Title: "The Low Correlation of Bitcoin with Traditional Markets"

Source: The Economist
Translation: czgsws & 0x22D, Rhythm BlockBeats

Recently, The Economist published an article titled "Why it is wise to add bitcoin to an investment portfolio." The article mentions that the low correlation of Bitcoin with traditional markets makes it a potential high-quality source for portfolio diversification. This article quotes Nobel laureate Harry Markowitz from a paper published in the Journal of Finance, which expresses the idea that "what matters is not the risk of the asset itself, but its contribution to the overall portfolio's value volatility," laying the groundwork for "Modern Portfolio Theory."

The original text is as follows:

"Diversification is both observable and wise; one must reject the non-diversified behavioral norms, whether in making assumptions or treating them as maxims."

This quote is from economist Harry Markowitz's 1952 paper titled "Portfolio Selection: Efficient Diversification," published in the Journal of Finance. This paper helped him win the Nobel Prize in Economic Sciences in 1990 and laid the foundation for "Modern Portfolio Theory."

Left: Harry Markowitz

In this paper, Harry Markowitz was the first to apply the mathematical concepts of mean and variance of portfolio returns to explicitly define investor preferences. He was the first to apply the principle of marginal analysis to the analysis of portfolios. This research primarily helps households and companies rationally utilize and combine their funds to achieve maximum returns at a given level of risk.

The theory posits that a rational investor should maximize their returns relative to the risk they undertake (the volatility of returns). Naturally, assets with reliable high returns should hold significant positions in a wise investment portfolio. However, Mr. Markowitz's brilliance lies in revealing that diversification can reduce risk volatility without sacrificing returns. If this financial concept were to be expressed in a common saying, it would be "the whole is greater than the sum of its parts."

Given the frequent crashes and surges in cryptocurrency values, investors seeking high returns without volatility may not be attracted to cryptocurrencies like Bitcoin. But Mr. Markowitz's insight is that for investors, what matters is not necessarily the risk of the asset itself, but its contribution to the overall portfolio's value volatility—this primarily concerns the correlation among all assets. An investor holding two weakly correlated or uncorrelated assets may have a more direct experience; when the value of one asset crashes, the other may not fluctuate much.

Considering that a wise investor's portfolio may include: stocks from different regions, bonds, real estate funds, and individual types of precious metals (like gold), the highest-yielding assets—"stocks and real estate"—often move in the same direction simultaneously. However, the correlation between stocks and bonds is quite weak (around 0.2-0.3 over the past decade). But bonds also offer much lower returns; investors can reduce volatility by increasing bonds, but this often leads to lower overall returns.

This is where Bitcoin's advantage lies. The volatility of cryptocurrencies can be significant, but within its short lifespan, the average return of cryptocurrencies is also high. Importantly, the volatility of cryptocurrencies is often independent of other assets; since 2018, the correlation between Bitcoin and all stocks in the world has remained between 0.2-0.3, and if you look further back, this correlation is even weaker. The correlation between Bitcoin and real estate and bonds is also very weak, making Bitcoin an excellent potential source for portfolio diversification.

This may explain Bitcoin's appeal to some large investors. Hedge fund manager Paul Tudor Jones has stated that his goal is for 5% of his investment portfolio to be in Bitcoin. As part of a highly diversified portfolio, this allocation seems reasonable. In the four tests conducted by Buttonwood over the past decade, the best portfolios included 1-5% Bitcoin, not just because of the cryptocurrency's surge; even during periods of high Bitcoin volatility, such as the sharp decline from January 2018 to December 2019, a portfolio with 1% Bitcoin still showed a better risk-return ratio.

Of course, not all calculations regarding which assets to choose are straightforward. Many investors not only seek to make good investments but also strive to be environmentally friendly, believing that Bitcoin is not environmentally sustainable. Additionally, to select a portfolio, investors need to gather relevant information about the expected performance of these assets. Expected returns and future volatility are often measured by observing the past performance of assets. However, for cryptocurrencies, this method has obvious flaws, as past performance does not always indicate future returns, especially considering the very short history of cryptocurrencies.

Although Markowitz articulated how investors should optimize asset selection, he wrote, "We have not yet considered the first stage: the formation of relevant beliefs." The returns from investing in stocks are part of that company's profits, while the returns from investing in bonds are the risk-free rate plus credit risk. As for Bitcoin, aside from speculation, it is unclear what drives Bitcoin's returns, and we even have reason to believe that Bitcoin may not generate any returns in the future. Many investors hold strong philosophical beliefs about Bitcoin—it is either salvation or a curse—but whether it is salvation or a curse, it cannot constitute 1% of these investors' assets.

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