when she was rejected by every single college she applied to.
But it’s not that her grades were bad, they were decent (though not outstanding) — her decision to hedge across a broad swathe of top colleges without focusing on what she really wanted meant that her application fell into the fattest part of the curve of college applicants for these exclusive schools — that part of the curve that got rejected.
Selective colleges don’t always take in students on the basis of grades — newsworthy backstories work as well.
By hedging her college admissions, Reid was essentially dooming them all to mediocrity — the very quality that top institutions of learning are wont to avoid.
To understand college admissions in the U.S. is to understand something about statistics — grades are one thing, but standing out at either end of the tails is what ensures admission — and tails are usually filled with people who don’t hedge but go all in — same as for investments.
Most investors will make or lose the bulk of their money at the tails, and the thick meaty center of the curve will do little either way.
Yet somehow, investors have been taught to adopt the same tact when it’s come to their portfolios.
How’s my portfolio?
Much of what we understand today to be a recommended investment portfolio comes from the Nobel Prize-winning work of Harry Markowitz and James Tobin in the 1950s.
Markowitz and Tobin showed that the risk of an investment shouldn’t be considered in isolation, but in the context of the overall portfolio of investments that an investors holds.
Take the price of gold for instance, which is highly volatile.
In isolation, gold is a very risky investment, but if added to a stock portfolio however, could reduce the overall volatility of that portfolio because historically, gold prices tended to rise during recessions, when stocks generally fell.
To use a fancier term to describe that relationship, the price of gold is “negatively correlated” with the prices of stocks.
Thus, according to Markowitz and Tobin, a well-diversified investor can tolerate a risky investment like Bitcoin, that they would otherwise not be willing to hold if that was their sole investment.
The problem though is that correlation is rarely, if ever, static.
Correlation very simply is the co-movement of two variables. It’s how much the movement of one variable affects the movement of another.
For instance, if your married friend appears at a dinner party, you’d expect to see them with their wife (hopefully and not their mistress) — because the duo are positively correlated.
But such correlations, just like a marriage, can vary over the time period which they’re being measured, the directions of the variables can shift and things very quickly become confusing.
Which is why most financial advisers recommend that investors maintain a sufficiently diversified portfolio, typically a mix of assets.
What many investors don’t realize however is that during periods of sustained inflation, which appears to be where the world is headed to, both stocks and bonds suffer and many assets can become unwittingly correlated.
For the longest time, Markowitz and Tobin held court when it came to portfolios, proving the value of a sufficiently diversified portfolio as bond and equities moved opposite to each other over the course of the business cycle.
When recessions hit, bond prices tended to rise sharply (their yields fell) as investors searched for safety.
But when the economy recovered, bond prices would fall sharply (their yields would rise) and stock prices would go up again.
An easier way to understand this is in terms of risk appetite.
Government bonds are considered safe assets — investors rush to buy them when they are uncertain about the present and the future.
Stocks, by contrast, are risky assets, which investors typically avoid during periods of uncertainty.
But over the course of the pandemic, those assumptions were upturned because massive amounts of both fiscal and monetary stimulus saw both stocks and bonds rise in value.
What happened to my correlation?
With interest rates so low, investors starved for choice had little option than to feed the markets.
That low interest rate environment sent the prices of stocks rising.
The ascent of passive investing over the past several decades hasn’t helped either — as stock prices rise, funds which track those stocks are forced to buy more of those securities to maintain their balance, pushing prices even higher.
But take a step further back and investors will notice that the most recent correlation between stocks and bonds isn’t new.
Since the early 80s, bond and stock prices have moved in broadly the same direction, upwards.
Examining low-frequency data over a long period, the bond-equity correlation isn’t negative at all, it’s positive.
Over the past four decades, there has been a secular decline in government bond yields, mirroring a secular decline in interest rates.
The earnings yield on stocks has fallen as well, as have yields on other assets, such as corporate bonds and property.
And that’s created room for non-yielding assets such as gold and Bitcoin.
Because yields were so low anyway, the holding costs of investing in Bitcoin, which generates no income, becomes relatively lower in real terms.
Yet none of this should be surprising — yields are a gauge of expected returns, while bonds and stocks compete for investor dollars — over the long term, the prices and yields of each will respond to the other.
The past two weeks have demonstrated how both bonds and equities can travel in seeming lockstep.
As U.S. Treasury yields soared, with the prices of bonds falling, so too did stocks, this despite the belief that the economy is recovering.
