Many of us have followed the dramatic rise and fall of Bitcoin over the past few years and the cryptocurrency in general. Some shut them down completely after an 80% decline in 2018, only to see them roar in the collective consciousness of investors in 2020.
Of course in two years the sentiment has changed – more institutional investors are taking a hard look at crypto and previous heroes have softened their outlook. This all leads to a question: How much cryptocurrency should I have?
The math of salvation.
Needless to say, this is the answer to a difficult question. But, we can borrow a page from modern quantitative money to help arrive at possible answers.
For several years, Wall Street “Quants” managed their portfolios using their mathematical framework as a Black-Litterman model. Yes, the “black” here is the same from the famous Black-Scholes option pricing formula, Fisher Black. And “Litterman” is Robert Litterman, the longtime Goldman Sachs Quantum.
Without getting too many details, the model starts with a neutral, “balanced” portfolio and provides a mathematical formula for increasing your holding based on your outlook on the world. Surprisingly, this includes not only your assumptions about how an investment can grow, but also your confidence in those assumptions and translates those inputs into a specific portfolio allocation.
Your starting point: 0.50%
The Black-Litterman model uses a global market portfolio হ holding all the assets in the world হিসাবে as its starting point for building a portfolio. This means that if you have no other opinion on what an investment can do for good or bad, then you should keep this portfolio.
By early 2021, the global market for stocks totaled tr 5 trillion and the global bond market reached ৫ 105 trillion. The value of the cryptocurrency market was roughly $ 1 trillion. This means that cryptocurrencies represent 0.50% of the global market portfolio.
Global market portfolio in early 2021
Source: The above cryptocurrency data and third party stock and bond data have been improved to create this visualization.
Just as there are many arguments for holding more cryptocurrencies, there are also many arguments for holding less. However, from a model perspective, 0.50% should be your start allocation.
Now, add your opinion.
This is where the mathematical magic comes in. For a given rate of growth in cryptocurrency (or any investment in that regard), the Black-Litterman model will return the amount in your portfolio. What’s more, you can determine the level of confidence in your visual growth rate and the model will adjust accordingly.
The chart below allocates a portfolio of bitcoins derived from the Black-Litterman model. This chart can serve as a useful, predictable guide when thinking about how much cryptocurrency you want to keep.
How to use it: How well do you think Bitcoin will make the stock, + 5% to + 40%. Each expectation matches a line in the expectation chart. For example, if you think that Bitcoin will surpass the stock by 20%, it matches the purple line. Now, follow the left or right line depending on how confident you are. If you are at least 75% confident (a solid “probably”), the purple line includes an allocation of 4% bitcoin.
The graph presents a hypothetical rendering of the return value confidence based on the input of the Black-Litterman model. The image does not represent actual performance, past or present.
One of the most interesting things to note is how much you need to estimate your return and how confident you need to be in order to take a big position in Bitcoin. For example, the model tells you to keep a 10% allocation so you have to be extremely confident that Bitcoin will surpass the stock by 40% every year.
Note that it doesn’t take much to run a model allocation at 0%, for example: no crypto holding. If you don’t think there’s a 50/50 chance that Bitcoin will be at least a little higher, the model says to avoid it altogether.
How did we get here?
The inputs of the Black-Litterman model tell an interesting story between them and them. The main input of the model is the global market cap, which we discussed earlier, the volatility of resources and the interrelationships between resources.
It goes without saying that cryptocurrency is risky. In the last five years, Bitcoin’s volatility is six times that of stocks and 30 times that of bonds. At worst, the value of digital currencies fell 80%, while stocks fell 20%. Other cryptocurrencies were even worse.
Source: Improvements to create the above scenario by encouraging the above ACWI data and cryptocurrency data from third party sources. Visualization is for informational purposes only and does not reflect any better portfolio performance. Past performance is not indicative of future results.
If an asset is volatile, and no one can diversify that volatility, investors will need a higher rate for that investment, otherwise they will decide not to invest.
Bitcoin is so volatile, but offers so few investors (compared to stocks or bonds) that many investors still don’t see the risky potential potential returns. On the other hand, cryptocurrency is a new technology at their core, and new technology always has an adoption curve. The story here may be less about expected return vs. risk and more about early adoption vs. mass appeal.
The final element of the model is the interrelationship of Bitcoin with stocks and bonds. Bitcoin has something to do with both stocks and bonds, meaning that when the stock goes up (or down), Bitcoin can do the same. The less reciprocal the relationship, the more diversity your assets will bring to your portfolio. Bonds have a low correlation with stocks, which makes them a good ballast against turbulent markets.
Bitcoin is more interdependent, meaning it can offer some diversity benefits in a portfolio, but not like bonds.
Cryptocurrency can be an element of your financial planning – but it shouldn’t be the only thing.
While it may not tell you if Bitcoin will be the next digital gold, this mathematical model can help you think about what kind of allocation for crypto might be right for you and what ideas about risk and return might be inherent in it.
Although Betterment does not currently include cryptocurrencies in our proposed investment portfolios, you can learn more about how to properly invest in them using our Cryptocurrency Guide.
Since crypto should have only a small portion of your overall portfolio, you should still have a diversified portfolio and long-term investment plan that will help you meet your financial goals. Improvements can help you make short- and long-term plans, recommend appropriate investment accounts that are consistent with your financial goals, and allow you to select the risk-levels of your choice. You can align your investments with your values using our three socially responsible investment portfolios.