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Do Cryptocurrencies Provide Diversification?

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Many investors own cryptocurrencies to add diversification to their portfolios.   Diversification is achieved when asset prices in your portfolio are uncorrelated, i.e. they tend to move independently of each other.  Low correlation means low portfolio risk.

Given that cryptocurrencies far outperform stocks/equities (shown in the charts below), it would be reasonable to assume that crypto prices are uncorrelated with the stock market.  But is this assumption true?

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To answer the above question, we must measure the strength of the relationship between cryptocurrencies and the other asset classes.  This means calculating the correlation coefficient between them (two assets at a time). 

Correlation coefficient values range from -1 to 1, where 1 implies a perfectly strong positive relationship (i.e. prices of two assets move perfectly together up or down). -1 also implies a perfectly strong relationship, but they move in opposite directions (one up, the other down, and vice versa).  0 means there is no relationship/no correlation (i.e. when one asset moves one way, there is no telling which way the other one will move).  For more information on the calculation and interpretation, go to https://en.wikipedia.org/wiki/Pearson_correlation_coefficient

The bottom line with correlation coefficients is that we want them to be as close to 0 as possible in order to consider two assets to be uncorrelated; somewhere from around -.35 to .35 is an acceptable range for me.  Conversely, owning assets that are highly correlated, say with a coefficient of .80 or above in absolute terms, would be redundant, hence not diversified. So there is an inverse relationship between diversification and correlation. Keep in mind that everyone should have their own tolerance threshold, depending on their risk appetite.

What Do The Data Tell Us?

To keep the analysis simpler, I use three proxies for the asset classes: Bitcoin (BTC) to represent the cryptocurrency asset class, the S&P 500 index for stocks/equities, and the Spyder Gold Trust ETF (GLD) for gold prices.  Below are correlation coefficients for the six-year window 2016-2021.   

Each square in the matrix shows the correlation coefficient for two intersecting assets.  Surprisingly, over the six years 2016-2021, there were quite strong positive relationships between all three asset classes.  Focusing on the orange squares, BTC/cryptocurrencies moved almost perfectly in the same direction as the stock market. At first glance, this is not desirable, as it implies that there is no diversification provided by cryptocurrencies.

To get a better sense of the data, I parse the six-year window into individual years, shown in the table and bar chart below:

In the yearly table and chart, I disregard 2020 as an outlier because there were massive Covid-response fiscal and monetary stimuli on a scale unlikely to be seen again.  In that year, we saw a large dip followed by a spectacular rise in all asset classes (the “everything” bubble), hence the spike in correlation between cryptocurrencies and the stock market.

Putting aside 2020, we see that the correlation between BTC (cryptocurrencies) and the stock market was highest (above .80) in 2016 and 2017 during the previous crypto bull market; this is surprising given that the crypto market was still relatively undeveloped.  After the crypto market crash in December 2017, the BTC-stock market correlation came down  to .14, .55, and .28 in 2018, 2019, and 2021 respectively; these levels are acceptable to me, based on my tolerance threshold of about -.35 to .35.

Another noteworthy observation is the correlation between BTC and gold.  We see an increasing level of correlation between gold and BTC from 2016 to 2019 — that is before and after the previous crypto bull market.  Again ignoring 2020, the uptrend in BTC-gold correlation is followed by a steep drop to negative .43 in 2021. 

This sudden reversal of trends is an indication that, in the early years, investors didn’t buy into the notion that cryptocurrencies, particularly BTC, could be a substitute for gold; therefore their prices were positively correlated (or they could have been uncorrelated).  But the -.43 correlation coefficient in 2021 is a sign that investors may finally have bought into the notion that BTC is a gold substitute; therefore, they were selling gold to buy BTC/cryptocurrencies. Of course, one data point doesn’t make a trend, so it is something that I will track going forward.

Final Verdict

Yes, cryptocurrencies have provided portfolio diversification due to their lower correlation with stocks in the past four years. And yes, investors are finally treating cryptocurrencies as a gold substitute.

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