A classic painting of a man weighing and recording gold in a ledger.

Time travel back a decade thanks to some comic mishap with Dr Who, and the idea of owning Bitcoin in your portfolio was for the birds.

Or, more specifically, for geeks, drug dealers, and nihilists.

Many things were different then, of course.

No Brexit. No Covid-19. Insurrection just one man’s dream. No blood oxygen monitor on the latest Apple Watch.

Society and technology moves on, is my point. Bitcoin is no different.

For one thing the price has soared:

Price graph of Bitcoin from 2013 to 2021
Source: Statista

The Bitcoin network reportedly now uses more energy than Argentina.

Bitcoin is also far more widely owned than it was.

Long-term holders – or HODL-ers, in Bitcoin-speak – still own many of the 18.5 million bitcoins mined so far. It’s estimated 1,000 whales control 40% of the market.

But there’s a good chance you too have at least a bit of a bitcoin. And if you don’t then you know someone who does.

Perhaps you bought it just to get in on the fun? Or maybe you’ve been in since the beginning.

With Bitcoin refusing to die and becoming a more valuable sliver of your assets, it’s natural to wonder where it fits into your asset allocation.

How to think about Bitcoin in your portfolio

Already this article will have got some readers’ hackles up.

I have no idea what a hackle is, any more than most Bitcoin owners have an idea of how a peer-to-peer network verifies transactions across a public distributed ledger called a blockchain.

But I do know that if you talk semi-seriously about Bitcoin, hackles go up – whatever hackles may be.

Well this is not a post attempting to debate cryptocurrency in general – or Bitcoin specifically.

What I will say is that for something often decried as a fraud or a Ponzi scheme, Bitcoin seems remarkable resilient.

And I believe the case for Bitcoin as a store of value – digital gold, if you like – strengthens the longer it sticks around.

That’s because as it does so, ever more people believe the story, trust the technology, and decide they want in. It’s a self-reinforcing circle.

Yes, this makes it a construct of the human mind.

So what?

Gold is only worth what someone will pay for it.

Rihanna has 91 million followers on Instagram because 91 million minds see her value.

The pound in your pocket – or displayed on your smartphone – has value because you believe you can buy things with it, and that the government and the Bank of England will keep things that way.

There’s the same self-fulfilling quality to Bitcoin.

Three things to ask about Bitcoin

Bitcoin is one of those Marmite-y things that people love or hate.

I believe a framework for thinking rationally about Bitcoin in your portfolio is useful wherever you stand – and it can help move you towards a sensible middle ground.

Too many people are either all-in on Bitcoin, or else fending it off with scam-repellent barge poles.

Rather than fire emojis at each other on Twitter, let’s break down whether you should hold Bitcoin with three key questions:

  • #1 What do you think is the future of Bitcoin?
  • #2 Do you need to have Bitcoin in your portfolio?
  • #3 How much should you allocate?

Answer these and you should at least know why you do or don’t own Bitcoin, and where it fits into your asset allocation.

#1 The future of Bitcoin

We won’t tarry long on the future of Bitcoin. (If you can have your hackles up then I can refrain from tarrying.)

PhDs have been written on the future of Bitcoin. Yet someone uninformed will still quip below that it’s all a crock while another will urge you to dump your worthless fiat money ASAP.

It’s too big a debate for this ‘umble blog post.

Are you a believer, a denier, or an agnostic? This will play the biggest role in determining how much Bitcoin you own.

I believe Bitcoin has earned a role as an up-and-coming store of value. The potential becomes increasingly realised every day.

Bitcoin now has a pseudo-market capitalization of $840bn. It is being integrated by the likes of Mastercard, PayPal and Square. Tesla just bought $1.5bn worth of Bitcoin and you will soon be able to buy a Model 3 with it. Some institutions have begun accumulating.

None of this guarantees your grandchildren will be begging you for one more bedtime story with an eye on your private key, mind you.

It took millenia for gold to be established as eternally valuable. Warren Buffett still hates the stuff. Bitcoin will be controversial all our lives.

But for now I’m satisfied it works, has momentum, and is winning over ever more people as a place to park some wealth.

I’m less convinced by Bitcoin as a currency.

Most of its non-criminal advantages are being quickly replicated by fintech. And it’s far too volatile to be a currency as we generally use the term.

Sure you’ll be able to buy stuff with bitcoins. You can part-exchange with a house or a car, but we don’t call a Fiat 500 a cash substitute.

