Over the past decade, there have been countless stories, articles, interviews, and videos published about investors who managed to strike it rich by taking a chance and investing in cryptocurrencies in the early days of the industry.
The prospect of easy money that these accounts have popularized has made investors of all ages begin to ask:
Should I be investing in cryptocurrency?
Does crypto still have room to grow, or are its best days behind it?
How much of my portfolio should I allocate to crypto?
What role does cryptocurrency play in an investment portfolio?
What are the risks of crypto that I need to consider?
The good news is that these are excellent questions to ask. They show that an investor is thinking critically about their investments, and that they are performing their own proper due diligence before blindly piling into what is really still an emerging asset class.
Below, we walk through the roles that crypto can potentially play in a portfolio, the risks inherent in the space, and provide a framework that you can use to determine how much (if any) of your portfolio should be allocated to cryptocurrency.
The Roles of Crypto in an Investment Portfolio
There are a number of reasons that an investor might choose to add crypto to their portfolio. These include: To diversify their holdings, to hedge against inflation, and to capture growth in rapidly-evolving spaces.
1. As a Diversifier
Cryptocurrency is an asset class all its own, independent of stocks, bonds, real estate, commodities, etc. For this reason, many investors view it as one more option that should be considered when building a well-diversified portfolio.
But it isn’t enough to simply hold different assets and asset classes in a portfolio and call it diversified. Ideally, at least a portion of these assets should also be non-correlated. What this means is that the price actions of one asset class should be distinct from the price actions of another asset class. Otherwise, if prices move in tandem with one another, they offer little in terms of stabilizing a portfolio during a turbulent market.
According to a 2018 study conducted by the National Bureau of Economic Research (NBER), cryptocurrency filled this important role, stating that “the risk-return tradeoff of cryptocurrencies…is distinct from those of stocks, currencies, and precious metals.”
That being said, it is worth noting that in recent years the cryptocurrency market has become more positively-correlated with the stock market. A recent study by MoneyGeek, for example, has found correlation between cryptocurrency and stocks to be increasing since the first quarter of 2021.
Because crypto is still a very young asset class, its correlation to other asset classes isn’t yet fully understood. In order to truly understand if and how crypto is correlated to other assets (and whether or not it offers true diversification) it will need to be observed through a number of economic cycles.
2. As an Inflation Hedge
Inflation is, at its heart, the measure of how much consumer prices rise over time. It’s a powerful force in our economy, and something that consumers, economists, and investors spend a lot of time fretting over.
While it’s easy to see why consumers might worry about inflation—it eats into buying power and translates into a less powerful dollar—it’s less intuitive why investors should care. But ultimately, it boils down to the fact that inflation lowers the real return of an investment. If you invest your money and earn a 6% rate of return per year, but inflation during that same period is 5%, then you’ve truly only grown your money by 1%.
For this reason, investors will often include certain investments in their portfolio that are designed to act as a hedge against inflation. Real estate, gold, and some commodities, for example, can act as inflation hedges. It turns out that certain cryptocurrencies may also be able to fill this role in a portfolio.
Bitcoin, for example, is often referred to as “digital gold” due to the belief that it can act as a store of value and inflation hedge. That’s largely due to the fact that there is a limit to how many Bitcoins will ever be mined: 21 million. If demand for the cryptocurrency continues to rise, this natural supply cap may push its price higher.
3. As a Growth Driver
Finally, many investors view cryptocurrency as a potential growth driver for their portfolios. This view is due in part to crypto’s performance over the past decade.
As a point of illustration, consider the fact that in October of 2010, a single Bitcoin was worth 10 cents. In November 2021, Bitcoin reached an all-time high of $68,000 per coin. Likewise, when Ether launched in 2015 each token had a value of 31 cents. At its highest point, the cryptocurrency was worth $4,981 per token. Even though both of these cryptocurrencies are well off their all-time highs (as of April 2022), they have offered early investors astronomical returns.
Of course, past returns do not translate into future performance. And yet, many investors view cryptocurrency as a driver of future growth specifically due to the many different use cases that crypto represents.
Blockchain and smart contracts, the technology that makes cryptocurrencies possible, can be leveraged in many ways: For example, in the development of Web 3.0, decentralized finance (DeFi), decentralized applications (dApps), and more. Each of these has the potential to disrupt entire industries. Investing in cryptocurrency is one way that investors might gain exposure to these nascent fields.
Risks of Investing in Crypto
Of course, investing in cryptocurrency brings its risks, as is true for any investment. Some of the most important to consider are its volatility and lack of regulatory framework
1. Volatility
Cryptocurrency is an incredibly volatile investment. Individual cryptocurrencies—and the market as a whole—can experience wild swings in value from day to day, week to week, and month to month.
Just how volatile is crypto compared to other asset classes? According to the same MoneyGeek study cited above, between 2013 and 2021 cryptocurrency as an asset class was four times more volatile than stocks and a whopping 26 times more volatile than bonds.
This volatility is driven by many factors, including supply and demand, hype, and general investor sentiment. Additionally, as crypto is still a very young asset class, many experts believe that it is still in the price discovery phase. It will likely remain in this phase until individual and institutional investors gain a solid understanding of the space.
