In short, cryptocurrencies such as Bitcoin or Ethereum are digital or virtual currencies that use cryptography for security and operate on decentralized networks. These networks are normally based on a digital ledger technology, the so-called blockchain. Unlike traditional currencies (fiat money) which are issued by governments, cryptocurrencies have so far been launched by corporations or people. They are typically decentralized and rely on peer-to-peer networks for transactions and their validation. This mechanism helps make them resistant to fraud, central control, or interference. Despite these protection mechanisms, investors have witnessed that not all cryptocurrencies were resistant against fraud in the past.
Some cryptocurrencies including Ethereum have extended their usage beyond being just a medium of exchange or a storage of value. These cryptocurrencies offer a platform for decentralized applications (dApps) and smart contracts. These innovations allow individual contracts with automated and/or embedded features and enable developers to create software that runs without centralized control, which has implications for finance, gaming, and even digital identity.
The pros and cons of the inclusion of cryptocurrencies in an investment portfolio are widely discussed in the asset management industry. While some investment professionals think that cryptocurrencies are just a gimmick which will disappear sooner or later, others believe in the future of cryptocurrencies as alternative asset and/or as a hedge against inflation or other risk within the traditional financial system. The latter assumption is based on the decentralized nature and limited supply of cryptocurrencies, which means that unlike fiat currencies—where central banks can print additional money—the number of tokens of a cryptocurrency is limited and can’t be expanded easily.
The performance of Bitcoin and Ethereum has shown that cryptocurrencies can enhance the performance of a portfolio. Nevertheless, the high performance of cryptocurrencies such as Bitcoin and Ethereum came in combination with high volatility, which means investors need to be careful when adding cryptocurrencies to their portfolio. That said, it should be obvious that investors need a high risk-bearing capacity when investing in cryptocurrencies, even as the uncorrelated nature of cryptocurrencies with traditional markets can offer diversification benefits, which may potentially enhance the risk-return profile of a portfolio.
However, one needs to bear in mind that the prices of cryptocurrencies are influenced by factors such as market sentiment, regulatory news, and technological developments. This means the development of cryptocurrencies is less predictable than for fiat currencies or other assets. In addition, one needs to bear in mind that there are hundreds of cryptocurrencies available and only a few may survive. Unfortunately, nobody knows which ones are the winners of the future. To evaluate and handle this risk, investors should have a sound understanding of the cryptocurrency markets and the risks associated.
When it comes to risk evaluation, incorporating cryptocurrencies requires carefully conducted research on the respective cryptocurrencies and market conditions. In addition, one needs to take the strategic and tactical asset allocation, as well as the overall investment strategy, of the portfolio into consideration before adding them to portfolio of an investor. Depending on the risk tolerance of the respective investor, the allocation of cryptocurrencies in a well-diversified portfolio might be between 1% and 5% of the overall portfolio.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
