When crypto is viewed in the context of a single investment then it certainly should be regarded as a high-risk investment due to the significant amount of capital at risk. However, when crypto is viewed in the context of a portfolio and blended with other assets, then the risks are not only reduced, but in fact the risk is lower than traditional assets. This may seem like an outrageous claim, but the claim has mathematical integrity in its reasoning.
The assertions about crypto being risky all pivot on how we define and view risk. In traditional markets where the market movements are more pedestrian, risk is measured as volatility, or possible drawdowns. This is a fairly accurate representation of risk as asset prices behave in a symmetric way that follows the normal bell-curve distribution of returns. This principally means that the upside and downside returns are fairly equal.
However, when an asset starts demonstrating exponential returns that are multiples of capital invested, then this measure of risk no longer applies. This price characteristic of outsized returns relative to capital invested is called asymmetry. The asymmetry exists because the downside is capped to full capital loss, but the upside is virtually unlimited.
In traditional markets where returns are small compared to crypto, annualised returns are a fairly accurate and intuitive metric. When returns are measured in multiples of capital such as in crypto markets, this is also an inaccurate representation, as the enormous effect of compound interest is not captured. For instance, an asset showing 80% annualised returns will only yield half the performance of an asset yielding 100% annualised returns over five years. Therefore, returns are also better described using an absolute return measurement.
The ultimate objective of any portfolio is to combine assets that will achieve a defined measure of risk, while delivering the highest possible returns. To achieve this most effectively, the most desirable assets for the portfolio will be the assets that exhibit the highest returns relative to the lowest risk. This asset characteristic exactly describes crypto to be the most desirable asset.
Coupled with the additional quality, that crypto will exhibit uncorrelated return to traditional assets, which lowers the portfolio risk even further, crypto is simply an asset class that cannot be ignored when constructing well-balanced portfolios. The ultimate risk of crypto will boil down to the allocation within the portfolio. Only a very small allocation to crypto will achieve the possibility of very large returns to the portfolio, while only have the small allocation amount at risk.
The above analysis is largely contingent on cryptos’ ability to show similar future exponential performances. The total crypto market capitilisation of US$3-trillion is still relatively small, and still has potential for growth.
However, this gives a skewed picture as the crypto universe is completely dominated by Bitcoin and Ethereum, which account for 60% of the entire market capitalisation. There are over 2 000 crypto coins and 99% of these cryptos have market caps less than US$10-billion. It is evident that most crypto assets are still in a very nascent stage, and opportunities for electrifying growth that has been observed in the last five years are still possible.
Within the crypto universe there are also very different and uncorrelated opportunities. It is a common misconception that crypto is a single asset class. The term crypto, Bitcoin and Ethereum are used synonymously and interchangeably to mean the same thing. This is certainly not the case. There are crypto assets that will be used for very specific use cases, such as medium of exchange, NFT or Metaverse, and it is expected that the price behaviour will also be different longer term.
In conclusion, it should be apparent that when assets are showing performance returns in multiples of capital invested, then the normal metrics of risk (volatility) and returns (annualised returns) need to be adjusted. It is not possible to apply traditional finance metrics to an asset class that behaves so differently in performance.When using a different measure, crypto is a sensible investment within the context of a balanced portfolio.
With the added features of uncorrelated, long-term behaviour, the prospect of spectacular returns and multiple asset classes within crypto, it becomes a very compelling addition to a portfolio. Crypto as an asset class is becoming increasingly difficult to ignore.