Bitcoin has been a volatile asset since its inception in 2009, making some investors wary of investing. We believe that with relatively limited risk, Bitcoin can be allocated to have a meaningful impact on portfolio performance.

In this article, we highlight the potential diversification benefits that an allocation to Bitcoin can provide to a traditional 60/40 stock/bond portfolio. In particular, Bitcoin's lack of correlation with other assets potentially makes it a more useful alternative asset for investors looking to reduce business cycle risk, especially compared to other popular alternative investments such as gold or a basket of commodities .

So, how much should you invest in Bitcoin?

While there is no one-size-fits-all approach, we believe that Bitcoin is steadily developing as a store of value and backtesting Bitcoin price performance in a portfolio can still provide valuable insights for long-term investors. We also believe that it is essential to inform investors about the optimal allocation of Bitcoin in their portfolios, based on their risk appetite.

To help investors understand how Bitcoin can help or impact a portfolio, we created a database of daily returns starting in 2015; the first time investors were able to invest in Bitcoin via an exchange-traded product (ETP) currency. We start with a traditional balanced portfolio (60% stocks and 40% bonds) and then add notional Bitcoin (which subtracts the same weighting from stocks and bonds).

Since Bitcoin is an early growth stage asset, most investors will allow some degree of skewing in their portfolio weights. We decided to rebalance quarterly - despite its potential impediment to improving yield - because we believe rebalancing helps smooth out volatility.

Bitcoin Portfolio Allocation: Volatility

Adding Bitcoin to a portfolio does increase the volatility of the portfolio. So, how much should you add to your portfolio? There are several ways to solve this problem. One such approach is volatility positioning, and the chart below highlights the impact of different weightings of Bitcoin in a portfolio relative to risk.

Bitcoin's Impact on Volatility in a "40/60" Stock/Bond Portfolio Balance

For reference, the graph shows that a 4% weighting in the portfolio will increase the volatility of the overall portfolio by a little over 1%.

Bitcoin Portfolio Allocation: The Sharpe Impact

Another approach is to blend risk and return by analyzing the impact of different bitcoin portfolio weights on the portfolio Sharpe ratio (a measure of return relative to the level of risk taken).

The figure above is the backtest results of the past 5 years. A shift to the right indicates higher risk-adjusted returns, while an upward shift reflects a higher allocation to Bitcoin during the testing period. This analysis shows that the most significant Sharpe ratio improvement can be obtained by allocating up to 10% of the portfolio in Bitcoin. This highlights how even a small increase in Bitcoin can have a large impact on the Sharpe ratio. We also include other comparable assets and indices from the same period, even with extreme weights, which have less impact relative to Bitcoin on the Sharpe ratio.

Investors may view this 5-year time period as too favorable, and given that Bitcoin has risen during this time period, any analysis will look good. To account for this, we also included analysis from the Bitcoin price peak on December 18, 2017 to the present, a period during which Bitcoin had a negative impact on overall returns. The results show that the Sharpe ratio is still positive, although not to the same degree. This may seem like nonsense, but it is due to our quarterly rebalancing strategy, whereby Bitcoin is reset back to its original weight every quarter. We found that regular rebalancing may reduce the potential for higher returns, but is desirable in controlling Bitcoin's volatility.

Gold has a similar impact on portfolio diversification, although the portfolio weight needs to be over 20% to have any real impact on diversification. In contrast to Bitcoin, the minimum weight has a much greater impact.

All in all, the investment characteristics of Bitcoin have historically made it attractive as a driver of returns and diversification of investment portfolios. Compared to other common alternatives and diversification tools, Bitcoin has a huge positive impact on returns, Sharpe ratio and diversification, even at very low allocation sizes.

As for the answer"How much should I invest in Bitcoin?"This question largely depends on your appetite for risk. However, allowing for a modest 1.2% increase in overall portfolio volatility based on our analysis would suggest a Bitcoin portfolio weight of slightly less than 4% in a traditional 60/40 stock/bond portfolio, although investors should always Pay attention to regular adjustments to return to the original investment proportion.