Cryptocurrencies like Bitcoin belong in every portfolio. But what about their risk-return profile and how high is the correlation to traditional assets? Iconic Holding from Frankfurt has taken on this topic and written a report on it.
The following report comes from Iconic Holdingfrom Frankfurt, an asset manager who specializes in digital assets. The company was founded in 2017 by Patrick Lowry and Max Lautenschläger . In regular analyzes, they provide the necessary know-how to better understand digital assets.
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One of the fundamentals of portfolio theory is diversification, through which the risk – measured by the standard deviation – is to be minimized without reducing the expected return. Because every single asset class has its own risk-return profile, as can be seen in the graphic below.
The optimal investment would be located at the top left, i.e. a high expected return with a low standard deviation.
Normally, a riskier investment also delivers a higher expected return
Correlations are measured with the so-called correlation coefficient, which can be between +1 (perfectly positive) and -1 (perfectly negative). In terms of risk diversification, both values are not desirable, as either the entire portfolio rises or falls with one event or half of the portfolio rises while the other half falls. Diversification is achieved above all by adding an asset that, ideally, does not show any correlation with other asset classes. The lower the correlation between the assets of a portfolio, the more risk that can be eliminated. A non-correlating asset is considered the holy grail of portfolio construction.
In the context of this article, the strategic asset allocation is assumed, not the tactical asset allocation. So it’s about a long-term breakdown into different asset classes and not about short-term earnings opportunities in certain industries or which asset manager is selected.
Correlations of traditional and alternative asset classes
First, let’s take a look at traditional asset classes such as stocks, bonds, commodities and real estate.
As can be seen in the top left quadrant, stocks correlate very positively with one another worldwide, so they are only suitable for risk diversification to a certain extent. Gold is very suitable for adding to an equity portfolio, but correlates relatively strongly with other commodities and real estate. Long-lived bonds in particular are ideal for diversifying into stocks, commodities and real estate.