How Much Crypto Should I Own? Math can help

The 60/40 rule is well known among investors and it has been used as an allocation guide for many years, but it doesn’t take Crypto into account and is therefore of little help to the crypto-curious.

Traditional Portfolios

The 60/40 rule is the general balance in an investor’s portfolio, whereby 60 represents 60% of all of your holdings in equities. The other 40, represents 40% of your holdings in bonds. That was historically a very strong balance for a portfolio that would see long-term growth to meet most investor's objectives, and on the other hand, the bonds would bring a reliable source of income and little volatility no matter how the stocks were performing.

But the investment climate we are now in is very different to that of a decade or two ago. Equities and Bonds are no longer the only asset classes you have access to. And the yields you can get from bonds these days are far removed from those of the past. As an example, if you take a look at the benchmark 10-year Treasury note (US Government bonds that payout for 10 years) in the chart below, you can see just how far yields have fallen in the last 40 years.

In 1981, this Treasury paid you 15.68% annually. By 2001, returns had fallen as low as 4.37%, and now in 2021, we are seeing a return of around 1.51%.

For this reason, many institutions including JP Morgan, Morgan Stanley, and Bank of America have declared the death of the 60/40 rule. According to one well-known analyst at JP Morgan, over the next decade if investors stick to the 60/40 rule they can enjoy mere returns of around 4.2%.

He says: “Strong returns from equities and high-quality bonds through the pandemic have left valuations stretched. A traditional 60/40 portfolio of global stocks and U.S. bonds presents a very subdued frontier of potential returns.” He goes on to say” Because of this, a plain vanilla 60/40 portfolio of global equities and U.S. bonds is now projected to provide an annual return of just 4.2% over the next 10 to 15 years compared to 5.4% a year ago.”

The inflation target of most of the developed world’s central banks being 2%, which means your net returns would be 2.2%.

This means that for higher returns you will need to take more risks. So you might want to diversify those risks, as opposed to piling into stocks only.

Further Diversification as a Risk Management Tool

The above, and the rise of a new and easily accessible asset class, makes reconsidering the balance of their portfolios critical for investors.

A good balance will mean a diversified portfolio that allows you to effectively weather any storms as you are holding assets from different classes, countries, and industries. So if big tech crashes, you will be exposed to other asset types that might not be so affected by the same drivers. It is also better if it allows you to sleep at night and does not get you overly worried.

Amongst the asset classes that are not stocks and bonds, you will find art, cars, wine, commodities like gold or copper, Hedge Funds, real estate, and also crypto. They can pretty much all be purchased directly or - if you would rather diversify more easily - through funds.

Crypto, like real estate, is something that is made up of a lot of different types of assets. Store-of-Value (like Bitcoin), decentralised networks on which to rebuild the internet (such as Ethereum, Cardano, or Polkadot), or decentralised software startups such as decentralised exchanges (like Uniswap), or decentralised data companies (like Chainlink). And all of those endeavours are pretty young. Bitcoin is the eldest, and it was only created in 2009.

In that regard investing in Crypto is a little like being a venture capitalist. You could even aim to build a portfolio like some of them, such as Coinbase Venture’s or Pantera Capital’s.

Corporations Get it

Many savvy investors are holding Bitcoin. This includes leading banking institutions and corporations.

Michael Saylor, CEO of MicroStrategy has recently again increased the company’s holdings in Bitcoin. Saylor tweeted that they currently hold 91,579 BTC.

Square Inc. in October 2020, invested $50 million in Bitcoin, before increasing this by a further $170 million, early 2021. Tesla made the news in February 2021, by investing $1.5 billion in the cryptocurrency. And it’s not just Bitcoin. Ethereum is having more than a moment as Decentralized Finance (DeFi) apps are showing that it’s usable.

Ethereum now represents over 25% of crypto investments by institutional investors. A CoinShares report from 1 June 2021, shows that investors are moving funds from Bitcoin to Ether. Over 63% of inflows from institutions are now in ETH products according to this report and Ether products represent 27% of the total AUM for crypto investment products.

Portfolios for a new world, not your parent's portfolio

When it comes to deciding how much Bitcoin, Ethereum, or other Crypto to own, there are several ways to look at it. Let’s look at just a few.

The Black-Litterman Model

Dating back over 30 years, this mathematical model was invented by two members of the Goldman Sachs team, Fischer Black and Robert Litterman.

In broad strokes - because you are not managing billions of other people’s money and don’t need the exact math - the model starts with the world as it stands today, and then lets you include your vision as to how the world might develop. And if you don’t know, you can always go with the default. So you start by working with an allocation based on the weight of every different asset class in the world (like an indexing system) and your opinions are what moves the needle. If you don't have opinions on any asset classes, then this represents your portfolio. Here's an example of using the Black Litterman Model for building a portfolio:

At the start of 2021:

The world’s stock market was valued at $95 trillion

  • 39% is the USA
  • 10% is EU
  • 30% is the rest of the developed markets (R.O.DM)
  • 21% is the remaining emerging markets (EM)

The world's bonds market was worth $105 trillion

  • 39% in the USA
  • 21% in the EU
  • 24% rest of the developed markets
  • 16% in the emerging markets

The Crypto market was valued at about $1 trillion, which means that cryptos would represent 0.50% of the entire portfolio.

Data taken from here and there.

So your starting portfolio is the following: 47% of stocks, 52.5% of bonds, and 0.5% of Crypto.

47% of stocks, 52.5% of bonds, and 0.5% of Crypto

There are plenty of reasons why you might want to hold more of any of those assets. As we said at the beginning of the article, for example, most advisors have recommended 60% stocks and 40% bonds for a long time, even if there are more bonds than stocks in the world, and that’s because the risk is worth it in terms of returns.

