Key Lessons from Asset Allocation and Risk Modeling of Bitcoin in an Institutional Portfolio by Joel Coverdale

1. Bitcoin's Risk Characteristics

• Lesson: Bitcoin exhibits high volatility and lower liquidity compared to traditional asset classes, which adds to its unique risk profile in institutional portfolios. However, its risk can be quantified and managed using standard risk modeling approaches.
• Example: Bitcoin’s weekly return distribution shows a positive mean of 2.5%, but with a large standard deviation of 13.2%, indicating significant price swings.

2. Low Correlation with Traditional Asset Classes

• Lesson: Bitcoin has historically shown low correlation with traditional asset classes like equities, fixed income, and commodities, which makes it a valuable diversification tool in a portfolio.
• Example: The rolling 120-day correlation between Bitcoin and the S&P 500 index remains close to zero, meaning that Bitcoin behaves independently of major stock market movements, especially over the long term.

3. Volatility is Not Synonymous with Risk

• Lesson: While Bitcoin is volatile, volatility does not necessarily imply high risk in an institutional portfolio. Its volatility is manageable if allocated in small proportions, and Bitcoin’s long-term growth prospects justify its inclusion.
• Example: During the COVID-19 market crash in early 2020, Bitcoin showed short-term high correlation with equities, but over the long term, its price movements were uncorrelated with traditional markets.

4. Bitcoin as a Portfolio Diversifier

• Lesson: Due to its low correlation with other asset classes, adding Bitcoin to a portfolio can improve diversification and reduce overall portfolio risk, despite Bitcoin’s high individual volatility.
• Example: In a portfolio with 5% Bitcoin allocation, Bitcoin contributed 16% of the overall portfolio risk, but the overall concentration in equities decreased from 80% to 69%, improving portfolio diversification.

5. Performance during Stress Events

• Lesson: During periods of market stress, Bitcoin can behave similarly to equities, but its long-term risk-return profile still makes it an attractive asset. Its high volatility needs to be counterbalanced by lower weighting in a diversified portfolio.
• Example: During the market turmoil of March 2020, Bitcoin and equity markets saw their correlation spike, but in the long term, Bitcoin reverted to its lower correlation pattern with traditional assets.

6. Bitcoin’s Positive Return Skew

• Lesson: Bitcoin exhibits a return distribution with positive skew, meaning it has a tendency to produce extreme positive returns. This asymmetry provides an opportunity for outsized gains in a portfolio with controlled downside risk.
• Example: Even in years when Bitcoin underperformed, such as 2014 and 2018, portfolios with 5% Bitcoin allocation only underperformed by around 3%, while the potential for upside gains remained substantial.

  evolution-of-Bitcoin

Author: Lyn Alden

Source: How to Value Bitcoin and Other Cryptocurrencies

Key Lessons

1. Price vs. Value

• Price is what an investor pays.
• Value is what an investor gets.
• Cryptocurrencies, especially Bitcoin, have soared in price, but determining their value is complex.

2. Difficulties in Valuing Cryptocurrencies

• Unlike traditional assets like stocks or bonds, cryptocurrencies don't produce cash flows, making standard valuation methods like discounted cash flow analysis inapplicable.
• Valuation methods must be adapted to consider the unique nature of digital assets.

3. Cryptocurrency Characteristics

• Scarcity: Bitcoin has a maximum supply of 21 million units, making it inherently scarce.
• Decentralization: Cryptocurrencies operate without a central authority, unlike fiat currencies.
• Security: Bitcoin's encryption makes it extremely secure, but it is still subject to risks like theft of private keys.

Frameworks for Valuing Bitcoin

1. Quantity Theory of Money

• This approach applies the macroeconomic equation MV = PT, where:
  • M = Money supply (total bitcoins)
  • V = Velocity of money
  • P = Price level
  • T = Transaction volume
• The equation is rearranged to value Bitcoin: Bitcoin Value = T / (M * V)
• Example calculations show Bitcoin's value could range significantly depending on transaction volume and velocity.

2. National Currency Comparisons

• This method compares Bitcoin’s market capitalization to the money supply (M2) of countries.
• For example, Bitcoin's market cap might be compared to countries like Israel or Malaysia, offering a rough valuation benchmark.

3. Store of Value

• Bitcoin is increasingly viewed as a store of value, similar to gold, rather than as a medium of exchange.
• A comparison between Bitcoin and gold’s total market capitalization provides a way to value Bitcoin.

4. Stock-to-Flow Model

• This model is often used for commodities like gold and silver and applies to Bitcoin due to its capped supply.
• The stock-to-flow ratio of Bitcoin increases with time due to halving events, which limit new Bitcoin supply.

Example Valuation Scenarios

• Optimistic: If Bitcoin becomes widely adopted, a significant portion of global GDP could transact in cryptocurrencies, leading to high valuations (e.g., $75,000 per Bitcoin).
• Pessimistic: If adoption remains limited, or Bitcoin loses market share to other cryptocurrencies, its value could fall dramatically (e.g., below $1,000).

Final Thoughts

• The future value of Bitcoin hinges on its adoption as a store of value or medium of exchange.
• Cryptocurrencies are extremely volatile and speculative, making their future value difficult to predict with certainty.

Source: How to Value Bitcoin and Other Cryptocurrencies