Crypto as part of an investment portfolio (or is it better than tuna?)

This text has nothing to do with Kiyosaki (and no tuna was harmed in the process of writing!). I just came across an interesting research article about crypto as a separate class of investment assets and decided to share it with you.

Robert “Running Dad” Kiyosaki had recently advised everyone to buy Bitcoin to protect against inflation, but in June he suddenly changed his recommendation in favor of buying canned tuna.  Don't listen to him, he's not our bro!
Robert “Running Dad” Kiyosaki had recently advised everyone to buy Bitcoin to protect against inflation, but in June he suddenly changed his recommendation in favor of buying canned tuna. Don’t listen to him, he’s not our bro!

In early June, a large article was published entitled An Investor’s Guide to Crypto from guys from Duke University and investment company Man Group. The article is a detested reading by all real cryptans in the genre of “old farts from traditional finance state their shameful opinions about the blockchain.” Well, in general – about the same as what I do, only without funny memes!

Some charts from this article seemed curious to me, and I decided to share them with you. In short, do not expect any mega-coherent story below or incredible revelations (and even more so, investment, God forbid our souls, signals). But if you are interested in investments and periodically think about what place crypto can take in a portfolio, you may be able to draw some separate thoughts for yourself.

The place of crypto in the financial world

It is often said that in 2021, crypto has become such a significant market that it is simply indecent for traditional investors to ignore it. In absolute terms, phrases like “total capitalization of $1.3 trillion” sound very cool, but let’s compare how crypto looks against the background of other asset classes.

Help Dasha find the crypt in the picture...
Help Dasha find the crypt in the picture…

Considering that the bond market is collectively valued at $129 trillion and the stock market at $88 trillion, the crypto $1.3 trillion does not look so impressive anymore … Well, we must also take into account that since February 2022 (when the data for the picture was collected above) Bitcoin managed to double again, so you can safely divide the capitalization of the crypt at least in half.

It is interesting that different people will draw directly opposite conclusions from this picture. Cryptoskeptics will say “yes, this is some kind of insignificant crap, when it disappears no one will notice”, and true cypherpunks will respond “there is space to make x ten times!”. Who will be right in the end, only time will tell.

Bitcoin and Ethereum: sometimes it hurts a lot

The two most popular cryptocurrencies are, of course, Bitcoin and Ethereum. The authors have drawn a beautiful picture of the ups and downs of BTC & ETH in logarithmic coordinates, there is something to think about. (Ether for some reason only from 2018, I don’t know why.)

Drawdowns of Bitcoin (left scale) and Ethereum (right scale) in logarithmic dimension
Drawdowns of Bitcoin (left scale) and Ethereum (right scale) in logarithmic dimension

As you can see, drawdowns from -60% to -80% are common for Bitcoin; and the Ether was briskly shaken as much as 10 times in 2018 (-91%). The current drawdown was not included in the picture, but on June 18, 2022, Bitcoin fell below $19,000 (by 72% from the previous peak), and Ether on the same date fell below the psychological mark of $1,000 (drawdown over 79% from the peak).

Looking at the current decline in BTC/ETH and the historically achieved returns of +3’000-10’000% after similar drawdowns, it might seem that now very an attractive moment to buy these coins for a long time. Maybe this is so, here I do not undertake to make predictions. But remember that an increase in the drawdown of an asset from -80% to -90% looks like a small step on the chart (“just another 10% fell”) – but for someone who entered this asset at the level of -80%, such “ additional” drawdown will mean halving the invested capital.

Not Bitcoin Alone

If back in 2017, Bitcoin accounted for up to 90% of the turnover on the largest crypto exchanges, by now its share has decreased to about 20% (at least according to Coinbase data – apparently, the authors take only currency pairs against USD, which can severely distort the result of the analysis).

Structure of trading volumes for different coins on Coinbase, excluding stablecoins
Structure of trading volumes for different coins on Coinbase, excluding stablecoins

It is likely that the trend towards increasing diversity in this entire cryptozoo will continue further: Bitcoin will remain the largest single coin, but its relative share in the overall crypto market will be gradually eroded by new projects.

Crypto is a bubble?

Bitcoin is often called a bubble, so the authors decided to draw a sign with other infamous financial bubbles. Three bubbles, so to speak, are quite “historical” – Tulip Mania, the Mississippi Bubble, and the South Sea Bubble; and three more relate to stock markets that are closer to us.

