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Research: Portfolios are Augmented with Bitcoin

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Shashwat Gangwal, an academic at the Indian Institute of Technology, published a paper called ‘Analyzing the Effects of Adding Bitcoin to [a] Portfolio’ in Volume 10 of the World Academy of Science, Engineering, and Technology International Journal in late 2016. The topic of investigation; what is the impact of adding bitcoin to various portfolios such as stock, bonds, gold, real estate and crude oil? Gangwal uses data from July 2010 to August 2016 to show that adding bitcoin to each portfolio would have resulted in a higher Sharpe ratio.

The Sharpe ratio “describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.” Gangwal’s findings show that bitcoin’s returns - over the six-year period that is analyzed - offset the volatility of the cryptocurrency.

As well as showcasing financial data to support his claims that bitcoin is a positive addition to any portfolio, Gangwal gives some reasons that set it apart from fiat currency.

Decentralized

Bitcoin is not regulated by any central bank. Governance is decentralized, and transactions can, to a certain extent, fall outside of traditional regulation.

Pseudoanonymity

Bitcoin transactions by default are not linked to real world identities. However, every transaction is recorded on the public blockchain, and it is possible to connect a public key to an individual with a little detective work.

Accessibility

Bitcoin can be exchanged for every major currency. They offer an off-ramp for individuals suffering from capital controls, currency manipulation, and hyperinflation in their home countries. The cryptocurrency gives people instant access to the global markets.

Reduced Transaction Costs

As bitcoin requires no third party to transfer value between individuals without a third party, transaction fees are considerably lower than other methods.

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Gangwal’s experiment was an attempt to replicate portfolios of international investors holding a wide array of assets. Via backtesting, using daily return data, he was then able to compare their returns with the impact of adding bitcoin to each portfolio. He assumed daily purchases of the asset classes and one-day holding periods.

Through Gangwal’s analysis it is easy to see that adding bitcoin to a portfolio is advantageous:

“Returns from Bitcoin are quite intriguing with a high volatility but also a high mean return. This is a powerful observation and can be taken advantage of in a portfolio.”

Bitcoin can give a better Sharpe ratio for every portfolio considered within the study. Portfolio B gave the highest ratio, at 0.0716, which was equally weighted between the S&P500, Bitcoin, and the Barclays Bond Index.

Having proved that adding bitcoin to investor portfolios would have been advantageous, Gangwal then attempts to create the optimal portfolio, using Solver in Excel, from the six years of data and based on the following constraints:

  • No Short selling
  • Unconstrained Short selling is allowed
  • Minimum holding constraint with no short selling

Gangwal's calculation results, shown above, reveal that Solver allocates the maximum proportion of bitcoin possible to create optimal holdings between 2010 and 2016; regardless of the level of short selling, and despite the high levels of volatility. Bitcoin’s low correlation with other asset classes and the high risk-adjusted returns on offer could explain this result. Previous performance does not guarantee future success, but these figures suggest it would be wise to add bitcoin to any diversified portfolio.