But for me Bitcoin’s potential as digital gold is enough to take it seriously.

You’ll have to make your own mind up.

#2 Do you need to have Bitcoin in your portfolio?

It’s one thing to see a future for Bitcoin. It’s another to believe you need it in your portfolio.

I see a bright future for dog-owning. I’m not about to open a puppy farm.

We can briefly consider four reasons for adding an allocation to Bitcoin: returns, diversification, global weighting, and FOMO.

Returns

Our portfolios are designed to grow our future wealth. Ideally we want to own stuff that will go up in value.

So let’s put aside all the earnest talk about money-printing and Bitcoin’s censorship resistance.

The reason we’re having this conversation is the price chart above. This thing has been on a flyer for years.

Owning Bitcoin over the past five years would have turned $1,000 into $118,000. That’s an annualized rate of 259%.

Please sir, can I have some more?

Nobody knows whether Bitcoin will keep rising in the future like it has in the past – and those who think it’s the future of cash have some explaining to do if it does.

But it’s easy to construct a plausible thesis for prices going higher still.

There will only every be 21m bitcoins, and 18.5m have already been mined. Several million have been lost. Millions more are being HODL-ed, and so rarely come into circulation.

This doesn’t mean you can’t buy a bit of bitcoin. Bitcoin can be divided many times. But the hard cap on total issuance is a positive for the price.

One sanity check is gold. There’s $10 trillion worth of gold at current prices. The value of all bitcoins mined is still less than $1 trillion.

If you believe Bitcoin can be the equivalent of digital gold then perhaps the price can rise at least ten-fold. That could underpin future returns.

Diversification

Ideally we want to add assets to our portfolio that go up in value over the long-term, but do so at different times.

This smooths the ride as different assets wobble. We can also earn extra returns by rebalancing between our holdings.

If the price of Bitcoin just rose and fell in sync with equities or government bonds, we might decide to stick to those more established assets1 and skip the bother of crypto-whatnottery.

So far, Bitcoin has shown diversification benefits in a portfolio, says ARK Invest:

Table showing how Bitcoin's price has demonstrated low correlations to other asset classes.
(Click to enlarge)

Note that an ongoing low correlation to other asset classes isn’t guaranteed.

Bitcoin is young, relatively speaking, and as it gains more owners – especially listed companies – I suspect correlations will rise.

Recently I’ve noticed the price direction of Bitcoin overnight can be a good indication for where the stock market will open the next day.

In other words, it seems to be more of a ‘risk-on’ asset than a safe haven. Speculative, even.

Many things drive asset prices, however. Disentangling it all is complicated.

Being subject to risk-on speculation shouldn’t rule out Bitcoin from serious consideration.

Consider the many gold rushes or even the dotcom bubble. Yet people still allocate to precious metals and stocks for the long-term.

Exposure to global GDP / assets

If or when Bitcoin becomes bigger and more integrated with the financial system, it may be harder to ignore if you want broad exposure to global economic trends.

This still doesn’t necessarily mean you need to own any bitcoin.

Listed companies like Tesla, Square, and MicroStrategy2 already hold bitcoins. If more firms follow their lead and carry Bitcoin on their balance sheets or accept it as payment, your portfolio should gain exposure anyway.

Whether you like it or not!

FOMO

Fear of Missing Out (FOMO) may seem a flaky reason to own bitcoin.

But we are all human, and psychological factors loom large in investing.

FOMO is what got me wanting to own one bitcoin.

Bitcoin’s rally confused me in 2017. I lost a few hundred quid buying late into that short-term bubble and then bailing, which at least saved me from losing more. But it got me reading.

Eventually I shifted from an agnostic position to become a weak believer.

That – added to the FOMO I felt in 2017, and knowing Bitcoin had been through several booms and busts before – meant I wanted some ahead of any future surge. Long story short, I accumulated my way to owning one bitcoin in early 2020 at what now seems a bargain price.

The good thing about buying something you’re not certain about is you have skin in the game. You pay more attention, and you panic less if the price rises. You do have to watch your total exposure to stay comfortable.

The worst thing would be if you’re keen on Bitcoin but prevaricate, then pile half your money in during a bubble before selling after the price pops.

Some people really do that sort of thing in times of wider madness.

Being realistic about your human frailties in advance and setting some guardrails can help protect you from extreme emotional investing.

