Bitcoin, the world’s first and most widely recognized cryptocurrency, has been a subject of intense debate and speculation since its inception in 2009. While its volatility has been a cause for concern among some investors, its exceptional returns have captured the attention of many others. This post will put Bitcoin’s current volatility into context and investigate the intricacies of Bitcoin’s performance, risk-adjusted returns, and the factors contributing to its remarkable success.
Recently, Bitcoin has experienced a 20% decline from highs. This type of drop can happen historically, however is atypical so soon after a “halving”. Recently, Bitcoin headlines have been dominated by the announcement that Mt. Gox, which was the main crypto exchange until 2014 when it experienced a major hack, is returning $9 billion worth of Bitcoin to creditors, and the German government is unloading $2.2 billion of their bitcoin reserves. With a 24-hour bitcoin volume of nearly $40 billion on July 8, this should have a nominal effect on bitcoin’s price, but nevertheless became a noteworthy event. Investors that look at bitcoin through the lens of a fundamental thesis can learn to navigate the short-term overreactions to crypto news and benefit from them.
Exceptional Risk-Adjusted Returns
Despite its volatility, Bitcoin has consistently outperformed traditional asset classes in terms of risk-adjusted returns. The Sharpe ratio is a measure of the risk-adjusted return of an investment, considering both the return and the volatility of the asset. A higher Sharpe ratio indicates better returns for the level of risk taken, and a Sharpe higher than 1 is good. Similarly, the Sortino ratio measures the risk-adjusted return, but it only considers downside volatility, ignoring upside volatility. A good Sortino ratio is 2 or higher.
Over the past year, even with significant price drops of 15% in April, 11% in August, and 19% in the past 30 days, Bitcoin has delivered an impressive 86% return, dwarfing the S&P 500’s 26% gain. This remarkable performance is further highlighted by its Sharpe ratio of 2.1 and Sortino ratio of 2.7 over the past year. This is down from an unheard of 5.3 Sharpe and 4.7 Sortino since it has fallen from above $71,000 to below $56,000. Even when compared to other cryptocurrencies, Bitcoin is in the top decile on a risk-adjusted basis. Historically, when Bitcoin sneezes, altcoins catch a cold, and meme coins get covid. Bitcoin’s Sharpe and Sortino ratios suggest that investors are well compensated for the risk they take when investing in the cryptocurrency.
Volatility: A Double-Edged Sword
While Bitcoin’s volatility has been a source of concern for some investors, it is important to note that this volatility has been steadily decreasing over time. The average 30-day volatility of Bitcoin has dropped from a staggering 5.17% in 2021 to a more manageable 1.73% now, which is comparable to the volatility of gold (1.2%) and major currencies (ranging from 0.5% to 1%).
Bitcoin’s implied volatility, a measure of the expected future volatility of the asset, is similar to that of NVIDIA (NVDA), a leading semiconductor company, in the low 50s. However, Bitcoin’s perceived upside is greater, with a medium-term price target of 13.9 times higher than its current value, which would equal the market capitalization of gold. The thesis behind this is that bitcoin is digital gold and although a newer asset, it offers superior portability, divisibility, and scarcity to physical gold, while also providing greater utility in the digital age through its use in transactions and emerging financial technologies.
Fundamentals and Adoption
One of the key factors driving Bitcoin’s success is its strong fundamentals and increasing adoption. The stock-to-flow ratio, a measure of scarcity that shows the number of years required to mine the total supply at its current rate, is twice that of gold. It is also set to double again in four years due to the next “halving” event, where the rate of new Bitcoin creation is cut in half. Bitcoin’s total supply is capped at 21 million coins with 94% already being mined, while gold’s supply is still unclear when considering the potential to mine new sources over the next 100 years. This scarcity, combined with growing investment flows and adoption, creates a tight supply-demand dynamic that supports Bitcoin’s price appreciation.
Moreover, the Bitcoin network’s hash rate a measure of the computational power dedicated to securing the network, is at an all-time high. A hash is a cryptographic function that converts input data into a fixed string of characters, serving as a digital fingerprint for transactions and blocks on the blockchain. The hash rate is measured in hashes per second and the increase indicates that the network is stronger than ever, with increasing adoption and resilience against potential attacks or disruptions.
BlackRock’s data showing 80% of inflows into their new Bitcoin ETF (IBIT) coming from retail investors challenges the prevailing narrative that institutional money would drive mainstream Bitcoin adoption. However, this dynamic could shift rapidly given the increasing crypto-friendly stance from both major U.S. political parties ahead of the upcoming election.
A pro-crypto administration coupled with the potential replacement of SEC Chair Gary Gensler with a more accommodative regulatory leader could catalyze institutional interest. The successful launch of regulated Bitcoin ETF products like IBIT provides institutions a familiar investment vehicle to gain exposure, lowering barriers to entry. As the political and regulatory landscape evolves in Bitcoin’s favor, the dynamics around adoption may transform, with institutions playing an increasingly significant role alongside the retail investors currently leading the charge.
Diversification and Portfolio Management
While Bitcoin’s volatility may be a concern for some investors, it is important to consider portfolio diversification and risk management strategies. A 10% allocation to Bitcoin in a portfolio may be excessive, as it could lead to significant swings in the overall portfolio’s performance. However, a more modest allocation of 3%, which historically has been a common gold allocation by wealth managers may be a reasonable approach as it would limit the potential monthly downside risk to the portfolio to around 45 basis points (0.45%), based on Bitcoin’s recent 15% price drop in April. This level of risk may be manageable for investors seeking exposure to the cryptocurrency’s potential upside while mitigating the impact of its volatility on their overall portfolio. Each investors goals and risk tolerance should be considered, but even in conservative portfolios, a small allocation to bitcoin could be appropriate. It is important to find an advisor that can tailor a portfolio to the individual, instead of the cookie-cutter 60-40 approach.
With the current market capitalization of U.S. stocks around $55 trillion, and a $1.10T market cap for Bitcoin, a 2% allocation to Bitcoin would essentially be an equal weight position. A truly diversified portfolio without a strong conviction in crypto would still have this exposure—something many investors have not considered.
Conclusion
Bitcoin’s exceptional risk-adjusted returns, combined with its strong fundamentals and increasing adoption, make it a compelling investment opportunity. While its volatility should not be overlooked, prudent portfolio management strategies and a diversified approach can help mitigate the associated risks.
As with any investment, it is crucial to conduct thorough research, understand the risks involved, and align your investment decisions with your personal financial goals and risk tolerance. Finding an investment advisor that understands your objectives is recommended. Bitcoin’s journey has been remarkable thus far, and its future remains an intriguing prospect for investors seeking exposure to this innovative and disruptive asset class.
