This might explain its appeal to some big investors. This makes it an excellent potential source of diversification. Its correlation with real estate and bonds is similarly weak. Over longer time horizons it is even weaker. Importantly, it also tends to move independently of other assets: since 2018 the correlation between bitcoin and stocks of all geographies has been between 0.2-0.3. The cryptocurrency might be highly volatile, but during its short life it also has had high average returns. Investors can reduce volatility by adding bonds but they tend to lead to lower returns as well. The correlation between stocks and bonds is weak (around 0.2-0.3 over the past ten years), yielding the potential to diversify, but bonds have also tended to lag behind when it comes to returns. The assets that yield the juiciest returns-stocks and real estate-also tend to move in the same direction at the same time. An investor holding two assets that are weakly correlated or uncorrelated can rest easier knowing that if one plunges in value the other might hold its ground.Ĭonsider the mix of assets a sensible investor might hold: geographically diverse stock indexes bonds a listed real-estate fund and perhaps a precious metal, like gold. (Indeed, while Buttonwood was penning this column, that is exactly what bitcoin did, falling 15% then bouncing back.) But the insight Mr Markowitz revealed was that it was not necessarily an asset’s own riskiness that is important to an investor, so much as the contribution it makes to the volatility of the overall portfolio-and that is primarily a question of the correlation between all of the assets within it. Diversification is the financial version of the idiom “the whole is greater than the sum of its parts.”Īn investor seeking high returns without volatility might not gravitate towards cryptocurrencies, like bitcoin, given that they often plunge and soar in value. But Mr Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing returns. It follows, naturally, that assets with high and dependable returns should feature heavily in a sensible portfolio. The theory posits that a rational investor should maximise his or her returns relative to the risk (the volatility in returns) they are taking.
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