There’s a simple formula for adding crypto to your portfolio

Imagine coming home and opening your fridge to find a jar filled with your favorite juice. After taking a sip, you realize that the kind soul who prepared the juice added too much water, and there’s not much you can do to fix it — removing water from juice is a complicated process. However, if instead the juice-maker was too stingy with water, you can simply dilute the juice with extra water and enjoy a perfect refreshing drink.

A similar phenomenon happens with the risk of financial assets. If an asset has too little risk, it is complicated to “remove water” and make it riskier, usually through leverage. On the contrary, if the asset is too risky, it is straightforward to dilute it with cash equivalents, such as short-term Treasury Bills, or T-Bills.

Crypto assets have emerged as a new asset class in the past 14 years. As they’ve gained popularity, debates have arisen about their role in a portfolio of traditional assets. The controversy largely stems from concerns about the level of risk associated with these assets, which is significantly higher than that of even the riskiest traditional assets.

Well, instead of complaining about the high risk, one can add some water (e.g., T-Bills) and then check how well the diluted crypto assets fit in a traditional assets portfolio. This is precisely what we did. We took three years of post-pandemic data, from second quarter 2020 until first quarter 2023, for indices representing (global) equities (the MSCI World Index), (global) bonds (the Bloomberg Global Agg Credit Total Return Index Value Hedged USD), short-term T-Bills (the Bloomberg 1-3 Month U.S. Treasury Bill Index), and crypto. The next step was to dilute crypto with T-Bills. We chose two parts crypto for three parts T-Bills, which led to volatility levels that were less than double what is typical for equities.

The grand finale is three-fold: We took all the portfolios ranging from 1% to 99% equity with the rest allocated to bonds (quarterly rebalance was used in all the simulations), which we called original portfolios; determined how much of the equity portion could be replaced by diluted crypto maintaining the same level of volatility, which led us to the final portfolios; and analyzed what happens with other relevant portfolio

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Author: João Marco Braga da Cunha

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