Money managers have two top priorities: identifying and investing in non-correlated assets, and rebalancing around volatility. With the ups and downs of the past year, it’s a perfect time to discuss the value of volatility and how a sound rebalancing process can harvest it to add value.
Let’s start with a hypothetical: If an asset has a return of zero percent over the long term, can it add significant value to an investor? The answer lies in its volatility.
Here is a graph of the hypothetical asset. It returns zero percent over the long term, but it experiences large swings, going down 50%, returning to even, going up 50%, and then back down to even. Over and over again.
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Say someone makes an initial investment of $100 in this asset, and their money manager/adviser places a rebalancing strategy around the holding. If the value of the holding drops 20%, buy it back up to $100, or buying low-ish. If the value rises 25%, sell it back to $100, or selling high-ish.
Over time, the portfolio would then look like this:
The buy-and-hold portfolio generates a total return of zero percent. The rebalanced portfolio generates a total return of 119%, or an average annual return of 14%.
Note: If, perhaps, you have a crystal ball and know that an asset will only go down, don’t buy it! If your crystal ball indicates that an asset will only go up, never sell it. But if you don’t have a crystal ball — and since historically assets experience both ups and downs — a rebalancing strategy is actually what matters.
Volatility, if used correctly, is an investor’s friend.
Bitcoin has been among the most volatile assets of all time. But the more volatile an asset, the less of it you want in a portfolio. Currently, there is only one way to purchase Bitcoin in a brokerage account, which is through the Grayscale Bitcoin Trust, ticker GBTC.
Let’s run a fictitious study… assuming you purchased GBTC at its all-time high, on Dec. 18 of 2017. This would have been the worst possible day to make the purchase. The price was $38.05 per share (the current price is around $20). Here is what would have happened to your $100 investment.
The buy-and-hold investor would have lost around half of their money. Now, let’s put a rebalancing strategy around this. If it goes down 33%, buy some. If it goes up 50%, sell some. Remember there is nothing magic about the rebalance parameters presented here … almost any reasonable parameters provide value. The parameters used here are not intended to maximize results, but are roughly based on volatility.
The rebalancing strategy took an asset that lost half of its value and turned it into a positive 70% return.
An investor does not need a positive view on Bitcoin, only an understanding of its volatility. No one knows what the future holds. In the medium-term, the volatility of Bitcoin is likely to add value to portfolios merely through a sound rebalancing process.
How much of a volatile asset should you own?
If you believe that an asset will behave in a different manner than the rest of your portfolio, the question isn’t whether you should own it. The question is how much of it you should own? Bitcoin will, of course, behave differently than the average portfolio, but by harvesting volatility, you can add value over time.
One should not go crazy here. Remember: The more volatile an asset, the less of it you should own. A 2% position won’t make or break you. Again, there’s no crystal ball. But rebalancing is key to navigating how valuable it can be.
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