The Bitcoin Bounce Fuels Faulty Calls for Crypto ‘Diversification’

Stocks hit a fresh year-to-date high Friday, and they aren’t the only thing rallying of late: Bitcoin is also storming back. The hype train is rolling along with it. Headlines argue that with regulators reportedly becoming more amenable to the idea of a bitcoin ETF, it is finally hitting the big leagues. We have seen some suggest it is wise for investors to add a bit of it to their long-term asset allocation. Alas, “wise” isn’t the word we would use.

To see why, let us start with first principles—in this case, the principle of diversification. Those who say bitcoin belongs in long-term investors’ asset allocations (the mix of stocks, bonds and other securities you own for the long haul) seem to be operating on the presumption that diversification means owning as many types of securities as you can in order to spread risk around multiple asset classes. This crowd argues not just for stocks and bonds, but also gold, other commodities, private assets, real estate and other such things, with the idea that you will own whatever is rallying whenever it rallies. We guess that is a perspective, but we disagree with it. In our view, the best asset allocation is the one whose long-term returns and expected short-term volatility are most consistent with your long-term goals, cash flow needs, time horizon, comfort with temporary declines and other personal factors. Rather than taking a kitchen sink approach, we think it is best to blend the assets with the long-term risk and return profiles that best fit your goals and needs. As part of those risk and return profiles, they should have predictable fundamental drivers—you should be able to know, generally, how they will perform in various environments. And then, once you have picked your asset allocation, you set about doing the hard work of diversifying within each asset class.

An all-stock portfolio works for an investor with long-term growth objectives, a multidecade time horizon and minimal to no cash flow needs because stocks have demonstrated that, as a share in corporations’ future earning power, they generate solid long-term returns. They can have painful drops along the way—sometimes lasting for a year or more—but there is a strong history of the good times outweighing the bad. In other words, the long-term return is worth the short-term risk, in our view. For investors with higher cash flow needs and/or shorter time horizons, the temporary declines can be a greater burden, so we think blending in fixed income makes sense. Bonds may not always rise when stocks fall, but overall they have demonstrated lower short-term volatility, making them a viable way to generate a smoother return path overall and on average. They, too, tend to deal with economic and political conditions in predictable ways.

Bitcoin doesn’t fit here at a basic fundamental level. For one, its performance history is short—far too short to assess risk and return over a long time horizon. It doesn’t even have a single rolling 30-year set of returns, never mind dozens of such sets. Its limited history has big booms and busts—speculative mania and their aftermaths. With bitcoin’s supply stable, the main return driver is demand, and demand is tied to sentiment. There is no visible, repeatable, explainable link to the economic cycle, inflation, interest rates or anything else people will occasionally argue is a reason to own bitcoin. Sometimes it correlates highly with stocks, sometimes negatively. Its use case as money has fallen apart amid its complex tax treatment (spending it would amount to realizing a capital gain or loss), and judging from the deep-seated problems at the two most famous exchanges, cryptocurrency’s use cases in general are tainted by fraud, criminal activity and money laundering. Hence it is a purely speculative digital commodity.

As such, it might add returns at times, sometimes big ones. But it also adds risk, sometimes the risk of big declines. And with those booms and busts tied to sentiment, we have a hard time seeing how blending it with stocks, bonds and other securities would improve the overall risk/return profile. You can’t even run a long-term portfolio simulation since there is nowhere near enough data to do so. And without a fact-based and logical argument for how it can improve the likelihood of reaching a concrete set of long-term investment goals, either by raising potential returns or reducing expected short-term volatility, then we don’t think there is a case to add bitcoin. Or crypto in general.

Keep in mind, too, that we wouldn’t even be seeing these pro-bitcoin arguments if it weren’t rallying—this is all just heat chasing dressed up as deep diversification. But we have seen this before, like the last time bitcoin had a big run in 2021. It then proceeded to plunge about -75%, and it is nowhere close to its 2021 peak.^[i] Stocks, by contrast, fell much less and are ever-closer to breakeven. Where they go from here over the next 3 – 30 months will rest on how the economic and political backdrops evolve relative to expectations. Where bitcoin goes from here will rest on fickle feelings and the madness of crowds. In our view, that is too flimsy a thesis to invest on.