Retail adoption of Bitcoin has never been higher. Investors all over the world are directing their capital towards Bitcoin, however, for most of these new investors, Bitcoin is not the only asset in their portfolio. Many hold some combination of stocks, bonds, commodities, and cash that round out their investments. For investors like this, it's important to have a clear view of the relationship between Bitcoin and the other assets in their portfolios.
What is a hedge?
Bitcoin is often spoken about as a "hedge", but what exactly does that mean? According to Investopedia:
A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset.
For those not well versed with risk analysis, it may seem counter-intuitive that making a hedge investment (i.e. putting more cash at risk) would reduce the overall risk in a portfolio. However, the reason this is the case is due to the relationship between the original asset, and the asset used to hedge the original asset. When the hedge is negatively correlated with the original asset, there is a general expectation that the price of the hedge asset will rise when the price of the original asset falls, thus minimizing the overall loss to the portfolio.
What (if anything) does Bitcoin hedge against?
To determine the viability of Bitcoin as a hedge against traditional portfolio holdings, an examination of its correlation with major assets and asset classes can be conducted. The following charts show a one year rolling average correlation between the daily returns of Bitcoin and the daily returns of the traditional asset.
Is Bitcoin a viable hedge?
Looking at the charts above, there is little consistency to be found in terms of correlation between Bitcoin and the chosen traditional assets/asset classes. Moreover, we notice that while there are periods of negative correlation between Bitcoin and traditional assets, generally Bitcoin is either slightly positively correlated or uncorrelated. This means that in the simplest sense, Bitcoin is not a suitable asset for hedging existing assets in a traditionally focused portfolio.
That being said, all portfolios could greatly benefit from owning Bitcoin as a standalone investment. While uncorrelated assets are not great at hedging existing specific asset risk, they can help greatly reduce the overall dollar weighted risk in a portfolio. From this perspective, a small allocation of Bitcoin in every portfolio can help diversify returns, and set the portfolio up for more risk-efficient future growth.
While correlations are useful tools for garnering a general sense of the relationship between assets, they are far from complete. Correlations are based on past data and must always be taken with a grain of salt, as they can change rapidly and do not provide any amount of certainty about the future relationship between assets. This context is especially important when making forward looking decisions based on correlations. While Bitcoin is currently not a hedge for any of the examined traditional assets, that doesn't mean it won't be in the future.