Uncorrelated diversification – an investor’s exemplar in building a profitable investment portfolio.
Two articles were published this week investigating Bitcoin and the broader crypto space, their correlation to each other and the U.S. equity markets. For interested investors, take a look, important information can be gleaned.
One way in which an investor uncovers correlation between two assets is done by calculating the Pearson Correlation Coefficient, which is the strength of a relationship between the relative movement of two variables. In this case, public equities and Bitcoin.
The coefficient ranges from -1.0, a perfect negative correlation, to 1.0, a perfect positive relationship.
As Larry Cermark of The Block gathered, the top-traded cryptocurrencies have been trending almost in tandem for most of the past year. The data extends to 2017, but showed a weaker relationship. An obvious truth in times of bear markets.
Crypto Correlation. The Block.
It’s long been an adage of Wall Sreet. When markets fall, correlations go to 1. It’s why investing in down markets can be so challenging. Why build a diversified portfolio when you can just buy the index? Equities are trading concurrent anyway. (See the 2012 Euro crisis.)
Adding fuel to the fire of correlation is the complete lack of ability to value cryptocurrencies. Run-of-the-mill sovereign fiat trades at particular pairs for a reason – GDP growth, treasury rates, trade deficits, etc.
Cryptocurrencies have none of that. Though more than a few evangelists would take heed with this statement, it’s true. Cryptocurrencies are valued on what people are willing to pay for what they think it represents in the future; that’s it.
If a risky asset has no inherent value that the market is willing to accept, then by sheer definition, correlations will seamlessly move to 1.0 in times of risk-off.
Crypto markets are rife with manipulation, but what is more ubiquitous are the rumors of whales and deep-pocketed cabals moving markets on a whim to lace their pockets. The wild west of penny stock markets can be seen throughout the cryptosphere.
And why not? Regulation is almost non-existent. High-frequency traders and heavy movers can spam the order book whilst dumping or buying large blocks, pushing tokens in whichever direction suits the fancy of the day.
When focusing strictly on equities, investors use the measure of Beta, which is the stock’s correlating relationship, or lack thereof, to the broader index, normally the U.S.’s top 500 companies – the S&P 500.
Mitchell Moos of CryptoSlate examined the data of a putative correlation between equities and Bitcoin. He used both the Pearson Correlation Coefficient as well as Beta to unearth a relationship.
BTC/SPX Correlation 2018. CryptoSlate.
His findings showed what is probably the obvious conclusion: a weak link of correlation between the two assets. But he admits that there is insufficient data to draw causation.
What we can take away from his study is that if Bitcoin is as uncorrelated as the minimal amount of data is showing, then investors can diversify into the token in order to hedge market risk out of their portfolios. It takes risk-adjusted returns a step further than gold, which tends to be negatively correlated to the stock market.
A perfectly hedged, risk-free, multi-asset portfolio has yet to be compiled; but it would behoove investors to carve out a space for crypto.