Imagine the challenge of removing water from a diluted juice to enjoy the perfect balance of flavors. This analogy can be applied to the world of financial assets, where it’s complicated to make a low-risk asset riskier. However, if an asset is too risky, it can be easily diluted with cash equivalents like Treasury Bills (T-Bills), similar to adding water to concentrated juice.
In the past 14 years, crypto assets have emerged as a new asset class, raising questions about their role in traditional asset portfolios due to their high level of risk compared to even the riskiest traditional assets.
Instead of focusing on the risks, one can dilute crypto assets with water (T-Bills) and examine their compatibility within a traditional asset portfolio. By using three years of post-pandemic data from global equities, bonds, short-term T-Bills, and crypto assets, one can create an “equity-Bill-crypto” portfolio with volatility levels remarkably below double that of typical equities.
The findings demonstrate a linear relationship between the amount of equities in the original portfolio and the room for crypto assets. A simple formula (0.17% + 6.40% times the fraction of equities in the original portfolio) was established as a general rule of thumb for adding crypto assets to portfolios.
Remarkably, despite the small proportion of crypto in the portfolio, there are significant gains in risk-adjusted returns (measured by the Sharpe ratio), ranging from 0.05 to 0.25. This shows that portfolios with crypto deliver higher returns while maintaining the same level of volatility. Furthermore, the more crypto assets added, the more significant the increase in the Sharpe ratio.
For example, a traditional portfolio with 60% equities and 40% bonds returned 7.6% yearly with an annualized volatility of 11.4%, resulting in a Sharpe ratio of 0.59. A portfolio with 4% in crypto, 6% in T-Bills, 50% in equities, and 40% in bonds maintained the same volatility but returned 10.2%, yielding a Sharpe ratio of 0.82, which is 1.4 times higher.
The focus should shift from whether crypto assets have a place in traditional portfolios to the best approach for allocating this asset class. The formula mentioned earlier offers a simple solution that yields good results. So, if you’re still unsure about investing in crypto, enjoy a well-balanced juice and contemplate the opportunities offered by these innovative assets.
Source: Cointelegraph
