To invest or not to invest in digital assets, that is the question!
Or at least you might think that’s the question if you’ve read anything written about the recent decline in digital assets. Such a question paints the election in stark, black-and-white terms: as if the only two options available were blind trust or total distrust with nothing in between. There is a much more pertinent question to ask, but it requires a more nuanced perspective.
Contrast this stance with recent discussions of current capital drawdowns and potential recession risk, never framed in black and white terms. Total divestment in shares is not mentioned. In their outlook or investment commentary, asset managers discuss: underweight stocks, move from cyclicals to defensive stocks, focus on high-quality companies. All nuanced and thought strategies that allow us to grasp the situation and its many uncertainties.
Investing, in digital assets or other assets, is not a play by Shakespeare. Investors never trade absolute values. Is about scenarios and probabilities.
Why should an investment in digital assets be any different? Why wouldn’t investors apply the same nuanced approach to their investment in digital assets? Whether taking a market portfolio approach, reflecting the 1% weighting of digital assets across all asset classes, or taking a longer-term approach to benefit from the effects of digital assets on Sharpe’s index, there are many ways to make an allocation that balances the risks and opportunities of this emerging asset class.
1% in Digital Assets, the rational choice?
Not investing in digital assets is, in fact, an active decision. It may reflect the belief that the digital asset space will eventually disappear entirely. This vision could be an ambitious position to take. The market capitalization of digital assets reached 3 trillion US dollars in November 2021.
Despite the current downsizing, in recent months the ecosystem and the number of use cases have been growing steadily for over a decade. The size of digital assets is still on par with emerging market small caps, REITS or global high yield bonds – assets that are part of most asset allocations and portfolios.
Figure 1 shows the current market portfolio, that is, the different listed assets available to investors weighted by their total market capitalisation. The total market accounts for around $160 trillion after the recent slump in risk assets, with digital assets accounting for around 1% of that.
To minimize this hypothetical market portfolio drift, a passive or uninformed investor should theoretically have around 1% invested in digital assets. This is the rational choice in the absence of any added view or information. This is a safe position that allows you to benefit from the continuous growth of the space in positive scenarios and that allows you to limit losses (to 1%) in more negative scenarios.
Figure 1 – Source: Bloomberg, WisdomTree. As of May 31, 2022. Market capitalizations are shown in billions of US dollars. You cannot invest directly in an index. For illustrative purposes only.
Why is 6% per year enough to justify an investment in digital assets?
The main rejection of the investor when it comes to investing in digital assets is usually the volatility and risk reduction. However, such concerns tend to overlook two important facts:
Whatever the volatility of digital assets, if an investor invests only 1% in digital assets, the maximum loss is 1%. In the context of a multi-asset portfolio, the 1% loss occurs several times a month due to stocks or any other risk assets.
The return required to justify the volatility similar to that of digital assets is not as high as investors expect.
Digital assets growing above 6% per year would be enough to justify investing in the hypothetical portfolio.
In the taxonomy “WisdomTree Insights – A New Asset Class: Investing in the Digital Asset Ecosystem“, recently published, we use multiple allocation techniques to determine the risk/reward balance offered to a long-term investor in digital assets. Figure 2, for example, shows the difference in the Sharpe’s index of a portfolio that invests 1% in digital assets, compared to a portfolio without digital assets. The illustrative portfolio consistently invests in:
- 59% in the MSCI All Country World
- 40% on Bloomberg EUR Agg
- 1% in digital assets
Equity and fixed income return and risk are estimated using JP Morgan Asset Management’s Long-Term Capital Market Assumptions (LTCMA) for 2022. These assumptions are intended to estimate returns, volatility and correlation for the next ten years. The historical correlation of digital assets with equities and fixed income is used. We vary the annualized return and volatility of digital assets from 0 to 100% to study the impact on the illustrative portfolio.
Figure 2 – Source: Bloomberg, WisdomTree. From December 31, 2014 to May 31, 2022 2022. Calculated in EUR on monthly returns. You cannot invest directly in an index. Historical performance is not an indication of future performance and any investment may lose value. For illustrative purposes only.
It is clear that for most levels of digital asset volatility and return, the portfolio’s Sharpe ratio benefits from its inclusion (‘green’ in Figure 2). Digital assets had a return of 99.2% per year with a volatility of 97% in the last seven years or so. It is doubtful that digital assets can function like this for the next ten years, but assuming volatility remains the same (99%), the Sharpe ratio of a 60/40 portfolio improves with the inclusion of digital assets as long as they return to the least 6% per year.
Given this analysis, investors could finally argue that it is too late to invest in digital assets and exponential growth is behind us. However, from an asset allocation point of view, this is not so relevant. Looking at Figure 2, instead of asking the Shakespearean “To invest or not to invest in digital assets?“, the only relevant question really is: will digital assets grow more than 6 or 7% in the future?
If the answer is “Yes“, then they deserve to be considered for some assignment.
Disclaimer: The information and/or opinions expressed in this article do not necessarily represent the views or editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.
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