How to use modern portfolio theory in bitcoin

Modern Portfolio Theory (“MPT”) has long been one of the most widely used financial theories for portfolio optimization in the world of large investments. More than a theory, it is a common practice among investment portfolio managers. Basically, it is a model that combines different types of assets taking into account their profitability and risk, calculates past volatility and the correlation of markets. Does this apply to investing in Bitcoin?

This theory comes from the academy and is a theory derived from the efficient market theory. Indeed, its creator and main exponent, Harry Markwitz, Nobel Prize winner in economics in 1990, built his theory on the efficient market theory. That is, the two theories are closely related. Modern portfolio theory has enjoyed great popularity in the investment world since its inception in 1952. And you could say that it is the norm. Its popularity is partly due to its great simplicity.

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How to use modern portfolio theory in bitcoin
How to use modern portfolio theory in bitcoin

Of course, despite its success, this theory has many critics. In fact, it is viewed as absurd by many well-known investors. For example from Warren Buffett and Charlie Munger. Well, in general, it is criticized by all critics of an efficient market theory. This primarily includes value investors and opponents. In other words, Anyone who believes that markets are essentially irrational.

However, If we go straight to the results, modern portfolio theory is pretty mediocre. In this sense, investing in value as an investment strategy has produced better results. In this case, Buffett and Ben Graham’s other students have reasons to dismantle modern portfolio theory.

What is the underlying problem? One of the problems is the use of volatility as the main measure of risk. That said, the risk is reduced to a simple number. In practice, of course, many of us find it necessary to say that volatility is a risk to simplicity. However, the matter is not that simple. It is obvious that a company’s risk goes much further. Logically, we need to consider other factors as well, such as: B. Your debt, the valuation of your assets, your business model, your sales and your market share. In short, when a company is consistently making profits, the risk is reduced. The volatility of your stocks doesn’t really matter.

Here is something to think about on the subject of diversification. If you have good business, diversification wouldn’t make sense. In other words, getting several mediocre deals instead of a good one doesn’t reduce the risk. In this case, diversification would be absurd.

Modern portfolio theory places an emphasis on past data. That is, it is based on the premise that past profitability and volatility data can be used to calculate future profitability and volatility. And thus ignore other variables. This emphasis on quantitative factors for the composition of a portfolio underestimates the irrationality of the markets and the surprise factor.

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However, it can be concluded that volatility is not the only element determining the risk of a company or any other productive asset. With a purely speculative asset, however, the volatility factor becomes more important. The mere fact of having no use or intrinsic value, but only an exchange value, places greater emphasis on fluctuations in the exchange rate.

For a moment, let’s say we apply for a loan in dollars. When our income is in dollars, the most certain thing is that we can sleep peacefully as the dollar is an extremely stable currency. In this sense, the risk is relatively low. The problem changes when the loan is in dollars but our income is in, for example, Venezuelan bolivars or Argentine pesos. In this case, it would not be unwise to say that the volatility of the local currency increases the risk of the operation.

Now let’s say we apply for a bank loan to invest in Bitcoin. If we listen to the trending crypto influencers on Twitter, this operation wouldn’t be very risky. After all, Bitcoin is officially a “safe haven” and fiat money will soon collapse. Apparently, Bitcoin’s scarcity guarantees its value in all climates. However, this supposed security of Bitcoin is just rhetoric. Because no one in their right mind would think that the idea of ‚Äč‚Äčthis reckless loan is risk free. The truth is that not even the most fanatical Bitcoiners believe this “Safe Haven” story. Why? Because of the great volatility of Bitcoin. Borrowing to invest in Bitcoin is insane. On the other hand, if Bitcoin were a safe haven, such a loan would make perfect sense.

In short, in all of this debate about the validity or non-validity of modern portfolio theory, there is an important lesson for every bitcoiner to learn. Which? Well, We need to study the concept of risk thoroughly. And it wouldn’t be a bad idea to acknowledge that Bitcoin is a very volatile (risky / unsafe) asset. That way, we could start designing our strategy to protect ourselves from this volatility.

Let’s start with the concept of asymmetric risk. We can evaluate this with two questions: What if we fail and lose everything? What if we beat and win? First, investing without your own capital is not a very good idea. I mean credit, other people’s money, or money necessary for expenses. Because we have to be ready to lose everything. Suppose we invested 1% of our capital and lost it. It wouldn’t be the end of the world because we would still have 99% of our portfolio. Now let’s say we did well and bitcoin increased 10 times. This means that our portfolio has increased by 10%. In this case the risk would be asymmetrical.

Another point. Time. Time is a hedge against volatility. And that means we shouldn’t have an obligation tied to the capital we put into the investment. It has to be exclusively speculative capital. The long-term investor in a good asset can tolerate its high volatility. Because volatility doesn’t always mean investments are bad. A good asset is sometimes a lack of liquidity.

Another protection mechanism is the way it is bought. The dollar cost average strategy is strongly recommended for volatile assets.. I have written a lot about this method in the past and invited those interested to do more research. If we go into detail now, this article will be extremely long.

Read on: Investing in Volatile Markets: How to Use Bitcoin to Lower Average Costs in US Dollars?

Now back to diversification. It’s not about investing in multiple assets at the same time. Many invest in different altcoins and consider this diversification. We have to remember that the idea is to protect ourselves from the volatility of Bitcoin. If we think the solution is to invest in assets that are more volatile than Bitcoin, we are missing the point of mission. Because volatility is combated with stability. This means that we need to supplement our Bitcoin holdings with various forms of fiat. So we don’t have to see Fiat as an enemy in our portfolio, but as an ally.

In conclusion, modern portfolio theory can be absurd if we take it to an extreme. His critics are absolutely right in their arguments. However, this does not mean that some elements of the theory are not useful in all contexts. It’s best to listen to both sides of the debate and develop a personal strategy that works for us. As a general warning, I would say that we must be very careful with Crypto Twitter’s financial advice regarding the risk, volatility and safety of investing in Bitcoin. Eye! Take care of your bag. Do your own homework. Don’t listen to the fans.

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