According to Modern Portfolio Theory, the fall in the value of bonds should have been more than made up for by a rise in the value of equities, yet that “hedging” effect failed to materialize.
There’s a simple explanation for all this though — and it’s that in a typical business cycle, interest rates tend to rise as the economy gathers strength, but each business cycle interest rate peak tends to be lower than the previous one (which is why bonds and equity prices tend to converge over the longer term).
But all of that has been in response to a secular decline in inflation.
For bonds and stocks to serve their role in portfolio diversification, then inflation needs to be kept in check.
Bonds promise fixed cash payments in the future, but those future cashflows are worth less in real terms when inflation unexpectedly rises.
By contrast, stocks have generally outpaced inflation over the long haul, but unfortunately, the relationship between stock prices and inflation isn’t stable.
Ever since the U.S. abandoned the gold-backed system of currency in 1971, checks on inflation by adding stocks to a portfolio have been less binding.
That’s why assets like bonds, stocks and even Bitcoin appear to be moving almost in sync — it’s because of perceived and anticipated inflation.
Which brings us to Bitcoin.
Although the likes of Tesla’s Elon Musk and MicroStrategy’s Michael Saylor have all touted Bitcoin’s power to defend a portfolio against inflation — the data supporting such a view is patchy at best and a work of fiction at worst.
Even gold’s role as an inflation hedge isn’t flawless.
Between 1895 to 1999, the real price of gold increased on average by just 0.3$% a year, which means virtually no change in the real value of gold over slightly more than a century.
But during shorter time horizons, gold might not only be unable to hedge against inflation, during 1980 to 2001, the nominal price of gold actually fell by almost 70%.
Adjusting for inflation, had investors bought gold in September 1980, holding it till April 2001, they would have seen the value of their investments fall by over 80%!
Yet there are some who liken Bitcoin to gold — if you like Bitcoin, it’s probably best to keep those comparisons as far from gold as possible.
Because Bitcoin has only ever existed in a period of low inflation, there’s no telling what would happen to it if inflation were to suddenly spike.
Investors bulking up their portfolios with Bitcoin now, sound sometimes like the gold bugs just after the Nixon administration abandoned the gold standard in 1971 — at the time, the price of gold went from around $35 an ounce to a staggering $850 just four years later around 1980 — a rise of 25 times.
But remember, at the time, U.S. interest rates were an eye-watering 20% — these days markets go into shock when interest rates approach even 1%.
Yet if the inflation narrative is believed to be the driving force behind rising bond yields, shouldn’t Bitcoin then rally as well?
The reason is that Bitcoin, stocks and bonds are all moving with a degree of synchronicity because fiscal policy, that blunt tool of economic intervention, is shifting the investment landscape altogether.
For the longest time, fiscal policy (governments acting directly in economies through investments or handouts) was considered ill-suited to tailoring aggregate demand.
In many ways, that perception was accurate — just consider the number of American families who didn’t really need stimulus checks, received them anyway, and went to buy Bitcoin or shares in GameStop.
The other reason why until fairly recently fiscal policy was frowned upon was because politicians are generally reluctant to cut spending or raise taxes even when the economy threatens to overheat.
Those concerns were dismissed of course in the aftermath of the 2008 Financial Crisis — whatever reservations that governments may still harbor have over alleged “moral hazard” have clearly been placated.
Making matters worse, the academic central banker, with his white hair and wire-rimmed glasses, paranoid about inflation, has given way to the proponent of Modern Monetary Theory, who believes that an absolute prince who knows how to govern can gain access to funds more cheaply and pay less interest than one who is not.
Gone are the concerns over inflation, instead, politicians believe they’ve found a magic porridge pot of money that can be used to do everything from pave roads to cure climate change.
All this will feed into a loss of fiscal discipline and therein lies the real danger.
Because inflation risks are higher than they have ever been before, investors could see their typical Markowitz portfolios upended.
And given that Bitcoin has been seen as both a hedge against inflation and a risk asset, its ability to adequately diversify a portfolio is dubious — there just isn’t enough data to determine if it works.
As the past decade has demonstrated, focus is key — hedging only works insofar as there are clear, sustainable and provable negative correlations between the various asset classes.
Over the past year, we’ve seen both tech stocks, gold and Bitcoin move together.
Now we’ve witnessed tech stocks, bonds and Bitcoin move in lockstep — that’s hardly the stuff of diversification.
So instead of looking for diversification, investors could do worse than to consider focus and double down on whatever investment they can most get behind, whether that be bullion or Bitcoin.