Is There Still A Case For Cryptocurrencies In Your Investment Portfolio?

Investors love or hate cryptocurrency This does not need to be the case. The unique properties of this asset class can make it a strong consideration for any portfolio.

Cryptocurrency is a little like Marmite. It attracts the extremes. Many investors believe it is going to be the most revolutionary technology of our time and overexpose themselves, while others label it a scam and keep it at arm's length. There are very few who are in between.

There are countless news stories of those who have overexposed themselves to cryptocurrencies by leveraging up with huge amounts of debt. While this approach may have paid dividends in 2017, 2018 will have pushed these investors out of the market, with 90 percent plus declines being commonplace.

On the other extremity, legendary investor Charlie Munger has compared trading Bitcoin to trading “freshly harvested baby brains” and “artificial gold.” But any percentage allocation to Bitcoin in a portfolio before 2017 would have had a positive impact on the overall portfolio. Bitcoin’s price at the start of 2016 was still around $400. It has increased over 1,000 percent since this point, even taking into account the huge market crashes we have seen during 2018.

At the essence of investing is a risk-reward tradeoff. Capital is being put on the line for a large potential payoff in the future. The very best traders and investors are highly skilled at allocating their capital to places where there is an asymmetric risk-reward. There is a limited and identifiable downside while the upside is huge and difficult to assess.

The Barbell Approach

History doesn’t repeat itself, but it often rhymes. If the past is anything to go by, there is a somewhat of a case to be made for adding cryptocurrencies to a portfolio. Investors can control their downside by only allocating the percentage amount they are comfortable with to be invested in cryptocurrencies. A 2 percent allocation to cryptocurrencies will have little impact on the overall portfolio in the event of depreciation.

However, in the event of 1,000% percent plus appreciations, returns of the overall portfolio will be significantly better even with just 2 percent allocated.

Nassim Nicholas Taleb proposes the barbell approach where the majority of a portfolio is allocated to low-risk instruments where the capital is better protected against losses. A smaller percentage is proposed to be allocated to higher risk instruments that have the potential to record large appreciations.

There are other upsides to having cryptocurrencies as part of the portfolio. In the event of a huge financial crisis, there is a high risk of many traditional investments becoming worthless. We have seen this in numerous past crises where sellers flood the market, and there is a quick realization that some markets lack liquidity.

An Asset with Unique Properties

Another question: How much control do you have over your assets? If you were wrongfully considered a federal criminal, the government would seize your assets until you can prove yourself innocent. This will make it more difficult to prove your innocence if you do not have the funds to hire legal support. With 100 percent of your portfolio allocated to seizable assets, situations such as these are not optimal.

Let’s consider the key properties of cryptocurrencies. Cryptocurrencies are built upon decentralized technology. This results in there being no single point of failure. It does not impact you if one of the computers in the network goes down or turns malicious. The other computers will maintain the network.

Cryptocurrencies are also politically neutral and censorship resistance. A user’s ethnicity or personal situation does not matter as long as the rules of the network are complied with.

What about if the central bank decides tomorrow that it is going to double the money supply. The value of the money in your pocket and bank account is going to lose value as there will be more of it in existence and there’s not a whole lot you can do about it. With cryptocurrencies, the economics will stay the same unless the whole network decides to change them. You will have some assurances as to the economic principles you are buying into.

Whether it’s for the high-risk allocation or the properties of the technology, many have the Marmite outlook on cryptocurrencies, but there is no need to either love it or hate it. You can appreciate it for what it is and have a balanced outlook and portfolio allocation.