Does Crypto Have A Place In A Portfolio?
Chapter 19 of the rational investor
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Chapter 19: Does Crypto Have A Place In A Portfolio?
The perfect investment portfolio has to meet two criteria.
Provides high enough expected returns to meet your financial goals.
Minimizes volatility to the point where you can stay invested.
Risk and reward are paired at the hip
Want higher returns?
You have to take on more risk.
But if you take on more risk than you can handle, you won’t be able to say invested long enough to build wealth and hit your goals.
Diversification helps investors thread the risk-reward needle
The basic premise of a diversified portfolio is to help investors hit that sweet spot where they are taking on enough risk to capture the returns they need while not being so volatile that they are unable or unwilling to stay invested.
For diversification to work, the assets in a portfolio should have a low correlation — meaning they don’t always move in the same direction — and critically, they should maintain a low correlation during downturns.
This is the rationale behind the classic 60/40 portfolio, which is made up of 60% stocks and 40% bonds.
Stocks provide higher returns, but it’s a bumpy ride.
Bonds have lower expected returns but are less volatile.
Adding bonds to a portfolio has historically provided exceptional diversification benefits because bonds tend to maintain their value or increase in value when stocks are falling — Helping to smooth out the ride enough for investors to say in their seats.
Vanguard has compiled some interesting data on returns and volatility of portfolios that range from 100% bonds to 100% equities1. The following data is from 1926–2020.
100% bonds
Average annual return: 6.1%
This portfolio had a negative return in 1 of every 5 years.
Worst year: 1969 with an 8.1% loss.
20% stocks-80% bonds
Average annual return: 7.2%
This portfolio had a negative return in 1 of every 6 years.
Worst year: 1931 with a 10.1% loss.
40% stocks-60% bonds
Average annual return: 8.2%
This portfolio had a negative return in 1 of every 5 years.
Worst year: 1931 with an 18.4% loss.
60% stocks-40% bonds
Average annual return: 8.6%
This portfolio had a negative return in 1 of every 4.3 years.
Worst year: 1931 with a 26.6% loss.
80% stocks-20% bonds
Average annual return: 9.8%
This portfolio had a negative return in 1 of every 4 years.
Worst year: 1931 with a 34.9% loss
100% stocks
Average annual return: 10.3%
This portfolio had a negative return in 1 of every 3.8 years.
Worst year: 1931 with a 43.1% loss.
This paints a perfect picture of what diversification is supposed to do; trading in returns for lower volatility. Remember, risk and returns are paired at the hip. Many investors focus on the returns and minimize what it feels like to experience the spectacular lows that risky assets like stocks go through.
In 1931 the U.S stock market lost 43.1% of its value which was the worst year in the record books. This also happened to be during the great depression. As the data shows, the more weighted towards bonds a portfolio was, the less painful 1931 was for investors.
100% stocks — 43.1% loss
80% stocks/20% bonds — 34.9% loss
60% stocks/40% bonds — 26.6% loss
40% stocks/60% bonds — 18.4% loss
20% stocks/80% bonds — 10.1% loss.
This is why the “60/40” portfolio of stocks and bonds has long been the poster child of diversification. Many investors have seen that as the sweet spot between high returns and a level of volatility they can stomach.