#3 How much should you allocate to Bitcoin?

So how much bitcoin should you have in your portfolio?

Luckily there is a simple formula:

Number of times you've written HODL in the past 24 hours
+ percentage of times you puy the word 'fiat' before the word 'money' in conversation
x 2 if you ever say 'debasement' outside of the bedroom
– your current allocation to bonds
= % to allocate to Bitcoin

(If over 100% please seek help. Or a mortgage.)

Obviously I’m joking. There is no simple rule of thumb for Bitcoin like there is for shares and bonds. It’s far too young and controversial.

I’d say less is more. To match gold, for instance, there’s still room for a 1% position to grow into a 10% position – or to be trimmed en-route – while not doing too much damage if it bombs.

Now you might say if you expect an asset to go up tenfold it makes no sense to hold just 1%. I hear you. Just take into account the uncertainty.

The brainiacs at ARK Invest ran a Monte Carlo simulation and found:

Source: ARK Invest

Efficient Bitcoin allocations range from 2.55% (to minimize volatility) to 6.55% (if you’re focused on returns), ARK says.

Those numbers seem reasonable to me.

Obviously they stand to look ridiculous if Bitcoin goes up five-fold by 2025 or if you can buy three bitcoins for £10 by Christmas.

That’s the nature of investing in highly uncertain super-fast growth.

No pain, no gain

Do not underestimate the pain caused by volatility in your portfolio, even if you’re bullish.

If you’re a passive investor in broad index funds, you won’t be used to seeing truly outrageous overnight moves.

Morningstar also crunched the historical data on allocations and found:

Source: Morningstar

We can see from the table that even small allocations to Bitcoin made a big difference:

Bitcoin’s standard deviation was more than 15 times that of the equity market, making it among the most-volatile assets in Morningstar’s database of 35,000-plus market indices.

As a result, both risk and returns increased with larger bitcoin weightings.

Even a 1% weighting would have led to a sharp increase in standard deviation compared with an all-equity portfolio, as well as significantly worse drawdowns.

These numbers assume annual rebalancing. Monthly rebalancing would have led to better risk-adjusted returns, but are costly and a lot of hassle.

Conclusion and what I’m doing

Hopefully this is all food for thought for anyone wondering about holding bitcoin in a portfolio.

If you expected a pat answer – 10% in Bitcoin, say, or a year’s earnings – then sorry. Come back in 20 years and I’ll be more precise.

In retrospect I was extremely lucky with my own timing. When I bought my bitcoin it was very expensive compared to ten years ago, but still manageable versus my net worth.

The price has since skyrocketed. But as my thesis is that Bitcoin really does become more valuable as the price rises (as opposed to it just being a Greater Fool game) I can live with that.

I even added a small stake in a Bitcoin miner as a trading play in my ISA. (Not enough to make me millions, alas).

It helps that I’m an active investor in individual shares. I have a direct position in a gene editing company that exploits a biological hack derived from slime mold to modify human DNA.

An allocation to Bitcoin does not keep me up at night.

Passive investors face a more difficult conundrum. Bitcoin is definitely not an established asset class. That it’s making a lot of headlines and going up in price doesn’t mean you need to own it. Plenty of things do that everyday.

It’s fine to say you’ll let the market take care of it. If Bitcoin does become established, then banks, fund managers, and others will incorporate it into their operations.3 You’d gradually get exposure to Bitcoin without doing anything.

This neatly sidesteps the questions about position sizing and volatility, let alone the risk of the technology failing or quantum computers someday cracking Bitcoin.4 (Weighing up Bitcoin makes bonds look easy!)

If you do see merit in adding some bitcoin for diversification, I suggest starting small. You could even pound-cost average in each month, as you might with other assets.

Bitcoin may be new, but we can still apply a sensible investing framework to it.

  1. Perhaps using debt to increase our position sizes if needed.
  2. Disclosure: I hold Tesla and Square.
  3. “Assuming it doesn’t make them obsolete!” – obligatory Bitcoin maximalist riposte.
  4. We will see a lot else rewritten in our financial lives if quantum computing lives up to the hype and cracks Bitcoin.

The post Should you own Bitcoin in your portfolio? appeared first on Monevator.

Leave a Reply

Your email address will not be published. Required fields are marked *

*

This site uses Akismet to reduce spam. Learn how your comment data is processed.