Cryptocurrency has captured the imagination of investors worldwide, driven by its potential for outsized returns and similarly outsized volatility. With a market capitalization that has soared to $4 trillion, it has gained traction within the corridors of Washington and become widely available to investors with the advent of crypto exchange-traded products (ETPs).
So, how should you think about cryptocurrency?
In a new report, Morgan Stanley’s Global Investment Committee looks at the potential role of crypto in a diversified portfolio and how to consider sizing a position responsibly. A key takeaway for many investors: Proceed with caution. Unlike other asset classes, cryptocurrency has a limited track record, marked by strong returns but also exceptionally high volatility.
Here’s more on why a measured approach may be warranted.
Understanding Crypto’s Role in a Portfolio
Views on cryptocurrency’s potential role in a portfolio vary.
Some investors see bitcoin—currently the largest cryptocurrency by market cap—as a type of “digital gold,” due to its scarcity and potential as a hedge against inflation. Others compare Ethereum, the second-largest, to a fast-moving tech stock because of its potential to disrupt industries through innovations such as decentralized apps. Still others see crypto as a diversifying investment, helping reduce portfolio risk by not moving in tandem with other investments—although there is evidence that crypto’s correlations with risky assets like stocks have risen over time.
The Global Investment Committee categorizes crypto as a “real asset,” alongside commodities. Like gold, for instance, its value is often driven by broad economic factors, such as inflation expectations or monetary policy shifts, as well as technical market dynamics like changes in supply and demand, but not the financial health of an underlying business, as with stocks and bonds. Also like some commodities, crypto does not directly generate income through dividends or interest.
Risks and Rewards
The Global Investment Committee expects cryptocurrency to deliver strong compound returns of around 6% over a seven-year horizon, but with significant risk to investors: Crypto’s annualized volatility is about 55%—which is approximately four times that of the S&P 500 Index.
This volatility means that crypto can experience dramatic price swings, including potential drawdowns of up to 70% over a 12-month period. A deeper dive shows that since 2010, the Bloomberg Bitcoin Galaxy Index has experienced a maximum drawdown of at least:
- 10% in each rolling six-month period,
- 30% in half of such periods and,
- 50% in 30% of such periods.
In addition, because major cryptocurrencies increasingly tend to move in tandem with other risky assets, they do not always provide the diversification investors might seek.
Crypto’s limited history also means that investors may be “driving blind” when trying to forecast future performance for any market conditions that differ from the past five to seven years. For example, while bitcoin has tended to generate higher returns amid more favorable financial conditions, it’s unclear how it might fare in an environment of persistently higher interest rates, tighter financial conditions or lower liquidity.
Portfolio Implications
Even small allocations to crypto can have an outsized impact on overall portfolio risk. For example, adding just a 6% position in crypto to a growth-oriented portfolio nearly doubled overall volatility in our simulations. In some scenarios, the position swelled far beyond its target allocation due to rapid price increases, leaving the portfolio more susceptible to losses in the event of steep declines in the crypto allocation.
This underscores the need for disciplined portfolio rebalancing to periodically return a crypto allocation back to its target size.
With that in mind, we recommend limiting crypto allocations to:
- Up to 4% in aggressive, “opportunistic growth” portfolios, which generally seek higher returns from short-term market opportunities.
- 3% in “market growth” portfolios, which often appeal to investors with a moderate-to-aggressive risk tolerance.
- 2% for “balanced growth” portfolios, which seek a mix of capital appreciation and income.
- Zero exposure for more conservative investors focused on income or wealth preservation.
Also, consider funding any crypto position from risky assets, not cash, and using ETPs, where possible. The key is balance, grounded in thoughtful position sizing, regular rebalancing and a clear understanding of the risks.
For the most current insights and guidance, consult with your Morgan Stanley Financial Advisor and request a copy of the Global Investment Committee special report, Asset Allocation Considerations for Cryptocurrency.
