Sophia’s Thoughts on the Markowitz Legacy for Crypto
Harry Markowitz, who established the contemporary way of thinking about investments, passed away recently. What does his legacy tell us about how crypto fits in the modern investment world?
These are Sophia's Thoughts:
Back in the 1950’s, Professor Markowitz began advocating for selecting investments based on their risk-return balance rather than just looking at returns. And, with that, he ignited a revolution in the finance world focused around the concept of diversification.
The recent push by BlackRock and Fidelity to open up Bitcoin ETFs in the US is a direct consequence of Professor Markowitz’s work.
Our analysis shows that traditional investors can improve their performance by as much as 20% through diversification with Bitcoin.
(We’re keeping this Sophia’s Thoughts shorter and earlier in recognition of the July 4 holiday in the US.)
🚀 Last week’s market performance
The crypto market gained 4% while Bitcoin (BTC) gained 3% last week. The market continued its rally when Fidelity also announced it was filing an application with the SEC to run a Bitcoin ETF. One coin in particular outperformed every other coin: Compound (COMP). It posted an impressive 78% return over the last 7 days. It was boosted by recent activity by some whales. On the other hand, Radix (XRD) lost 25%, correcting its recent rally.
🧐 What is your crypto mood today?
In each Sophia's Thoughts newsletter, we ask about your crypto mood. Your response to this question helps Sophia get a better sense of the pulse of crypto markets. And this ultimately translates into better insights for you when combined with Sophia's AI models. Your data empowers Sophia to provide you with even better intelligence going forward!
🌀 Diversification, diversification, diversification
If you asked a financial advisor back in the 1950's what investments you should make, then you would have probably been advised to invest all of your wealth into a single stock. The common investing approach back in the day was to concentrate all of your investments into the single asset with the most promising return profile. You see, back in the day investment professionals did not have a very good understanding that risk and return in investing are intimately tied together.
This all changed when Harry Markowitz published his doctoral dissertation at the University of Chicago in 1952. Markowitz recognized that future returns are uncertain — that’s what we call risk. And he also recognized that investors care about how much risk they are exposed to. So, Markowitz demonstrated that diversification is critically important for investors to achieve the best possible performance.
Diversification means to spread your investments over multiple assets to reduce the riskiness of your portfolio. Prior to Markowitz’s seminal work, diversification was not common among investment professionals. Most investors either held a few investments in their portfolios, selected purely based on the expectation of their returns.
Markowitz showed that there exists such a thing as an optimal degree of diversification. And that it all depends on how the investments in a portfolio move up or down in relation to each other. The weaker is the correlation between the assets in a portfolio, the more an investor stands to gain from diversification. Markowitz’s work led the way for a whole new area of research on financial investments.
Harry Markowitz was a long-time professor at the University of California in San Diego. He passed on Thursday, June 22, 2023. But his work has had a lasting impact on nearly all financial markets.
Harry Markowitz, Nobel-Winning Pioneer of Modern Portfolio Theory, Dies at 95 (New York Times)
Harry Markowitz, Father of Modern Portfolio Theory, Dies at 95 (Bloomberg)
🪙 Diversification & crypto
Crypto is not unfazed by Professor Markowitz’s work. As a new asset class, crypto has the potential to offer large diversification benefits for investors. Especially those that are not currently invested in crypto. The recent push by BlackRock & Fidelity to obtain approval from the SEC to run Bitcoin ETFs highlights that big institutions are recognizing the demand for crypto assets.
Fidelity spot bitcoin ETF application refiled with U.S. SEC (Reuters)
Probability for U.S. Approval of a Spot Bitcoin ETF Is Fairly High: Bernstein (Coindesk)
But crypto is a highly volatile asset class. So how much do investors stand to gain through diversification by investing in crypto? It all depends on the correlation between crypto and traditional assets. As we highlighted in our Sophia’s Thoughts article in March, the correlation between Bitcoin & equities tends to spike when financial markets become more uncertain. Lately, uncertainty in financial markets has been declining. Currently, we measure a weak correlation between Bitcoin and the US stock market.
We studied by how much traditional investors can improve their performance by diversifying and including Bitcoin in their portfolios. At current levels of returns, risks, and correlations in the market, a traditional investor that holds a 60–40 equity & bond portfolio could improve their performance by as much as 20% through diversification with Bitcoin. This improvement is reflected in the Sharpe ratio of the portfolio, which captures how much risk-adjusted returns the portfolio generates for every percent of volatility.
As recognized by Professor Markowitz, the low correlation between Bitcoin and traditional asset classes makes it possible for investors to improve their performance by diversifying their portfolios.
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