Part 2: Bitcoin as an uncorrelated and risk diversifier asset
Over its history, the correlation between Bitcoin and traditional assets and market indices has floated around zero.
One measure of a financial hedge is an asset’s lack of correlation to the more common assets in a portfolio. Modern Portfolio Theory (MPT), a trusted analysis often used by investors, posits that by holding uncorrelated assets an investor can increase returns without a proportional increase in risk.
Below is a correlation matrix that compares Bitcoin with and a mix of assets and indices, such as gold, Nasdaq, MSCI Emerging Markets ETF, S&P 500, Stoxx Europe 600, US Dollar Index (DXY) and the 10-year US Treasury Bond Yield.
Over eight years from May 2013 to May 2021, Bitcoin’s overall correlation to these assets was nearly zero. The indices which had the highest correlations to BTC during that time, though fairly small, were the Nasdaq (0.074) and the S&P 500 (0.07). The lowest correlations were the US Dollar Index (0.015) and gold (0.02).
After the COVID outbreak began in early 2020, Bitcoin’s correlation with the stock market reached an all-time high. This triggered a number of articles and opinions suggesting that Bitcoin had lost its position as a risk diversifier and an uncorrelated asset to the traditional financial market.
Fast forward over a year later, and the liquidity shock was overcome. Bitcoin recovered much faster than the stock market, and the correlation to stocks dropped again.
The data, taken together with MPT, shows that BTC can serve in the long run as an option to increase portfolio diversification due to its near-zero correlation with conventional financial instruments.
There’s also a growing demand for safe haven assets as risk sentiments change. During market cycles when there is macroeconomic concern or geopolitical risk, investors are eager to shift into these assets, driving demand and price upward.
Bitcoin has also been dubbed digital gold because of the role it can play long term in a diversified investment portfolio.
Gold and Bitcoin tend to increase in price in response to some events that cause the value of paper investments, such as stocks and bonds, to decline. Although the price of gold and Bitcoin can be volatile in the short term, both have always maintained value over the long term. As a result, gold and Bitcoin can be seen as hedges against inflation and the devaluation of major currencies.
Bitcoin evolved during 2020. The figure below shows that although volatility has come down since the market crash in March, the volatility of the S&P 500 remained above the January and February levels during the past year.
Chart 3 below shows the ratio of the historical volatility of BTC relative to other assets. A value of 2 means that BTC is twice as volatile as the corresponding asset.
As uncertainty was increasing just before the March 2020 crash, Bitcoin became less volatile relative to traditional asset classes. However, the March 12th “Crypto Black Thursday” showed weaker resilience and was followed by a spike in volatility as a consequence of the liquidation spiral that drove BTC prices to lower levels.
While volatility remains in BTC and other digital assets, history has shown us that it has worked as an effective portfolio diversifier because of its tendency to be uncorrelated from traditional assets and markets, and its ability to act as a hedge against inflation.
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