Historical financial mega-bubbles.  MMM for some reason not added!!
Historical financial mega-bubbles. MMM for some reason not added!!

Interestingly, of the stock bubbles, the most painful is the Japanese of the 80s, where it can still be considered that everything is in the minuses.

In general, if you recognize Bitcoin as a bubble, then it must be said that this is the largest bubble ever. Not only has it been swelling in total for more than a decade, but the scale of the “X” in the tens of thousands is unprecedented on a historical scale. It seems to me that even if you are the most seasoned crypto-hater, then all the more you should buy at least a piece of BTC. At least when else will you have a chance to participate in such a massive scam?!

How to value crypto?

TLDR: No one knows how to “correctly” value crypto, period.

The article contains some interesting reflections on the thesis about “Bitcoin is the new gold!” often repeated by cypherpunks. The authors, shall we say, are not convinced of the validity of this analogy.

In particular, the market price of many commodities fluctuates quite close to about 2x their operating cost of production (excluding depreciation). Bitcoin does not fit into this picture in any way: historically, it often cost tens and hundreds of times more than the cost of electricity for mining.

So, when they try to tell you that “Bitcoin is backed by the cost of mining it,” you can at least take this statement with a fair amount of skepticism. On the other hand, the capital costs of mining equipment still make up a significant share in the structure of mining costs – so it might be worth comparing them together.

By the way, the authors estimate that if Bitcoin had the same coefficients to the operating cost of production as gold, then it would have to cost about $11.5 thousand. the conclusion here, however, is rather “you shouldn’t draw too far-reaching parallels between gold and Bitcoin.”

Volatility: how much crypto allows you to lose in one day

If we talk about volatility, then, of course, crypto has no equal. The chart below shows the distribution of one-day returns for Bitcoin and for the S&P 500 index – you can see for yourself. (For some reason, the authors made scales of different scales on these charts – so I had to manually compress the picture for the S&P 500, sorry for the somewhat jackal quality of the result.)

Bitcoin and S&P 500 Daily Returns
Bitcoin and S&P 500 Daily Returns

As you can see, the daily volatility of the US stock index almost always falls within +/- 2.5%, and only really in hellish periods (like the covid March 2020) jumps over 10%. For Bitcoin, a jump of 10% is, roughly speaking, a “normal Monday”, and an unusual daily movement for BTC is, well, at least 20% (or -40%, as it was in covid March).

Correlation: well, at least something is growing!

Apparently, since 2018, the correlation of cryptocurrencies among themselves has increased significantly. This, of course, does not mean that different coins will give the same return; but it seems to hint that if some large coins fall or rise, then the entire market as a whole will behave in a similar way.

Correlation between cryptocurrencies at 15-minute intervals
Correlation between cryptocurrencies at 15-minute intervals

The picture of the correlation of Bitcoin (and with it the entire crypto market) with the S&P 500 looks even sadder. If, through 2019, it was possible to argue that adding crypto to the portfolio would bring a miraculous portfolio effect due to an approximately zero correlation with the stock market, then from 2020 th this correlation went up sharply to about ~0.5.

So everyone who expected that Bitcoin (digital, so to speak, gold!) Will powerfully act as a protective asset and save you from these drawdowns in stocks – they can probably no longer wait (the events of March 2020 are already as if hinted).

Correlation between Bitcoin/Ether and S&P 500 in 15-minute intervals
Correlation between Bitcoin/Ether and S&P 500 in 15-minute intervals

conclusions

And there will be no smart conclusions! I just liked some of the graphs and thoughts in the article by the guys from the Man Group, and I decided to share with you. (There themby the way, even more – so if you liked it, then it makes sense to read the original.)

In general, I have always been closer to the camp of cryptoskeptics and did not recommend investing in crypto anything that you are not morally ready to lose completely. I still fully support this idea – but the events of February nevertheless forcedly raised the degree of my enthusiasm for cypherpunk ideals.

So personally, I probably plan to eventually add at least 5% of real BTC / ETH crypto to my portfolio (not counting those stablecoinsthat are already there as an airbag). True, if you rely on history (and, as you know, you should not rely on it), then the best time to buy a crypt is when no one talks about it for at least six months or a year. And, of course, does not write articles!


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