Cryptocurrencies are also currently not regulated. While we discuss this in more detail below, it’s important to note here as well. That’s because speculation over potential regulation is often a key trigger for crypto’s volatility. When media outlets report on potential regulation, it often has a direct and dramatic impact on crypto prices one way or the other.
2. Lack of Regulatory Framework
As alluded to above, cryptocurrencies are not yet regulated in the same manner as stocks, bonds, and other investments. This lack of regulation raises a certain level of risk for investors, in two key ways.
First, it’s important to recognize the fact that financial regulators—like the Federal Deposit Insurance Corporation (FDIC), Federal Trade Commission (FTC), and Securities and Exchange Commission (SEC)—offer a layer of protection for investors. They do this by ensuring that companies act as responsible stewards of investors’ capital, and by working to detect and limit fraud (amongst other activities).
Because the crypto space is largely unregulated, there’s currently no mechanism for detecting and preventing fraud. Theoretically, anyone can conduct an initial coin offering (ICO) and sell tokens to unwitting investors, who may not realize that they have fallen for a scam. This has happened multiple times in the past. A recent scam involved the launch of a Squid Game token riding on the back of the popular Netflix series, where scammers made away with more than $3.3 million.
Beyond this, though, there is risk that comes from not knowing how future regulations might impact the space. Will governments recognize cryptocurrencies as a legitimate investment, or will they move to ban crypto as a number of countries (including China, Qatar, and others) have already done so? Will the field be left largely unregulated and free to experiment and grow, or will new regulations stifle innovation?
There is no way of knowing how governments will act until they finally do so. If all world governments banded together and decided to ban cryptocurrency (a move which seems exceedingly unlikely) it would effectively crater prices and likely make many projects worthless.
How much of your portfolio should be allocated to crypto?
With both the potential benefits and risks in mind, you might be wondering: How much of my investment portfolio should I allocate to crypto, if I decide that I do in fact want to invest anything at all?
As with so much else in investing, the answer is: It depends.
The guidance that is most widespread amongst financial professionals today is that you should only invest as much money in crypto as you are willing to potentially lose in a worst case scenario where the price crashes to zero—such as in the hypothetical scenario above consisting of a worldwide ban. While it is unlikely, it is possible, and that possibility is something that investors need to understand.
Looking for a specific percentage? While advice varies, most financial advisors tend to advise that crypto make up no more than 1% to 5% of a portfolio (though some advisors may recommend up to 10%). The thinking is that this is enough exposure where you can potentially capture some of the gains and diversification offered by cryptocurrency, without suffering unreasonable losses in the event that things go south.
Not sure how much of your portfolio you should personally allocate to crypto? The same three factors that should influence all of your investment decisions can help you reach an answer here:
Your Risk Tolerance
Knowing that cryptocurrency carries with it a certain level of risk and volatility, it’s important to take your risk tolerance into account when choosing how much of your portfolio you will allocate to it.
If you can stomach wild swings in value, then a larger allocation may be justified. If, on the other hand, wild swings would cause you to panic and potentially sell (locking in losses) then a smaller allocation may be the wiser choice.
Using the ranges mentioned above, an investor with a high level of risk tolerance might allocate up to 5% of their portfolio to cryptocurrency, while an investor with extremely low risk tolerance might limit themselves to just 1%.
Your Investment Horizon
It’s also important to consider your investment horizon, or how many years you plan to leave your money invested before you will need to access it.
Generally speaking, the longer your investment timeline, the more risk you can take on in your investments. That’s because you have more time to ride out volatility and recover from significant losses if you do experience them. But as you get closer and closer to needing your money, it is typically prudent to reduce risk and increase exposure to less volatile investments.
Again, using the range mentioned above, an investor with a long investment horizon might allocate up to 5% of their portfolio to cryptocurrency, while an investor with an extremely short investment horizon might allocate 1% (or 0%) of their portfolio to the asset class.
Your Financial Goals
Finally, your financial goals will play a big part in determining your ideal portfolio allocation—not just to cryptocurrency, but to all assets. That’s because each asset in your portfolio should serve a purpose, and these purposes should all in some way tie back to your personal financial goals.
So ask yourself: What are you trying to accomplish by investing? Are you trying to maximize growth? Do you want to generate income? Are you simply trying to match inflation? Your answer to this question will influence how much risk you might need to take on to reach your goals.
Here at Allio, we believe that cryptocurrency has exciting potential to help build the infrastructure of tomorrow’s technological and financial ecosystem but currently as an asset, doesn’t have the regime in place to drive its price up. Bitcoin, due to its limited supply could come into high demand if the global financial system ever experienced hyperinflation. Rather than have our clients purchase a wallet or trade on a messy exchange with hidden fees to purchase coins, we prefer to seek this upside via the use of an ETF which includes the added benefit of not being directly exposed to the speculative underlying asset. That said, they are still volatile and investors should only purchase them if they’re willing to lose that entire portion of their portfolio. For that reason, we offer our clients the choice for whether they’d prefer to have crypto exposure, alongside traditional asset classes—like stocks, bonds, commodities, and real estate— for a truly diversified macro investment strategy.
