Are We There Yet? Portfolio Diversification and Cryptocurrency

According to legend, it was a little over 10 years ago when a person or group operating under the pseudonym Satoshi Nakamoto logged the first entry into the bitcoin ledger. Fast-forward to today, and more than 4,000 other cryptocurrencies have joined the markets, with a collective market cap of $1.3 trillion as of February 2021.

The technology behind bitcoin and cryptocurrencies looks adaptable to numerous industries, including banking, retail, legal, health care, and others, leading to billions of dollars of investments in research and infrastructure.

Meanwhile, the financial community has taken note, building platforms and exchanges for cryptocurrency products. This build-out quietly continued through the steep drop in 2018 and the volatility of 2019 and 2020. And when the price of bitcoin surged through the $40,000s in early 2021, the message looked to be clear: Cryptocurrency may have been down, but it was far from out.

By many standards, the crypto market continues to mature. Institutional interest in bitcoin continues to accelerate in 2021, from the likes of BlackRock (BLK) and Tesla (TSLA), in addition to several prominent fund managers. Payment systems, including Square (SQ), PayPal (PYPL), and more recently Visa (V) have turned their attention toward crypto.

Perhaps it’s time to ask: “Does crypto have a place in my portfolio? Will it help me pursue investment diversification?”  

Before exploring the topic, it’s important to note that, as of 2021, bitcoin futures are the only cryptocurrency product available to qualified TD Ameritrade clients on the thinkorswim platform, and not all clients will qualify. Visit the bitcoin futures page for more information.

A Digital Asset Isn’t a Stock

Before deciding where cryptocurrencies might fit into a diversified portfolio, let’s take a step back and define what we’re talking about.

“Bitcoin is finite and fiat,” said Viraj Desai, senior manager, portfolio construction at TD Ameritrade Investment Management, LLC.* “There’s a fixed supply of bitcoin, and its value is derived from what buyers of bitcoin perceive it to be.”

Unlike a stock, for example, which has its intrinsic value tied to expectations of future cash flows, bitcoin isn’t tied to any underlying fundamentals. That’s helped make bitcoin’s fair value hard to pin down.

“When a company liquidates, they can at least sell buildings, inventory, and recoup some assets,” Desai added. “In the case of bitcoin, there are no buildings, no inventory, no assets, so value can evaporate instantaneously.”

This brings us back to the value of scarcity. Because the supply of bitcoin is fixed, the price can rise quickly if more people foresee long-term uses for bitcoin, but any time that future potential is called into question, the price can pull back quickly and—at times—violently.

And Just What Might That Potential Be?

Bitcoin and other cryptocurrencies are digital assets, typically obtained through the calculation of complex math problems (aka “mining”). Once a unit has been mined, it appears on a ledger that’s shared by all users and updated in real time. This distributed ledger, which is called a blockchain, becomes a virtually irrefutable point of integrity. That’s a fancy way of saying that because everything is transparent and shared, it’s nearly impossible to fake an entry or hack your way into a blockchain.

The certainty built into distributed ledgers “has attracted widespread attention from industries that see it as a way to do things more quickly and efficiently,” said Desai. “Many institutions have been looking at ways they can leverage blockchain to improve record keeping, security, and other useful applications.”

The list includes banks, exchanges, credit card companies, and other financial players that hope to make global payment systems faster and more efficient.

Others see it as a way to facilitate the transfer of ownership through what’s called a smart contract, which can verify legal documents and other agreements in real time. Any firm or government entity that manages a supply chain or stores large volumes of data might stand to benefit from cryptocurrencies and the blockchain technology that underpins them.

The Philosophical Arguments for Crypto

So, that’s cryptocurrency defined. But what about from a philosophical standpoint? Much depends on your perspective. Plus, some cryptocurrencies are built for different purposes. But here are a few crypto possibilities.

Currency. Cryptocurrencies can function as a store of value and medium of exchange. Bitcoin has gained some prominence in recent years as a facilitator of transactions, but as a store of value it may have a ways to go. The price has been quite volatile over the last few years. In late 2017 it spiked to nearly $20,000 versus the U.S. dollar, then down to about $3,000, up to $13,000, and then it bottomed out around $4,200 in early 2020. From there, it rallied tenfold.

That’s quite a bit of volatility compared to a stable, developed currency. If the dollar showed this much volatility, for instance, it likely wouldn’t enjoy its reputation as a global currency people can trust (see figure 1).

Inflation hedge. Many analysts have compared crypto assets to gold and other precious metals as a way to hedge against runaway inflation. The rationale is that because the control of bitcoin and other cryptocurrency supplies lies outside of any central bank, cryptos may be less susceptible to currency devaluation, hyperinflation, and other such risks.

Industrial commodity. Cryptocurrencies are mined, and the tokens created from this mining process have tangible value. The mined cryptocurrencies help to power payment systems, smart contracts, supply chains, and so on. How is that any different from, say, crude oil, aluminum, or silicon? It’s true that you can’t hold a digital asset in the palm of your hand, and you don’t store it in a warehouse or storage tank. But again, this is a philosophical argument. And some crypto adherents see the non-physicality of digital assets as a benefit relative to traditional commodities.

The World of Alternatives

What do foreign currencies, precious metals, and commodities have in common? They’re all part of a subset of investment choices called alternative assets, meaning they’re outside the traditional world of stocks and bonds. The allure of these “alts” is that they’re often uncorrelated to traditional assets, potentially adding a layer of diversification for investors and sometimes offering superior risk-adjusted returns. But many alts come with their own risks, such as higher fees and periods of volatility. They can also be difficult to liquidate quickly during times of stress. In other words, they’re not for everybody, but when structured properly, they have the potential to enhance a diversified portfolio.

If you decide to allocate a bit of your portfolio to alternatives, you’d need to decide how much. Of course, it depends on your objectives, investment horizon, and risk tolerance. Suppose, for example, you have a portfolio mix of 60% stocks and 40% bonds, and you’d like to allocate as much as 10% to alts. You might then dial back your stocks to 55% and bonds to 35%.

But what about cryptocurrencies? For investors interested in alts, should cryptos be part of the choice set? In the early days of bitcoin, the market was more geared toward traders and speculators with an appetite for risk. Bitcoin was frequently used for illicit transactions. And the largely unregulated platforms were rife with accusations of price manipulation.

Blockchain applications have moved to the mainstream. But there’s work to be done; it’s still in its early days. Although the market in the top coins is typically liquid, many of the 2,300+ are thinly traded and don’t have a clear use case from an economic standpoint. Some might be run by charlatans. Although there’s an established futures market, other derivative products such as exchange-traded funds and options have been slow to come online.

So, does crypto have a place in your portfolio? Again, it’s not a product for everyone. Cryptocurrencies are new and not fully understood. They’ve been risky. But if you’re the type who wants alts as part of a diversified portfolio, a compelling case can be made for potentially adding crypto to the mix. 

But remember Desai’s caution about underlying intrinsic value of bitcoin, or lack thereof: “It’s difficult to put a value on digital currencies, and considering the massive volatility, those looking to add it to their portfolio should consider that a little bit goes a long way. Overexposure could potentially have disastrous consequences should bitcoin fall out of favor.”

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.

Futures and futures options trading involves substantial risk, and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products.