Is Bitcoin a Good Diversifier?
When things go haywire in various traditional segments of financial markets, you would want to have at least some assets that can offset losses by moving in a different direction. Bitcoin, by the nature of its concept as a core element of an alternative decentralized financial system, should be a prime candidate for a diversifier of a portfolio composed of traditional asset classes. It is not a coincidence that some call it ‘digital gold’ — as gold itself has long been perceived as the ultimate portfolio protection and insurance against fiat collapse. But BTC has now been tested in several macro regimes and a couple of stressed market environments — and what the results show might surprise you.
Do individual investors benefit from adding it to portfolios of traditional assets
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only.
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Why should Bitcoin be a better diversifier?
Bitcoin was conceived to be separate from the existing monetary and financial system. By not being embedded in it, it should theoretically offer reduced (or no) sensitivity to swings in key macroeconomic variables compared to equities, fixed-income instruments or commodities. Two properties often considered to increase the benefits of holding BTC as a diversifier are its scarcity (i.e., limited supply not influenced by a central monetary authority) and low correlation with other asset classes.
If Bitcoin’s supply is indeed constrained and cannot be arbitrarily expanded at any central bank’s or government’s whim, then it should be more resistant to debasement compared to fiat currencies. This should mean that, in theory at least, it should hold its value and be an effective hedge against inflation over time. Additionally, as an apolitical alternative to fiat, it should also perform well as a safe haven, perhaps similar to gold. And if the weaker correlation persists over time, across different macro regimes and during times of market turmoil, then it would be likely for BTC to offer a very effective means of protection against crises and crashes.
Reality check
Empirical studies and data so far have shown that most of the theorized properties described above have not fully materialized. To be more specific:
– Bitcoin correlations with other asset classes are not constant over time. They were relatively low (for instance, if you look at the indices in the chart below, rolling correlations were mostly below 3%) before the pandemic. But since 2020, with the onset of COVID, the situation changed and most correlations spiked to double digits, mostly to over 25–30% (for US stock indices — to nearly 60%). This is true not just for the US but for international markets as well (equities and bonds).
– Bitcoin’s volatility is persistently higher than that of other asset classes, even though it has declined over the last couple of years. It also suffers from more drawdowns in terms of both frequency and magnitude. For instance, it has had a significantly higher number of 10%, 25% and 50% drawdowns between July 2010 and March 2024 than stocks, commodities and bonds. If we look at risk-adjusted performance, then it has in recent years changed significantly, and is no longer superior to stocks, for example, as it used to be the case before 2017. This means that BTC has become less attractive as an addition to portfolios of traditional asset classes, but also — maybe more importantly — it is not exactly a safe haven. This is also a conclusion from several empirical studies examining the conditional correlations with the other classes.
– The International Monetary Fund (IMF) and major global central banks have highlighted that the rising correlations and the spillovers between crypto and equity markets are an indication of growing interconnectedness across the traditional and decentralized financial system. With the introduction of the BTC Exchange-Traded Funds (ETFs) in early 2024, the ties between crypto and mainstream finance are also deepening further, with the possibility of shocks being transmitted from one side to the other. And if the banking system is taken as an example, the collapse of crypto lender Silvergate in 2023 demonstrated how a crash in the crypto world could cause tremors in the banking sector.
– Bitcoin enthusiasts always point out that the scarcity imposed by and hard-coded in the algorithm is its biggest strength. However, the biggest cryptocurrency has not existed long enough to provide a confirmation that it can truly and reliably serve as a hedge against inflation. The most recent period of elevated inflation in the post-pandemic era (2021–2024) certainly did not prove that. As the recovery after the end of the lockdowns, as well as the global energy shock, caused a spike in price levels worldwide, the price of Bitcoin first moved with inflation. But later, when it accelerated most significantly and other markets dropped impacted by a wave of pessimism and a risk-off sentiment, Bitcoin also crashed. It did recover recently to new all-time highs, however, that recovery also coincided with the recovery in equities, gold and other assets.
Conclusion: there could be more potential ahead
Despite the developments and risks just described, this does not mean that the potential to profit from Bitcoin will go away. As it matures and gets increasingly integrated into institutional and individual portfolios, the correlations could be higher on average over longer time horizons than they were before. But over shorter and medium terms, they could still fall, as has been the case since the latter half of 2023. Diversification potential can therefore vary over time and under stress it could depend on the nature of the economic shock (as well as the policy response). For some markets (e.g., commodities) correlations did not spike in 2021–2023 and have been persistently low for more than a decade, while for others (e.g., international bonds), they were much lower pre- and post-COVID. Bitcoin might not have acted as a safe haven and an effective inflation hedge recently, but we also need more time and observations to see how it behaves in a wider variety of macro and market environments. After all, other assets have had hundreds or some even thousands of years (e.g., gold) to show what they are capable of, especially in the extremes.
references:
1. Akhtaruzzaman, M., et. al., The influence of Bitcoin on Portfolio Diversification and Design, Finance Research Letters, 2020
2. Dyhrberg, A., Hedging capabilities of bitcoin. Is it the virtual gold?, Finance Research Letters, 2016
3. Chopra, M., et. al., Is bitcoin a diversifier, hedge or safe haven for traditional and alternate asset classes?, Cogent Economics & Finance, 2022
4. Adrianto, Y., et. al., The effect of cryptocurrency on investment portfolio effectiveness, Journal of Finance and Accounting, 2017
5. Pho, K., et. al., Is Bitcoin a better portfolio diversifier than gold? A copula and sectoral analysis for China, International Review of Financial Analysis, 2021
6. Bhuiyan, R., Diversification evidence of bitcoin and gold from wavelet analysis, Springer, 2023
7. Shehriyar, A., et. al., Cryptocurrency Investing, PGIM, 2022
Author: Nikolay
Founder of MoneyCraft
