Are Cryptocurrencies Good Diversifiers?

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Cryptocurrencies are digital or virtual tokens that use cryptography to secure their transactions and control the creation of new units. Cryptocurrencies are decentralized, meaning they are not subject to government or financial institution control. Bitcoin, the first and most well-known cryptocurrency, was created in 2009. Cryptocurrencies are often traded on decentralized exchanges and can also be used to purchase goods and services. Cryptocurrencies are often volatile, meaning their prices can fluctuate rapidly.

It’s commonly believed that cryptocurrencies can be good diversifiers because they are not correlated with other asset classes. This means that when one asset class is performing poorly, cryptocurrencies may be doing well. This makes them a good tool for hedging against losses in other investments. Cryptocurrencies can also add value to a portfolio by providing exposure to an asset class that is not well represented in traditional assets. For these reasons, cryptocurrencies can be good diversifiers for investors looking to add more risk to their portfolios.

Reference [1] formally examined the role of cryptocurrencies in asset allocation. It pointed out,

The empirical findings are three-fold. First, we identify: (i) a positive instantaneous and bidirectional volatility spillover effect between Ethereum and Litecoin and between Ethereum and Bitcoin, and (ii) a negative instantaneous and bidirectional volatility spillover effect between Bitcoin and Litecoin… Second, we show that the US stock market is detached from the studied cryptocurrency market offering hedging and safe haven opportunities to investors. However, disturbances in the bond market cause Bitcoin and Litecoin to deviate from equilibrium and Ethereum to converge to equilibrium. We notice that the two biggest cryptocurrencies in terms of market capitalization (Bitcoin and Ethereum) react in opposite directions to the volatility in the US bond market… Third, we show that high economic and financial uncertainties in the US stock market due to pandemic outbreaks affect the volatility of Bitcoin, Litecoin, and Ethereum. Precisely, it pushes the price of Litecoin and Bitcoin to converge to equilibrium while it causes Ethereum to shift away from its equilibrium…

Our empirical findings show the important role of cryptocurrencies in investment portfolios given their relative detachment from the majority of mainstream assets. Our results also highlight the importance of accounting for structural breaks in cryptocurrency data to infer more accurate conclusions and recommendations to investors in terms of optimal hedging opportunities and portfolio diversification strategies, in normal and turbulent periods.

In short, the authors showed that cryptocurrencies play an important role in portfolio asset allocation.

Unlike the authors, we have observed that Bitcoin and other cryptocurrencies’ correlations with the equity market have been positive and on the rise, hence they’re not good diversifiers.

Let us know what you think in the comments below or in the forum.

References

[1] Etienne Harb, Charbel Bassil, Talie Kassamany, Roland Baz, Volatility Interdependence Between Cryptocurrencies, Equity, and Bond Markets, Comput Econ (2022), https://doi.org/10.1007/s10614-022-10318-7

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