As for Crypto, from the model’s standpoint, 0.5% should be your starting point, but you can then go up or down.

From here, you factor in your assumptions or levels of confidence on future movements of these assets. So if you have no confidence about the future of crypto, this then moves down to 0% of your total holdings. If, like Andreesen Horowitz, you think it’s the future of the internet, you will probably want to move it up a bit.

But the downward volatility of Crypto (it can lose 60 to 80% of its value temporarily while stocks rarely lose more than 30%) means that, according to the BL model, you need to be highly confident (you think there is more than a 50% chance) that you will see much higher gains (over 20% more) than with stocks to make more than a 2% allocation.

Aleh Tsyvinski on Identifying Risk and Reward in Crypto

Aleh Tsyvinski is an eminent economist currently teaching at Yale. One of his studies shows that cryptocurrencies enjoy higher potential returns than other asset types despite their volatility and sharp drawdowns. His study shows that a portfolio should contain 6% bitcoin to achieve optimal balance.

He has had many papers published. One which is notable is his work on risk factors in the crypto market, where he looks at the three main factors affecting risk in cryptos – these are:

  • The cryptocurrency market, size, and momentum – capturing the cross-sectional expected cryptocurrency returns.
  • A list of price- and market-related factors in the stock market, and how this can impact their cryptocurrency counterparts.

In this paper, he shows that all of these strategies are accounted for by the cryptocurrency three-factor model.

He concludes that “the cross-section of cryptocurrencies can be meaningfully analyzed using standard asset pricing tools. Similar to other asset classes, size and momentum factors are important in capturing the cross-section of cryptocurrency returns.” This gives the reader the ability to establish facts that can be used to assess and develop theoretical models.

Well worth a read, if you are trying to ascertain what percentage of holdings you should personally allocate to this class. But a rational allocation, according to him, seems to hover closer to 6% than to 0%. This is helpful feedback for considering how you move the needle with the Black-Litterman model.

Other Takes

Most advisors and asset managers recommend no more than 1-5% of your overall holdings allocated to crypto. In this article from Time Magazine, some financial advisors weigh in.

Ryan Sterling from FutureYou Wealth says “I am using crypto as part of client allocations but limiting exposures to no more than 3% of total liquid assets”.

Theresa Morrison CFP says “Crypto-aware clients sit in two camps: crypto-savvy or crypto-curious,” says Morrison. “For the crypto-curious, a 1% diversification can be a way to explore (crypto).”

“For the crypto-savvy, think about your asset allocation and diversification strategies in a similar way as you would with your traditional portfolio” says Morrison in the article. “Crypto should be considered an aggressive asset. “The holistic picture of both is the important one. What’s the impact on your net worth?”

Kelly from Switchbank Capital says: “Although it is high volatility, the lack of correlation reduces the overall portfolio volatility and provides the potential to have significant upside for returns. Having just a small allocation in a portfolio can have massive return potential with minimal downside risk.”

This is what we show here, modeling a portfolio, albeit with a 10% allocation to crypto.

Some very rich millennials seem to believe crypto deserves even more of an allocation, but we can’t find any math or advisor that goes into that direction 😀

The Bottom Line

To help you decide what is the right allocation that crypto should have in your portfolio, you can use the following aids:

  • The Black-Litterman Strategy, a mathematical model which starts with building a portfolio that models the current existence of assets in the world, where crypto has a value of 0.50%, so it’s a non-stupid number to start with. This value is then moved by your assumptions, sentiment, or confidence on the future price of this asset class and all the others. For instance, if you are not at all confident about crypto in the future, this value becomes 0% and crypto will be 0% of your holdings.
  • The Aleh Tsyvinski study, which indicates that cryptocurrencies enjoy higher potential returns than other asset types despite their volatility. So if you feed that into the Black-Litterman model, you should move it up from 0.5%. His study shows that a portfolio should contain 6% bitcoin to achieve optimal balance.
  • The majority of Advisors surveyed by Time recommend between 1%-5% of your holdings invested in crypto. This is low enough that it cannot truly harm your portfolio, but enough to give you exposure to significant upside returns.
  • And besides the math, it’s also good to remember that your portfolio should not keep you up at night. If you can’t stand your overall investments lose 60% of their value temporarily (even if it also goes up 100% year over year on average), best not to put it all into crypto.

So if you are reading this blog, your answer is probably somewhere in the 0.5 to 6% range, or you have just realized you’re at 0. Going past a 6% allocation would make you a real crypto die-hard, as far as most portfolio building theory and advisors are concerned.

How Can Osom Help?

For those who are crypto-curious, the Osom Crypto Autopilot can be an interesting solution.

It offers a way to get a very diversified exposure to all the best the crypto realm has to offer, without you needing to become an expert in the various assets. A bit like if you believe in equities you can let an algorithm or a team of experts do the purchasing of stocks for you.

The Crypto Autopilot Algorithm aims to build a long-term portfolio with a “monotonous growth” by minimizing drawdowns, and it achieves this through quantitative analysis of price movements over long periods. It’s also fair in how you pay for the service because there are no flat fees and you can open an account for free. The revenue stream of the company comes as a result of a performance fee, where you pay Osom 10% commission from the BTC profit you earn.

Committee members from Osom and InvestSuite are responsible for assessing and monitoring the most promising crypto assets to be included in the allocation. From this selection of over 60 assets based on quality, market cap, and trading volume, the algorithm then takes positions with no single asset featuring in more than 30 to 40% of the entire portfolio.