This Is How Much Crypto To Hold in Your Portfolio

Nothing about crypto is that simple, of course, including its value as an alternative asset. Yes, some brokerages argue that adding a dollop may boost returns in a well-diversified portfolio. But the market is evolving so fast that data sets from even a year ago may now be stale. El Salvador’s Bitcoin adoption aside, more governments—including China—are cracking down on digital tokens than embracing them. Investors also need to separate the tokens from the technology: Blockchain networks have the potential to revolutionize financial markets. If you’re going to bet on crypto, those companies may be safer than speculating on the coins.

Advisory firms appear split on whether to recommend cryptos as an alternative asset—something other than stocks or bonds that can smooth out portfolio volatility and/or lift returns. Fidelity Investments and Morgan Stanley have both issued research indicating that Bitcoin could be a good alternative. Fidelity says that holding 3% in Bitcoin from January 2015 through September 2020 would have lifted returns by an average 3.4 percentage points a year over a 60/40 portfolio of stocks and bonds. According to Morgan Stanley, a 2.5% stake in Bitcoin would have boosted returns by an average 1.6 percentage points from 2014 to October 2020.

Tom Jessop, president of Fidelity Digital Assets, describes crypto as a “venture investment,” similar to Silicon Valley start-ups. “Like any venture, it has high risk/reward trade-offs, but it should have the effect of diversifying and amplifying returns,” he says.

Morgan Stanley is still “constructive” on crypto, despite a recent slide in prices, says Lisa Shalett, chief investment officer of wealth management. Bitcoin has had almost no correlation to interest rates over the past year and maintained low correlations to stocks, she points out, providing diversification benefits. “We continue to see crypto as being in the bottom of the first inning as an emerging asset class,” she says. “It has huge potential with uses that continue to evolve.”

UBS, though, isn’t on board. “To invest in Bitcoin strategically, you need to assume that prices are going to keep rising and we find it hard to draw that conclusion,” says Michael Bolliger, chief investment officer of emerging market assets. Bitcoin is often described as “digital gold” since they both have a fixed supply, conferring anti-inflation properties. But he rejects gold too, noting that it doesn’t pay dividends or interest and has a poor record of tracking economic growth. While tactical bets on Bitcoin and gold can pay off, he says, “we think there are better alternative assets for a strategic allocation.”

The diverging views reflect the fact that cryptos are like an unruly digital Rubik’s cube: maddeningly unstable and rapidly evolving. And they come with rising regulatory risks. Nothing about the market looks like it did three years ago, when Bitcoin dominated. There are now thousands of other tokens and underlying blockchain networks, including platforms for lending, trading, and other uses.

Ethereum is now the second-largest network, with tokens worth $345 billion in market value. Other networks with “native” tokens include Cardano, Solana, Uniswap, and the “meme” cryptos that started as a joke, like Dogecoin (now worth $26 billion). New arenas include nonfungible tokens, or NFTs—digital collectibles from artworks to tweets. Gaming platforms are incorporating NFTS and other cryptos as in-game currencies. Wall Street firms are developing ways to bypass exchanges and trade tokenized versions of securities.

The expansion has attracted hedge funds, foundations, and other big capital pools, turning cryptos into a tradable asset class. More than half of the 1,100 institutional investors surveyed by Fidelity this year said they had exposure to digital assets. More than 75% of professional investors in Europe and Asia plan to buy digital assets, according to the survey, along with 60% in the U.S.

Yet the money flow has also made cryptos more like other risky assets—vulnerable to macroeconomic trends and global capital flight during times of stress. Correlations to other risky assets have been rising, according to Bolliger, causing cryptos to tumble with stocks during global selloffs. Cryptos plunged in the spring of 2020, when the pandemic wiped out equities worldwide. The recent crisis over China’s overheated property market also sent cryptos reeling.

