In a new episode of the Coinist Podcast, Ari Paul, the chief information officer at BlockTower Capital, debunks some of the biggest reservations that potential investors have about Bitcoin and cryptocurrency.
Host Luke Martin calls out three major challenges for investors.
- So volatile
- Doesn’t make sense
- Too risky
“There’s a lot of professional investors, wealth managers, endowment investors who personally own cryptocurrency but will say it’s inappropriate for their institution…
Anyone who understands risk in the financial concept, anyone who has an MBA or a CFA designation, anyone who works in risk management team should have a full understanding of this basic idea – which is, you only care about marginal risk. I’ll explain what that means.
In 1920 there was a belief that it was irresponsible for most people to own equities at all. Because equities are risky. Equities are volatile. You should only be in blue chip corporate bonds. That’s safe. And if you were a wealth manager and you put your investor in – let’s say you put one dollar of your investor’s money in any stock or a corporate bond of a risky enterprise and they lost money, you would be on the witness stand and the judge would say, ‘Why did you think that investment was safe?’
Today we recognize that that’s nonsense. If you invest in the S&P 500 index where you own a basket of 500 stocks, you’re not saying that every individual stock is safe. What you’re saying is that as a whole, that basket of stocks looks attractive. And that maybe there’s a really, really risky company in that 500, but I only have 20 basis points of my money in that one company.
And so, a basic idea of risk is there’s two types of risk at a very high level within a portfolio. There’s systematic risk, which means risk that contributes to the risk of the total portfolio because it’s correlated to the market, and there’s idiosyncratic risk which is the risk of that company or that asset which has nothing to do with the market.
In cryptocurrency, what we’ve seen recently is there’s very little diversification benefit. There’s been very little idiosyncratic risk in practice. Most of your risk as a cryptocurrency owner is market risk – is the risk of the cryptocurrency market as a whole. Everything went up, everything went down together. I’m oversimplifying, but cryptocurrency has been almost uncorrelated to stocks, bonds and gold. I’m not saying for sure that will continue, but it’s a pretty good bet that cryptocurrency will remain less correlated with stocks than other stocks are, or less correlated with stocks than bonds are. So it’s not saying the correlation will be zero but if correlation is less than 70%, you get a wonderful diversification benefit.
If you have a portfolio of equity, bonds, real estate, commodities, most of your risk, you’re very highly correlated to the general global economy and to basically the US and global equities as a whole. So even your real estate, even your bonds are pretty highly correlated to public equities.
If you take 5% of that exposure and you shift it to a coin – to flipping a coin. If it lands on heads, you double your money. If it lands on tails, you lose your money. That’s a very risky bet. It’s a coin flip. But because it’s uncorrelated, because it has nothing to do with the rest of your portfolio, it actually reduces your overall risk.
Now with cryptocurrency, it’s kind of like that coin but we hope that instead of being 50-50, that there’s this positive expected value.
So cryptocurrency is a very, very risky bet with a chance of going to zero, but positive expected value because it’s uncorrelated. It’s all idiosyncratic risk relative to the rest of your portfolio. So your risk falls and your expectation of returns rises which makes it the holy grail of investing.
Endowments, pensions should be drooling over cryptocurrency because it’s literally – as a portfolio manager – what you’re desperate for. You’re desperate for a source of uncorrelated returns and uncorrelated risks.”