The S&P 500 has reached a new all-time high, coming full circle in just two years, despite growing uncertainty around the economy, the path of Fed rate cuts, and rising interest rates. Outside of traditional asset classes, Bitcoin also recently reached its highest level in two years, following last year's run-up.
This has been fueled by the broader rally in risk assets and the much-anticipated approval of Bitcoin ETFs by the U.S. Securities and Exchange Commission (SEC), the primary regulator of financial markets. Why did the SEC approve these ETFs, what were their concerns, and what does this mean for investors?
Bitcoin has become a household name as the most well-known cryptocurrency (sometimes referred to as a digital currency or digital asset). For purists, cryptocurrencies promise a fully decentralized financial system beyond the control of governments and large institutions.
For others, blockchain technology enables the frictionless exchange of value across the globe, regardless of who controls the networks. Whether these visions of a future financial system will come to fruition is still unclear. Given these ambitions, it can be difficult for everyday investors to understand and judge the merits of digital assets for their portfolios.
Bitcoin and the stock market have been positively correlated
Regardless of how transformational Bitcoin may or may not be, the SEC's approval of Bitcoin ETFs has been long anticipated. The impact of these ETFs is analogous to investing in gold since, without the availability of these financial products, investors would need to buy physical gold and store it safely in vaults.
Similarly, holding cryptocurrencies requires using digital wallets and safely storing cryptographic keys. The latest ruling opens the door for ETFs that hold the "spot" asset - meaning the asset itself, rather than a financial derivative on the asset such as a futures contract. For Bitcoin proponents, the hope is that this increases the accessibility and adoption for both everyday investors and institutions.
The wide range of wrongdoing in the crypto industry has tarnished the adoption of cryptocurrencies, ranging from poor financial management to outright fraud. This has occurred across large venture capital-backed companies such as FTX to individuals selling digital coins in classic pump-and-dump schemes.
Over the years, these technologies have also led to hype around initial coin offerings (ICOs), non-fungible tokens (NFTs), Web3, and more. Given all of this, it's unsurprising that everyday investors might be wary of these investments. These issues and a lack of clarity on how these assets should be regulated delayed the SEC's decision to approve Bitcoin ETFs.
Other major cryptocurrencies have not performed as well as Bitcoin
So, nothing is settled when it comes to digital assets and the crypto-universe. Fortunately, from a long-term investor's standpoint, Bitcoin can be considered another asset with specific characteristics. The question of whether and how much to invest in this asset should be the same as deciding on any stock, bond, currency, commodity, real estate property, etc, within the context of portfolio management.
After all, the fact that corporate scandals have occurred throughout history and that bear markets occasionally occur do not, on their own, mean that stocks are not an important asset class - just that analysis and risk management are needed. Understanding the potential risks and expected returns and weighing them against other assets in a properly diversified portfolio are what matter.
Given this perspective, there are two facts that investors must keep in mind. First, cryptocurrencies have not yet proven to be reliable portfolio diversifiers. In fact, they have often been strongly correlated with the stock market and other risk assets, amplifying risk, as shown in the first chart above.
Remember, diversification does not just mean holding many assets in a portfolio; it requires non-correlation. Many investors thought themselves "diversified" in 2000 by holding many tech dot.com darlings, only to find that their portfolios were only a highly concentrated, correlated group of stocks.
In 2023, Bitcoin gained about 156%, but this was a reversal of the previous year's 62% loss. In other words, this pattern is similar to the stock market's round trip from the beginning of 2022 to the end of 2023. Unfortunately, Bitcoin would not have helped to offset portfolio volatility during this period.
Higher portfolio returns often come with risks that must be managed
Second, Bitcoin and other digital currencies are extremely volatile. Depending on the period, they can be 5 to 10 times as volatile as the overall stock market, which is considered risky.
At the time of writing, Bitcoin is experiencing a pullback from recent highs despite prior enthusiasm around the SEC ruling. A classic "buy the rumor, sell the news" market dynamic, highlighting still their questionable store of value and alternatives to bonds, currencies, and most commodities. Additionally, while other cryptocurrencies, such as Ethereum, are volatile, they have also not performed as well as Bitcoin over the past year.
None of this is to say that digital assets may not be important in the future. After all, cross-asset-class correlations are not static, and the future may look different than the past. This is also not to dismiss that some investors have benefited immensely from cryptocurrency ascendency.
Instead, recent developments around Bitcoin and cryptocurrencies serve as a reminder for investors to focus on any investment within the context of their entire portfolio. This is especially true now that investing in these assets is far more accessible with the approval of Bitcoin ETFs, which grants access to the asset through traditional financial market investment channels - i.e., they can now be invested directly within their traditional investment portfolios.
The bottom line: When investing in digital assets, understanding how they affect a diversified portfolio tailored to financial goals is far more important than debating how they might transform the financial system. Investors should remain disciplined and focused on the long run as digital assets and the crypto industry mature.
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