Another changing dynamic is global liquidity. Cryptos have benefited from central banks pumping liquidity into capital markets, lifting demand for stocks, bonds, and other assets. That may be coming to an end: The Federal Reserve signaled recently that it will start scaling back bond purchases in November, a step toward raising interest rates in 2022. The impact may be gradual, but it will raise hurdles for capital investments in crypto and other speculative assets.

The other major concern for crypto markets is regulation. Led by Gary Gensler, chairman of the Securities and Exchange Commission, regulators are angling to rein in cryptos. Decentralized finance, or DeFi, platforms, used for lending and trading, are coming under scrutiny in Washington, along with stablecoins—tokens designed to maintain a stable $1 value. The Treasury Department is expected to issue a framework to regulate stablecoins soon, while state banking regulators are slowly cracking down on high-yielding crypto accounts.

China’s government is turning against crypto, too. Beijing, which banned crypto mining a while ago, recently announced a ban on business transactions—effectively warning residents not to even try using a token to buy a cup of Starbucks coffee. The ban could curtail the growth of cryptos in the world’s second-largest economy, affecting prices and demand worldwide. Other governments see threats from cryptos and DeFi networks where anyone can trade 24/7, under the radar of regulators and tax authorities.

Does all this mean investors should avoid crypto altogether? No. One of the strongest cases for the asset remains diversification. From 2015 through 2020, Bitcoin was almost entirely uncorrelated to U.S. and international stocks, high-yield bonds, real estate, and gold. Bitcoin also appears inversely correlated to the dollar.

“You want to hold assets that give you fair expected returns but are uncorrelated with other asset classes, which is the case for cryptos,” says Yukun Liu, an economist at the University of Rochester who has studied the investment. He recommends a 1% to 2% allocation, or up to 3% if you’re “highly optimistic” about the technology. Cryptos are additive at those levels because they won’t torpedo your portfolio if they crash, he says, and if their returns beat those of stocks, you’ll come out ahead in the long run.

Still, a diversifying asset can be highly volatile. Indeed, Bitcoin’s odds of a collapse are six times higher than in stocks. There’s a 30% chance of losing 63% in Bitcoin from a two-year high, according to Fidelity. For the S&P 500, there’s only a 5% chance of a similar drawdown, based on data since 1900.

Moreover, cryptos have other drawbacks: They’re high-velocity investments—you have to catch a wave before it turns to foam. And 38% of the Bitcoins that have been produced, about 7.2 million tokens, may be lost forever or don’t circulate on trading platforms, according to data provider Glassnode. It takes less than $100 million net inflow to push the price up 1%, according to Bank of America . That is 20 times less than it would take to have a similar impact on gold.

Crypto backers argue that the rewards are well worth the risk. “Cryptos give investors exposure to a technology that’s so disruptive, it’s threatening the profits of both Wall Street and Silicon Valley,” says Matthew Sigel, head of digital assets research at VanEck. “Because of the technology’s impressive characteristics, every investor should have some exposure.”

Cryptos, he adds, held up reasonably well in the latest China debt crisis. While taking a hit, cryptos didn’t collapse, partly because automated “liquidation bots” swept through decentralized lending platforms, swiping collateral from borrowers and returning it to lenders (for a fee). “There is a lot of leverage in cryptos, but a lot is liquidated based on formulas,” he says. “That’s why we haven’t seen systemic risk from cryptos. The losers get wrecked very quickly.”

Still, even proponents argue that investors should spread their bets, holding multiple tokens or companies involved in blockchain-based services. “You don’t want to make single bets,” says Shalett. “You want exposure to a diversified set of players—the coins, miners, custodians, transactional services. All of that is in play.”

Some advisors like index funds for exposure. Hal Anderson, managing partner of Utah-based Soltis Investment Advisors, holds up to 7% of some client portfolios in cryptos, including the Bitwise 10 Crypto Index fund (ticker: BITW) and the Bitwise Crypto Industry Innovators exchange-traded fund (BITQ). “Crypto is here to stay,” he says, “but there’s a lot that has to be worked out.”

Write to Daren Fonda at [email protected]