With the launch of the new spot Bitcoin (BTC -2.45%) ETFs in January, there's now growing debate about just how much Bitcoin is prudent to hold in a well-diversified portfolio. Until this year, the consensus view had been that Bitcoin should account for only a tiny portion of your overall portfolio. As a general rule of thumb, 1% was the norm, and any percentage over 5% was considered ultra-aggressive.
However, according to Cathie Wood of Ark Invest, the optimal Bitcoin portfolio allocation might actually be closer to 19.4%. That's an incredibly high percentage, and it's worth a closer look at some of her underlying assumptions.
Bitcoin and portfolio optimization
In Ark Invest's just-published "Big Ideas 2024" research report, the firm laid out the core building blocks of how it arrived at this figure of 19.4%. The starting point is thinking about Bitcoin as a stand-alone asset class with a unique risk-reward profile.
As Ark Invest points out, Bitcoin has outperformed every major asset class over long time horizons. Over the last seven years, the annualized return for Bitcoin was 44%. In contrast, the annualized return across all traditional asset classes was just 5.7%. If you pick any 5-year time horizon, there is a high probability that Bitcoin will outperform any other asset class.
And there's another property of Bitcoin that makes it attractive. Bitcoin's correlation with traditional asset classes is low. According to Ark Invest, the correlation coefficient with other asset classes is just 0.27. Any correlation coefficient under 0.40 is considered low, so Bitcoin really does appear to be an asset that's insulated from the zigs and zags of the broader market.
Thus, when you use a portfolio optimization model, it's going to tell you to add a lot of Bitcoin if you want to maximize potential rewards and minimize risk. According to Ark Invest, the optimal allocation of Bitcoin to a portfolio in 2023 was 19.4%. That's a big increase from the year-earlier period, when the optimal allocation was 6.2%. And that, in turn, was a significant increase from the year-earlier period, when the optimal allocation was 4.8%.
In fact, in every year since 2015, the optimal allocation to Bitcoin has been rising. And that means allocations to more traditional asset classes -- such as stocks and bonds -- have been falling. In 2023, says Ark Invest, the optimal allocation to stocks was only 30%.
Is Cathie Wood right?
It's hard to argue with Bitcoin's historical returns. In the period from 2011 through 2021, Bitcoin was the top-performing asset class in the world, and it wasn't even close. The same was true in 2023, when Bitcoin (up more than 150%) far outperformed every traditional asset class. While you can argue that past performance is no guarantee of future results, the impressive track record for Bitcoin now extends over a decade.
Image source: Getty Images.
Where I am concerned, however, is with the implicit assumption that the arrival of the new Bitcoin ETFs won't change the way Bitcoin performs in the future. With Wall Street now aggressively promoting its new Bitcoin ETFs, will the "new" Bitcoin behave the same way as the "old" Bitcoin?
For example, consider Bitcoin's correlation with other assets. One reason why Bitcoin has historically been so uncorrelated with traditional asset classes is because it took Wall Street so long to embrace crypto. It was only in 2021 (during the last crypto rally) that big Wall Street banks began to think of Bitcoin as an asset class, and only in 2022 when BlackRock (NYSE: BLK) -- the largest asset manager in the world -- decided to make Bitcoin available to its institutional investor clients.
But now Wall Street is embracing crypto. The top spot Bitcoin ETF issuers now have over $4 billion in assets under management. That works out to 100,000 Bitcoins that they've acquired in an incredibly short period of time. If Bitcoin ETFs continue to go mainstream, then it would only make sense that some of the correlations with traditional asset classes would start to tighten. As a result, when you plug the updated numbers into a portfolio optimization model, it's going to suggest you should hold less Bitcoin.
Is Bitcoin going to $2 million?
So what would happen if investors worldwide really did decide to allocate 19% of their portfolios to Bitcoin? Ark Invest ran the numbers and came up with a price tag of over $2 million for Bitcoin. That's double Ark Invest's previous $1 million price estimate for Bitcoin. The logic here is simple: Enormous buying pressure on Bitcoin is going to push its price to stratospheric levels.
While I'm long-term bullish on Bitcoin, and certainly relish the idea of owning Bitcoin valued at $2 million per token, I'm also pragmatic. There are still plenty of really smart investors who believe that you should hold no Bitcoin in your portfolio, among them Warren Buffett and the late Charlie Munger.
So before you rush out and boost your Bitcoin allocation to 19%, make sure you recognize the risks and potential perils involved. That percentage is a dramatic increase from previously suggested allocation levels, and may be entirely too risky for many investors getting into crypto for the first time.
