In the ever-evolving landscape of financial markets, the allure of Bitcoin (BTC) as a viable investment has been growing day by day. While some still perceive it as a risky venture, a closer examination reveals that Bitcoin offers unique benefits and can play a crucial role in diversifying investment portfolios.
In this article, let’s explore the misconceptions surrounding Bitcoin’s risk and reward, and how strategically incorporating Bitcoin can improve the health and performance of portfolios containing traditional assets.
Dispelling the myth of Bitcoin’s inherent risk
Bitcoin has long been associated with high volatility, leading many to view it as an excessively risky investment. However, a deeper analysis suggests that this perception may be somewhat exaggerated. Bitcoin’s volatility has decreased over time, and its maturation as an asset class signals a more stable crypto market.
Over the last five years, the annualised returns of BTC and various crypto indexes have consistently been higher than that of NIFTY 50 and other traditional market indexes in India.
Although the crypto market exhibits higher volatility compared to traditional markets, it is important to look at the risk to reward ratio. Let’s look at the Sharpe ratio, a financial metric that tracks the amount of rewards an investor will get per unit risk that the investor undertakes. The data indicates that the Sharpe ratio of BTC is comparable to that of the NIFTY 50 over the same period. Furthermore, the Sharpe ratio of BTC is increasing. NIFTY 50's Sharpe ratio stands at 1.3, while BTC exhibits a Sharpe ratio of 0.9. The Value at Risk (VaR), a metric gauging the risk level of an asset, is notably higher in the crypto market. Nevertheless, examining the past five years reveals a declining trend in the VaR for BTC and crypto market indexes, indicating a diminishing level of risk as the market matures.
To elaborate, BTC has had a VaR of 6% over the past 5 years, while NIFTY Indexes have a VaR of around 2%. A daily VaR of 5% implies that within a span of 100 days, there is a possibility of witnessing losses equal to or exceeding 5% on five days. This statistical measure provides insights into the potential downside risk associated with an asset or market.
The observed reduction in VaR of BTC over the past half a decade suggests a maturation process in the crypto market, contributing to a more stabilised risk environment.
Moreover, it’s essential to recognise that risk is an inherent aspect of any investment, and solely focusing on short-term price fluctuations can obscure the broader potential that Bitcoin presents.
Investors should adopt a long-term perspective, acknowledging that volatility can also bring opportunities for substantial returns.
Uncorrelated to Nifty —a diversification powerhouse
One of Bitcoin’s most compelling features for portfolio diversification is its lack of correlation to traditional assets like the Nifty index. Bitcoin operates on a decentralised platform, largely independent of the factors influencing traditional financial markets. This lack of correlation means that Bitcoin can act as a hedge against market downturns, providing a valuable diversification tool for investors seeking to mitigate risk.
For investors looking to delve into smaller-cap stocks represented by indices like Nifty Small and Nifty Midcap, the addition of Bitcoin can reduce the overall Beta of the portfolio. Beta is a risk metric that measures the sensitivity of an asset to volatility in the market. The higher the beta, the more susceptible an asset will be to market fluctuations. So, a positive Beta implies the positive correlation between the asset and the market in general while the magnitude of Beta on the other hand gauges the extent of fluctuations.
The Beta of BTC against NIFTY is a mere 0.26 while that for the NIFTY Smallcap and NIFTY Large Cap indices are close to 1. While BTC by itself is more volatile as compared to NIFTY, a low Beta implies that it is unlikely that both of them will have a downturn at the same time. This means that BTC can provide a good hedge against downturns and fluctuations in the traditional markets.
An illustrative portfolio scenario
As an example, let’s compare two hypothetical portfolios —one with NIFTY50, NIFTY Midcap and NIFTY Smallcap indexes in a 50:30:20 ratio and another where instead of 20% Small Cap holdings, Bitcoin is given 5% weight and 15% to NIFTY Smallcap index.
Both these portfolios have the same risk-to-reward ratio, but investing in BTC allows the latter to have better annualised returns. While both these portfolios have a Sharpe ratio of 1.5, the portfolio with Bitcoin has annualised returns of 25% as compared to 20% for the other one. Even though this seems like a small improvement, compounded over 5 years this 5% can translate to a difference of over 50% in aggregate returns.
Over the past 5 years, the Beta of the NIFTY MidCap and Smallcap indexes against the NIFTY 50 have increased while that of Bitcoin and crypto indexes have decreased. So, by introducing Bitcoin into these portfolios, investors can further improve diversification and returns. Bitcoin’s unique risk-return profile and lack of correlation to traditional assets can contribute to a more balanced and dynamic portfolio.
It is important to note that while higher volatility introduces additional risk, it also opens the door to greater potential rewards. Investors willing to embrace a slightly higher level of risk can strategically allocate a portion of their portfolios to Bitcoin, harnessing its characteristics to enhance overall portfolio performance.
Conclusion
In conclusion, the prevailing narrative that Bitcoin is an excessively risky asset is due for a reassessment. The evolving nature of the cryptocurrency market, coupled with Bitcoin’s maturation as an asset class, positions it as a valuable component in a well-diversified portfolio.
Its lack of correlation to traditional assets like Nifty, combined with the potential to reduce beta in portfolios containing assets such as Nifty Small and Nifty Midcap, makes Bitcoin a promising choice for investors seeking to navigate the complexities of today’s financial landscape.
As with any investment strategy, due diligence and a comprehensive understanding of the risks involved are essential. However, dismissing Bitcoin solely on the basis of perceived risk may mean missing out on a powerful tool for achieving diversification, resilience, and potentially higher returns in the long run. As the financial landscape continues to evolve, embracing innovative assets like Bitcoin can be the key to unlocking new avenues of growth and opportunity in investment portfolios.
—The author, Edul Patel, is CEO of Mudrex, a Global Crypto Investment Platform. The views expressed are personal.
(Edited by : C H Unnikrishnan)
First Published: Dec 21, 2023 11:07 AM IST
