During Janet Yellen's testimony to the House Financial Services Panel a member in the audience held sign reading, "Buy Bitcoin.".
Bitcoin has yielded a return of ~139% YTD.
Notorious software developer turned investor, John Mcafee, forecasts the spot rate of one Bitcoin to reach $500,000 within 3 years.
Despite the higher volatility and risk, adding some percentage of these crypto-assets to your portfolio is a prudent decision according to the data.
This article breaks down objective risk and return data for Bitcoin (BTC) with the goal of helping you determine whether you should initiate a long position. For simplicity I will only be covering BTC since it has the largest market capitalization in the space and is the most well known.
Currently I am reading a book by Yuval Noah Harari titled, "Sapiens: A Brief History of Humankind." One particularly interesting observation from Yuval is:
As far as we know, only Homo sapiens can talk about things we have never seen, touched, or smelled. Think religions, myths, legends, and fantasies. The telling of myths and stories allow Homo sapiens to collaborate in large numbers in extremely flexible ways. This separates us from all other animals.
As I contemplated this idea, BTC came to mind. Similar to the way homo sapiens were better suited to survive relative to other ancient human species like Neanderthals and Denisovans, there is a new breed of investor suited to understand and invest in these crypto-assets that no one has ever seen, touched, or smelled.
Astronomical Return Potential
Looking objectively at the return characteristics of BTC relative to other assets it is truly in a class of its own. JPMorgan (JPM) publishes a "Guide to the Markets" booklet each quarter with a plethora of informative charts. One of my favorites shows how well, or poor, the Average Investor does compared to each individual asset class.
If you were to add the new crypto asset class onto this chart, the bars representing every other asset would be hard to see. At the time I began writing this article BTC had already returned 140% this year. Below is a chart from Coin.Dance showing the dollar return of Bitcoin over different time periods.
The most astonishing part about that return figure is that due to several factors institutional investors are for the most part not able to invest yet unless doing so through the Bitcoin Investment Trust (GBTC) which means paying a ridiculous premium. If regulations are passed, institutional investors have access, and mass market adoption continues to become reality massive amounts of untapped funding would continue to push up the price of the limited supply token. John Mcafee, tech icon who founded the antivirus software company Mcafee Associates, recently made the bold prediction that BTC price will reach $500,000 in just 3 years.
In order to fairly assess the viability of BTC for your portfolio the risk characteristics need to be considered and compared to your current investment to determine the risk adjusted rate of return. Especially for such a volatile asset. To do this, I used daily pricing data from the last 3 years of BTC and the S&P 500 ETF (NYSEARCA:SPY).
While the S&P 500 expectedly had more tolerable Standard Deviations and Daily Ranges (high-low for the day as a percentage of price), the Sharpe Ratio of an investment in Bitcoin was higher meaning higher return is expected per unit of risk. Without accounting for stress, and chance of selling due to emotions it seems that BTC has a better risk-adjusted return profile.
Almost half a century ago Harry Markowitz proposed the idea of building a portfolio along the Efficient Frontier with an optimal risk/return profile. I created a basic model showing what this frontier looks like for the two assets that I compared above. (Risk is shown on the x-axis and daily return is the y-axis.)
The bottom of the curve is an allocation of 100% to stocks, or a portfolio simply holding SPY. The point on the far right of the curve is holding 100% BTC. The red circle at the leftmost point of the curve is the Global Minimum Variance Portfolio. This is the combination of SPY and BTC that results in the least variance due to their correlation. This Global Minimum Variance Portfolio as calculated from the previous 3 years daily prices is 96% stocks and 4% in BTC. According to Markowitz's theory it would not be prudent to hold a portfolio below this point since you could earn the same or higher return by simply selecting an allocation higher up the frontier curve.
The optimal portfolio in this simulation holds an allocation of 84% SPY and 16% BTC. This allocation results in the highest Sharpe Ratio: .1264. Compare this Sharpe Ratio to the portfolio holding 100% stocks over the same time period: .0835.
According to the data, holding some amount of BTC in your portfolio can actually increase your Sharpe Ratio! Put simply, this means the numbers say it would be a wise choice to invest some of your wealth into BTC, given you are able to tolerate the additional volatility.
In my next articles I will break-down the investment profiles of other assets in the crypto space such as ICOs and Alt-coins like Ether.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.