Sizing bitcoin in portfolios

Since its inception in 2009, bitcoin has boomed and helped spur the launch of a wide variety of cryptocurrencies. Over its short history, bitcoin has seen both major surges and selloffs. This volatility, plus bitcoin’s unique characteristics, raises the question of what role it should play in portfolios.

Bitcoin’s value drivers

Bitcoin’s value rises when its predetermined supply is met with growing demand – and demand changes based on evolving investor belief in bitcoin’s potential to become more widely adopted. Case in point: The run-up to record highs after the recent U.S. election reflects investors upping the chance of greater adoption given President-elect Donald Trump’s statements and personnel picks supportive of cryptocurrencies.

The potential for future widespread adoption is thus central to the investment case for bitcoin. We believe it is the period leading up to largescale adoption where the biggest future return potential could lie.

What could spur wider adoption of bitcoin? We see several factors at play. It allows for seamless and instant transactions across borders, anyone can participate in it and it’s decentralized, with no direct government ability to increase or decrease supply. Yet there is a risk it may ultimately never be widely adopted. Doubts around that are what have led to past selloffs.

Sizing an allocation

Taking all this into account, we do see a case for including bitcoin in multi-asset portfolios – provided you believe it will become more widely adopted in the future and are comfortable bearing the risk of potentially rapid price plunges. That’s why investors need to balance the pros and cons when deciding whether to allocate to bitcoin.

Investors size allocations for stocks, bonds and private market assets by considering the asset’s expected returns and risk, along with how its returns correlate with the other assets in the portfolio. But they need to think about bitcoin’s expected returns in a different way: it has no underlying cash flows for estimating future returns. What matters: the extent of adoption. Bitcoin may also provide a more diversified source of return: we see no intrinsic reason why bitcoin should be correlated with major risk assets over the long term given its value is driven by such distinct drivers.

So how can investors think about a bitcoin allocation? Bitcoin cannot be compared to traditional assets. But from a portfolio construction perspective, the “magnificent 7” group of mostly mega-cap tech stocks is a useful starting point. Those stocks represent single portfolio holdings that account for a comparatively large share of portfolio risk, as with bitcoin. In a traditional portfolio with a mix of 60% stocks and 40% bonds, those seven stocks each account for, on average, about the same share of overall portfolio risk as a 1-2% allocation to bitcoin. We think that’s a reasonable range for a bitcoin exposure. Why not more? Going beyond that would sharply increase bitcoin’s share of the overall portfolio risk. See the chart.

Sizing bitcoin in portfolios

Estimated contribution to risk in a 60/40 portfolio

Looking ahead, should bitcoin indeed achieve broad adoption, it could potentially also become less risky – but at that point it might no longer have a structural catalyst for further sizable price rises. The case for a long-term holding may then be less clear-cut and investors may prefer to use it tactically to hedge against specific risks, similar to gold.