Investing.com's extreme price swings have long been a concern for traditional investors. Many view its volatility as a significant risk, unsuitable for portfolios focused on capital preservation.
However, according to analysts at BCA Research, this volatility may not be a flaw but a unique feature that can enhance the value of Bitcoin in a diversified portfolio.
Rather than viewing volatility as an inherently negative thing, BCA argues that Bitcoin’s high volatility can serve as an advantage when viewed through the right lens.
Historically, investors have stayed away from bitcoin due to its dramatic fluctuations. Over the years, the cryptocurrency has shown an average monthly volatility of 76.1%.
In comparison, traditional assets like bonds have a much lower volatility of 5.4%. Bitcoin's track record includes multiple significant crashes, with two occasions when it lost more than 70% of its value.
For conservative investors, these numbers are alarming and often lead to the conclusion that Bitcoin is too risky to be considered a serious addition to any portfolio.
BCA Research argues that analyzing Bitcoin or any other asset solely on its volatility is misleading. What really matters is how an asset fits into the overall portfolio and influences its risk and return.
Focusing solely on volatility allows you to lose sight of the bigger picture of how the asset can add value in a diversified investment strategy.
A recent paper by AQR, which BCA Research applies to Bitcoin, reframes the issue of high volatility. Asness argues that high-volatility assets can be more capital-efficient than their lower-volatility counterparts.
This is because highly volatile assets like Bitcoin allow investors to achieve higher returns without committing a large portion of their portfolio to them. This frees up capital for other investments, allowing for more flexible portfolio construction.
BCA Research illustrates this with a comparison between Bitcoin and a hypothetical low-volatility asset they call Boringcoin.
Both Bitcoin and Boringcoin share the same risk-adjusted return profile, with identical Sharpe ratios of 0.61, meaning that on a risk-adjusted basis, both assets perform equally. However, they differ in their volatility.
Boringcoin has the same volatility as bonds, at 5.4%, which is much lower than Bitcoin. In practical terms, this means that investors would have to allocate more capital to Boringcoin to achieve the same portfolio returns as they would get with a smaller allocation to Bitcoin.
The difference becomes clear when looking at a portfolio that targets 10% annual volatility. With Bitcoin, only 8% of the portfolio needs to be invested to achieve the ideal balance between risk and return.
“In the case of the Boringcoin-based portfolio, there is a large gap between the unrestricted and restricted versions, as the Boringcoin-based portfolio would need leverage of over 100% to fully maximize the expected returns per unit of risk of the assets it comprises, the analysts said.”
To further explore this point, BCA Research conducted portfolio optimizations that compared traditional stock and bond portfolios to those that included Bitcoin and Boringcoin.
Bitcoin’s high volatility allows it to generate strong returns with a relatively small allocation, freeing up capital for other assets. In a well-constructed portfolio, Bitcoin’s volatility becomes a tool to maximize capital efficiency rather than a source of risk to be avoided.
High volatility assets like Bitcoin help achieve better returns per unit of risk, something that more conservative assets like Boringcoin can't match without leverage.
However, managing a volatile asset like Bitcoin in the real world comes with challenges that go beyond what portfolio theory suggests.
BCA Research notes that human emotions can complicate things. Managing clients’ money isn’t just about numbers; it involves dealing with how people react to market swings. In reality, investors can struggle with Bitcoin’s sharp ups and downs, especially during big drops.
While Bitcoin suffered losses of over 70% at times, Boringcoin, with its lower volatility, only fell 7% over the same period. This emotional challenge makes it harder for investors to stick to high-volatility strategies, even if they offer better returns in theory.
In fact, BCA makes a compelling comparison between the price charts of Bitcoin and Boringcoin. Boringcoin, with its smoother trajectory, would be a much easier sell to a conservative group of investors than Bitcoin, which resembles a financial roller coaster.
While Bitcoin may offer higher returns over the long term, the emotional burden of holding it through steep declines could lead to premature selling, negating your gains.
