Crypto’s Role in Investment Portfolio Management | CoinFlip Bitcoin ATM

Diversifying Your Portfolio With Crypto (And Diversifying Your Crypto)

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A question many ask is where does crypto fit into your portfolio of assets, though, some may ask, does it fit there at all?  

Cryptocurrencies rose out of the 2008 financial crisis with two basic goals: first, to create an asset that could not be inflated away by governments printing more currency. Bitcoin, the first and more prominent crypto, is limited to 21 million coins ever, so no government printing press will ever be able to arbitrarily pump out more coins to pay for "bridges to nowhere" or high-speed rail to the desert. There is simply no risk of its value being wiped out by wasteful government spending.  

Second, there was an interest in a direct peer-to-peer payment system that cut out the middlemen, who were seen as needless toll collectors, and seemingly monitoring every financial move one makes. Despite those humble beginnings, over the past decade, crypto has exploded into its own asset class. Yet, many professional money managers still struggle to figure out where it fits in the financial landscape.

The evolution of portfolio management

For most of the 20th century, client portfolios were typically some mix of stocks and bonds, based on the client's age and risk parameters. The typical portfolio was the famous 60%/40% stock/bond mix to mitigate risk and generate acceptable returns. 

As time went on and modern portfolio theory became more advanced, additional asset classes, such as commodities and real estate, were added to client portfolios. The idea is that adding non-correlated assets, although they may be more volatile, would diversify risks and improve net returns over longer economic cycles.

The theory is that when the economy is strong, the stock portion of the portfolio, and presumably commodities, will generate high returns. In contrast, the bond and real estate portion will have more pedestrian returns. Alternatively, when the economy goes into recession, the stability of bond coupons and rent payments will provide ballast to a portfolio that would otherwise be particularly volatile due to a declining stock market.  

So, the famous 60%/40% portfolio has morphed into something more like 50% bonds, 30% stocks, 15% real estate, and 5% commodities. Again, the non-correlated nature of those asset classes provided solid, if not sexy, returns while protecting through diversification from "black swan" events.

But where does crypto come in?

As noted, cryptocurrencies started as a tiny niche in the financial universe, and some early adopters were almost seen as Don Quixote investors, endlessly tilting at financial windmills... Fast forward, and now crypto is a multi-trillion dollar sector that investors seemingly cannot ignore.  

For perspective, most people have heard professional investors discussing the so-called "FANG" stocks, which stand for Facebook-Apple-Netflix-Google. This group of stocks has become symbolic of the rise of Technology within the economy and the markets. Interestingly, Bitcoin on an average day trades more in dollar volume than those FANG stocks combined. Niche sector no more, I say.

Regardless, where does crypto fit in a portfolio today? Well, it's definitely volatile. And it's clearly non-correlated. Oh, but it's also been the best performing asset class over the past ten years by a long shot, as in it's not even close. 

As noted earlier, modern portfolio theory doesn't mind volatility, as long as it's non-correlated, allocated in the proper amount, and offset by the other asset classes. So, if any professional portfolio manager were presented with a diversified portfolio where crypto represented an allocation of ~5%, it would be very difficult for them to argue that it was not a prudent portfolio structure. The net is, regardless of some of the skeptics, one should figure out the right mix of crypto for each individual portfolio, based on all of the usual parameters, age, risk tolerance, etc. Still, it seems clear that the proper allocation is not zero.

I need some crypto! What's next?

So, you've decided to allocate a portion of your portfolio to crypto. Now, how should you do it? Many people's approach to this is to simply say, "well, I'm just going to buy a Bitcoin, and be done with it." Sure, you are getting crypto exposure, but given that we keep referencing "modern portfolio theory," would that be a particularly wise decision?  

When you meet with your financial advisor, and he discusses the stock portion of your portfolio, would he ever say, "well, my favorite stock is XYZ, so let's allocate 50% of your portfolio to that stock?" Of course not; that would be financial malpractice. Almost assuredly, what he would do instead is recommend you put a chunk of your equity allocation into a fund, such as an S&P 500 index fund.  

For the same reason that your entire portfolio needs to be diversified among multiple asset classes, each asset class needs to be diversified as well. A broad equity index fund will provide you with exposure to a wide swath of stocks whose performance should be reflective of the economy as a whole, providing the needed diversification.  

The allure of these equity index funds is threefold: first is the aforementioned diversification. The second is that they diversify seamlessly. Rather than buying a share of 500 individual stocks, investors can buy just one share of the index. Finally, they are incredibly cost-efficient. The fees on this kind of fund are usually only ~0.05% or five basis points. This means that if you put $50,000 into that fund, it would only cost you $25 per year in fees. Excessive fees are the bane of any investment portfolio, so that index fund may seem like a no-brainer for your portfolio.  

That sounds great; in that case, should we run that same playbook for our crypto assets? Effectively, the answer is a yes and no. Yes, you should likely diversify the crypto coins you own for all of the reasons we have already discussed. Not to put too fine a point on it, but just adding one coin - Ethereum - to your Bitcoin holdings would have lowered your volatility and increased returns over time.  

The point is, you almost assuredly would want to diversify your crypto holdings with access to a number of coins rather than just owning BTC. Allocating your crypto assets into a multi-coin "portfolio" to hold alongside your other diversified asset classes is most consistent with prudent portfolio theory.

Avoiding diversification through crypto funds 

That said, here's the rub: you probably shouldn't diversify by putting your money in a crypto fund. That seems odd; why when it works so well for stocks? Two basic points: first are the exorbitant fees; on average, Crypto funds charge investors about 50-times as much in fees as a stock fund, potentially eating up a meaningful percentage of the investors' returns. 

Think about it this way: every time you buy tickets to a game these days, there is a "service fee" attached, and let's say it's around $20 on average; what do you do? Generally, you just grumble and pay it. What if that fee were $1,000, which is 50-times as much? Obviously, you would walk away, even if it's your favorite team. This is the same thing as paying for some crypto funds.

Second, one of the primary reasons to buy an equity index fund is that buying 500 individual stocks is too laborious when it can be done with a few keystrokes via the fund; it's so cheap and easy. Why bother trying to do it yourself? Alternatively, an investor can easily create his own crypto Index fund with around eight coins, providing the desired diversification with little extra effort and, importantly, no additional fees so that he can keep all the returns for himself over his investment horizon.

Final Thoughts

Talk to the crypto experts about diversifying your portfolio and, as importantly, diversifying your crypto.

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Interested in more from J. Andrew Barr? Read his piece on crypto spreads: Beware the Hidden Fees.

Financial Advice Disclaimer: Nothing in this blog constitutes professional or financial advice, performance data or any recommendation that any specific cryptocurrency, portfolio, index, investment product, transaction or investment strategy is suitable for any specific person. You assume the sole responsibility of evaluating the merits and risks associated with all financial decisions and should seek the advice of a registered financial advisor when in doubt.