What Is Bitcoin?

Bitcoin is both a network and an asset. The Bitcoin network is a real-time gross settlement system comparable to Fedwire (US) and Target (EU). Settlement systems are the base layer of any financial system, and they leverage net settlement systems built on top to scale and provide utility to the day-to-day user. The Bitcoin network requires miners to contribute resources to process, execute, and settle transactions. Performing these actions is costly, and miners are rewarded with bitcoin, the asset, for their participation. Bitcoin is the first example in history of a global settlement system that possesses no single point of failure. Participants can reach an agreement on who owns what and how much of it they own without the need for centralised, coordinating entities.

Bitcoin, the asset, is a commodity on the Bitcoin network, it can be transferred across the world, and you require it to pay the network’s fees. It is fungible, divisible, durable, portable, verifiable, scarce, and has additional censorship and seizure resistance properties. Bitcoin also provides the user with high levels of certainty over its future dilution. Unlike fiat money, the issuance of bitcoin is codified and enforced by changes in the difficulty adjustment. This codified approach means bitcoins supply is impervious to changes in its demand.

Bitcoin the asset is backed by demand for an apolitical settlement system and a non-discretionary monetary asset. The seeds of bitcoins success were planted in the 2008 financial crisis, and demand for an asset like bitcoin is expected to continue growing throughout the 2020s.

Why Should You Care?

Crypto Adoption is Growing Fast

After 13 years since bitcoins creation, we now have a cryptoasset ecosystem worth $2.65 trillion. The asset class has become too big to be ignored. We have already seen an array of institutions from financial services companies and media companies to nation-states adopting cryptoassets and blockchain technology.

Cryptonetworks aren’t a company or business model but rather an internet infrastructure that millions of businesses will come to use to make their applications more transparent, efficient, and cost-effective for users. The internet has caused tremendous disruption and resulted in entirely new business models for those who choose to use it. Blockchain offers companies and entrepreneurs a similar opportunity.

When compared to the rise of the internet, blockchains growth is something worth taking note of. When the internet hit 150 million users, it was growing at 63% per year. Crypto earlier this year hit the 150 million user mark and is growing 113%, almost doubling the growth rate of what was one of the fastest-growing technologies we have ever seen, the internet.

Crypto Offers Unique Diversification Benefits

Investors have never until bitcoin had an opportunity to hedge against the financial system itself. Even well-diversified portfolios spanning multiple asset classes are one hundred percent net long the financial system and government stability in decision making. Bitcoin and cryptoassets allow citizens of any country to own something that sits firmly outside of the political and financial system.

Below is the rolling correlation of the two biggest and most well-known cryptoassets, bitcoin and Ethereum. As you can see, these cryptoassets aren’t tightly correlated to either gold or the S&P500. This analysis shows that gold and the S&P500 are more tightly correlated to one another than they are to bitcoin or Ethereum. This offers investors real tangible diversification benefits.

Source: Investing.com, Yahoo Finance, St Louis Fed

Not only are cryptoassets uncorrelated to your traditional mix of assets, but they provide superior returns whilst not increasing the overall portfolio risk significantly. To illustrate this, we created 3 model portfolios.

Portfolio 1: Traditional 60/40 portfolio mix. Using the S&P500 as the proxy for equity exposure and a 50/50 mix of the Vanguard Total International Bond Index and Vanguard Total Bond Market Index.

Portfolio 2: 55/40/5 portfolio mix. Here we reduce equity exposure by 5% and add 5% in crypto assets. The allocation to cryptoassets here is 50/50 between bitcoin and Ethereum.

Portfolio 3: 50/40/10 portfolio mix. Here we reduce equity exposure by 10% and add 10% in crypto assets. The allocation to cryptoassets here is 50/50 between bitcoin and Ethereum.

The first observation between these three portfolios is that the overall risk of your portfolio does increase by a marginal amount. The riskiest of portfolios is the 50/40/10 portfolio.

Source: Investing.com, Yahoo Finance, St Louis Fed

Even though risk increases, investors who choose to take these risks are rewarded with superior risk-adjusted returns, evidenced by the higher Sharpe Ratios achieved on average by portfolios with allocations to crypto.

Source: Investing.com, Yahoo Finance, St Louis Fed

The last observation is what these allocations mean for your portfolio’s performance. Since August 2015, an allocation of 5% of your portfolio to cryptoassets has more than doubled a portfolio without crypto. The effects of adding 10% of your portfolio to crypto have had an incredible impact on overall returns, achieving 4,5x the cumulative return of a portfolio without crypto.

Source: Investing.com, Yahoo Finance, St Louis Fed

There is clear evidence that including cryptoassets as a portfolio component with allocations as small as 5% can have positive effects on your portfolio’s performance without dramatically increasing risk. Please note that this analysis assumes an active rebalancing strategy between your traditional portfolio and your crypto holdings. Volatility is to be expected for a new and nascent technology like blockchain, and investors should take advantage of this by constantly harvesting volatile price changes by rebalancing their portfolios to target weights.