How much crypto should be in your investment portfolio?

Cryptocurrencies may be all the rage, but good luck figuring out how they fit in a portfolio.

Money managers generally try to maximise gains and limit losses by estimating the expected risk and return of various investments and then assembling a mix that offers the best trade-off between risk and return. The most widely used measure of risk is volatility, or standard deviation in finance speak. For traditional investments such as stocks and bonds, historical averages are a good gauge of future price swings because volatility tends to hug a tight range over multiyear periods.

Estimating future returns is trickier. Investors can rely on historical averages there, too, and many do. But while multi-year returns often approximate their historical average, they occasionally vary from it by wide margins, usually during market extremes.

One way to handle those extremes is to deconstruct the drivers of returns. For example, most of the payoff from bonds comes from their yield, and bond yields in the US are at historic lows. So while long-term government bonds have returned about 6 per cent a year over the past 100 years, the current yield on 30-year Treasuries of just 2.4 per cent signals that returns are likely to be a lot lower going forward.

Stocks are a bit more involved, but the idea is the same. US stocks have returned about 9 per cent a year over the past 150 years, broken down into 2 per cent inflation, 2 per cent real (net of inflation) earnings growth, 4.5 per cent dividend yield and 0.5 per cent valuation expansion.

Looking ahead, the bond market expects inflation of 2.5 per cent a year over the next 10 years; real earnings growth might be closer to 2.5 per cent if US companies can maintain their recent pace; the dividend yield for the S&P 500 Index is about 1.5 per cent; and with the stock market at or near record high valuation, further expansion is probably a stretch. That adds up to an expected return of 6.5 per cent a year from US stocks.

Sure, estimating future returns involves judgment, and investors often disagree on the numbers. But none of that analysis is even possible with cryptocurrencies. Bitcoin, the oldest of them, has been around for only 13 years, so the record isn’t long enough to rely on. And it almost certainly isn’t indicative of the future.

Bitcoin has returned about 220 per cent a year during its short life, which is obviously unsustainable. Its annualised standard deviation has been 200 per cent over the same time, making its volatility about 15 times that of the S&P 500 and more than 60 times that of bonds. As cryptocurrencies become more established, their returns and volatility are likely to drop significantly.

How much is impossible to say because no one knows what drives cryptocurrency prices, and the answer may not be coming soon. Investors have long struggled to peg expected returns for fiat currencies and commodities such as oil, grains and metals, which, like cryptocurrencies, don’t generate interest, earnings or dividends that can be separated from their price. BlackRock, the world’s biggest money manager, publishes expected returns for 24 different investments, including stocks, bonds, hedge funds and private equity. It’s probably not a coincidence that currencies and commodities are not among them.

With little history and even less insight about what moves cryptocurrencies, investors are left guessing what to expect — and how to blend cryptos with other investments in their portfolios. Search Google for an answer about how much to allocate to cryptocurrencies and you’ll get a wide variety of results.

One “expert” recommends that investors allocate 2 per cent to 5 per cent of their net worth, while another in the same article cautions no more than 1 per cent. In another article, a financial planner says investors can allocate as much as 10 per cent of their risky investments to cryptocurrencies, and possibly more for younger investors.

There’s little harm in allocating a small percentage to cryptocurrencies if investors can stick with it. But hanging on may not be easy. While some data suggests that Bitcoin investors have skillfully navigated its gut-wrenching volatility, there’s more evidence showing that the more volatile an investment, the more investors tend to buy high and sell low. And nothing is more volatile than cryptocurrencies, which is all the harder to manage when investors can’t see what lies ahead.

Investors may have more visibility around cryptocurrencies in the years ahead, and perhaps it will shed light on longstanding questions about fiat currencies and commodities. But for now, how much to invest in cryptocurrencies remains a question of faith more than science.