Crypto is probably a bad investment!

So, what would be an appropriate expected return for the crypto assets? Well, just purely from the beta exposures to the stock and bond market index data, we could set the expected return of the crypto-assets the way you’d do in any other factor model application. For example, if Ethereum has an equity beta of 3.25 and a bond beta of 1.81, then the expected excess return is the beta-weighted sum of stock&bond returns, though adjusted by the cash rate for the portion of the total beta exceeding 1.0. That’s because if you invest in stocks or bonds on margin you have to account for the margin rate and subtract that again.

Then, if we calibrate the inputs as:

• Stock expected returns 8% (3% inflation plus 5% real return),
• 10-year Treasury bond expected returns 3%,
• and the cash/money-market rate as 2.5% over the next 10 years,

… then we get the following expected returns:

• Bitcoin: 14.5%
• Ethereum: 21.3%
• Litecoin: 19.2%
• S&P Large Cap Crypto Index: 16.1%

So, even without including any additional alpha, these are very impressive expected returns. If we assume a current market cap of $1t in the large-cap crypto market and a 16.1% overall index growth, then we should expect almost $4.5t in market cap in 10 years. Pretty impressive. With those expected returns, what kind of crypto portfolio weights can we justify? That brings us to the next section…

Adding Crypto in an “Efficient Frontier Analysis”

With the variance-covariance matrix constructed from the post-2020 return data and the forward-looking return data, we have all the tools necessary to construct efficient frontiers with and without crypto assets. I start with the traditional assets only (stocks&bonds), then add the SP Global Large-Cap Crypto Index, and then all four crypto assets (index + 3 individual coins). The efficient frontiers are in the chart below.

Dollar-Cost-Averaging effect, then you can clearly ramp up the risk target and use crypto assets, while walking up the efficient frontier, right? True, but there might be a better way. As I wrote in a post almost 6 years ago, we could take the efficient frontier diagram, identify the Maximum Sharpe Ratio portfolio, and use leverage to expand the efficient frontier to the left. For example, in the base case scenario with the calibrated expected returns, the tangency point is at about 53% bonds and 47% bonds. No crypto assets are used in the maximum Sharpe Ratio portfolio. If we simply extrapolate along this tangency line we can reach points far superior (i.e., lower risk and/or higher return) than any of the efficient frontier using crypto assets. For example, with a 4x leverage (about 212% bonds, 188% stocks, and -300% cash), we’d reach about 13.1% expected return and 32.6% expected risk. Close to the Bitcoin expected return but less than half the risk of Bitcoin. Who needs Bitcoin, then?

crypto critics warning of the impending doom, while the crypto fans extrapolate the spectacular past returns into the future. Both sides of the argument are “conditionally correct”, i.e. if crypto is all just a bubble, then stay away. And if crypto keeps going up at 100% a year then that’s very attractive. But in today’s post, I wanted to show that cryptocurrencies aren’t that attractive even in the “intermediate case” where you assume that crypto assets have expected returns of “only” around 2x to 3x that of equities. That’s because crypto volatility is simply too high, coupled with a noticeable equity correlation.

The rationale here reminds me of my old post from 2017 (“This fund returned over 100% year-to-date. I’m still not buying it!“) with a similar flavor: an ETF had strong returns, but it still was not worth it. Because the volatility and downside risk, as well as the equity correlation, were complete dealbreakers. (and sure enough, just a few months after publishing the post, the ETF indeed blew up in February 2018, though I’m not necessarily predicting the same for the cryptocurrencies).

So, if you want to mix a few % of Bitcoin into your portfolio, be my guest. But I would not invest in crypto on a large scale. Especially not in retirement when volatility and drawdowns can pose a real headache.

So, take it for what this is: I’m just a personal finance blogger with an opinion and some technical training and tools to test my hypotheses. People may accuse me of being a crypto curmudgeon because I missed out on the great wave up. Maybe that’s true. People have a tendency to justify their past actions and past mistakes. But I hope that even the crypto fans have gotten something out of my work. Use my ramblings as a devil’s advocate argument. Can you convince me and yourself that my analysis is wrong?

Thanks for stopping by today. Looking forward to your comments and suggestions!

Title picture source: History Channel

This article was originally published by Earlyretirementnow.com. Read the original article here.