What Percentage of Your Portfolio Should Be Crypto?

A recurring question that we get at Domain Money is “what percentage of my portfolio should be in crypto?”

Many of Domain Money’s clients appear to be convinced about the exciting future of blockchain technology and want to make crypto a meaningful part of their investment portfolio.*

However, investing in cryptocurrency comes with a great deal of market, asset class and individual asset risks. Each investor must consider these risks before investing in crypto.

An important part of managing risk is determining the appropriate allocation to make. We developed a model to demonstrate how adding relatively small amounts of crypto could have a positive impact on an investor's performance while limiting the associated risks of the asset class. Our model suggests that investors should consider allocating 0.50% - 5.5% of their portfolio to crypto. The actual amount suggested varies based on each investor’s risk tolerance, investment objectives, income level, net worth, and time horizon. 

In this piece, we discuss how the assumptions we’ve used to come up with our views are built on the historical volatility of Bitcoin. Crypto has historically been among the most volatile of asset classes, and there’s no guarantee that its future performance will resemble its past. As such, the future volatility and performance of the asset class may be less than or exceed the values we’ve used in our models.

In addition, it’s worth noting that our suggestions are based on information made available to us regarding each individual’s existing portfolio. We confirm with each customer that the person is satisfied with their current investment mix and the risk it entails. Our goal is to help solve for how much crypto a person can add to their existing portfolio without meaningfully changing the expected volatility of their overall portfolio.

Step One: What's In Your Portfolio Now?

While we are not in a position to formulate each investor's asset mix, we typically begin by making certain assumptions about what an investor with a certain risk appetite maintains in their portfolio. From this model account profile, we can begin to consider how much exposure to crypto may be appropriate for a person with the same investment objectives.

Using this information, we classify investors into 1 of 5 buckets (conservative, moderate-conservative, moderate, moderate-aggressive, aggressive). For modeling purposes, we assume each bucket has an asset mix that roughly corresponds to what’s displayed in the table below:

Once we classify each investor, we can then analyze the effects of adding crypto to each of the 5 model portfolios.

Adding Crypto to Each Portfolio

Once we have a rough approximation for how each client profile may invest (if they follow the model above) their money today, we make a suggestion for how much crypto a customer with their hypothetical profile should own. The amounts suggested for each of the customer profiles is based on risk tolerance information provided to us by a customer. Our goal is to understand how much crypto a person could add to their current portfolio while keeping expected volatility close to that which we have calculated for the profiles in the chart above.

For each of the 5 model investment portfolios modeled above, we analyzed the effect of adding various amounts of crypto (and selling a proportional amount of assets from the existing portfolio) on the expected annual volatility and expected annual return of the model risk profile’s entire portfolio.  

To calculate the expected annual volatility for portfolios with crypto, we use historical returns for each asset class as well as Bitcoin** to build a covariance matrix, a tool used to calculate a portfolio’s expected volatility. We use Bitcoin because it has the longest history of reliable trading data.  We then use the covariance matrix to estimate the future volatility of each portfolio with various levels of crypto. 

To calculate the expected annual returns for each portfolio category once Bitcoin is added, we used the following estimates*** of the future annual returns of each asset class:

At Domain Money, we conservatively estimate the annual returns of crypto will be 20% per year over the next decade. In A Fundamental Approach to Investing In Crypto, we detail why we believe the asset class is a $10-$100T opportunity in aggregate and that reaching this goal will likely take about a decade.  Currently, crypto has an aggregate market cap of ~$1T.  If our projection is accurate, the annualized returns of crypto could be as high as 25% to 58% per year over the next decade.  To be conservative we use a 20% growth rate rate in our calculations.

Adding various amounts of crypto to the optimal portfolios yields the following expected annual volatility and returns:

Using this data, we estimate the amount for each bucket that an investor may consider allocating to crypto.  Since September 2014, the realized volatility of crypto (Bitcoin) was 73%, much higher than any of the model portfolios without crypto. Accordingly, adding crypto increases the volatility of all optimal portfolios.

While adding crypto to a portfolio provides the potential opportunity to increase returns, our goal is to suggest a crypto allocation that does not meaningfully change portfolio volatility risk. Our research indicates that adding a modest amount of crypto to each model portfolio likely will not meaningfully change  portfolio risk because crypto is generally uncorrelated to other investment assets, thereby increasing the diversification of each model portfolio. We take the view that investors should consider  accepting a portfolio with 2% higher volatility to account for the increased potential volatility represented by adding crypto to their portfolio. Using this rule of thumb, we solve for an allocation to crypto that we believe enhances the opportunities for each investor profile:

The result is that we suggest that investors consider a crypto allocation from 0.5% to 5.5% depending on the aggressiveness of a client’s existing portfolio and their investment objectives.  Adding the above allocations of crypto will increase the risk of each portfolio. However, over the next 5-10 years, we expect the allocation will lead to materially better outcomes for the portfolios that include crypto.  

Please keep in mind that these allocation amounts correspond to the model portfolio structures presented above.  Your portfolio may include different allocations of assets, which will change the volatility impact of adding crypto to your portfolio.

Conclusion

Crypto is a promising, yet risky asset class. Digital assets have historically traded with much higher volatility than traditional financial instruments like stocks or bonds. And they come with risks that investors may not recognize. In particular, the regulatory framework for the asset class is still largely a work in progress. Substantive changes to the existing laws and regulations that apply to crypto could adversely affect prices. This lack of regulatory clarity distinguishes crypto from traditional asset classes.

We built Domain Money to help clients navigate markets.  One of the most important decisions investors make is sizing their allocation to various asset classes, including crypto. To help our investors feel more informed about allocating to the crypto asset class, we created a framework  to give clients information that may help in considering whether a crypto portfolio allocation is appropriate. Our approach suggests that investors consider holding 0.5% - 5.5% based on their existing risk profile. The framework we used is based on the idea that investors  considering crypto may do so without meaningfully increasing volatility (risk) in their existing portfolios (based on the model portfolios presented in this piece). 

Crypto is still an emerging asset class and making assumptions about future risks and returns is challenging. Ultimately, the choice on how much of your portfolio should be put into crypto is one that you have to make for yourself. That said, we believe our modeling approach is robust and we will continue to refine our research over time. We believe the framework provided is a reasonable guide and provides information that may help you in choosing a crypto allocation that matches your current risk appetite.


Domain Money Advisors, LLC is providing this information for informational purposes only. While Domain Money Advisors, LLC believes that the information contained herein is reliable and derived from reliable sources, it makes no representation, warranty or undertaking, stated or implied, as to the accuracy or completeness of the information. Domain Money Advisors, LLC, and its parent company, Domain Money, Inc., expressly disclaims any liability or loss incurred by any person who acts on the information, ideas or strategies discussed. The information contained herein is not, and shall not constitute an offer to sell, a solicitation of an offer to buy or an offer to purchase any securities or cryptocurrency, nor should it be deemed to be an offer, or a solicitation of an offer, to purchase or sell any investment product or service.  Investing comes with inherent risks and you should always invest within your means and risk tolerance.  Past performance is not an indication of future returns and you should always consult a financial advisor prior to making investment decisions. Please see important disclosures at https://domainmoney.com/legal

*Based on a proprietary survey conducted by Domain Money

**Dates 9/17/14 to 6/30/22

***BlackRock capital market assumptions