Episode 82 Crypto Correlation

Most of you already know that digital assets like Bitcoin, Etherium, and Nonfungible Tokens (NFT) experience huge price swings or volatility. Today's focus is diversification of your portfolio and digital assets. When you choose from among different investment options, you diversify. You likely already started do this by investing in mutual funds or exchange traded funds through a workplace retirement plan like the Thrift Savings Plan or a 401k. If you  have a portfolio of stock and maybe bond funds, what happens  if you add in VERY volatile digital assets in the hopes of earning a bigger return (profit)? Will  those stormy seas will turn into a tsunami of risky volatility?

Not necessarily. That’s due to correlation, the tendency of different investments to swing up and down together.  Two investments with a correlation of 1, are perfectly correlated, they go up and down together. If the value of investment A goes up, investment B also always goes up. If the value of investment B goes down, investment A goes down too.  This could be the stormy seas turned tsunami scenario. If you need that invested money for something else, you’re going to take a loss. 

If two investments have a correlation of -1, they are perfectly negatively correlated, when one investment goes up the other always goes down. And vice versa. But just like unicorns, perfect negative correlation pretty much never occurs. it they have a correlation of 0, there is no correlation. If A goes up,  B has an equal chance of going up, going down, or not changing at all. 

The volatility, or price swings of digital assets is VERY high.  Fortunately digital assets are NOT perfectly correlated to stocks, or any other assets. In plain English, most of the time digital assets values do their own thing and fluctuate in ways that do not match stocks or bonds.

Although Bitcoin is almost a decade old and many investors have jumped on the digital asset band wagon, the digital asset market is still more like the wild west than traditional investments. In addition to wild price swings, regulations and insurance programs that help protect investors of traditional assets haven’t developed yet for digital assets. Fees associate with buying, trading, and holding digital assets can be high and are often buried in fine print. If you do invest in digital assets, you literally need to be prepared for the possibility you could lose your entire investment.  

Because digital asset prices are not strongly correlated to other assets like stocks and bonds they could be beneficial to broader portfolio. But be careful. Adding too much digital assets to a portfolio can have the affect of the tail wagging the dog. How much? Depending on your tolerance for risk probably just 1% to 5% of your overall portfolio. Yes, that small an amount could make a meaningful difference in your portfolio’s return, while managing the risk of price volatility and the very real uncertainty of the new investment type over all. 

Always keep very detailed trading records. You are responsible for reporting and paying taxes on your profits and losses. If you’re a HODLer that buys and never sells, you won’t owe taxes until you eventually do trade or sell your assets. If you are an active trader, be very careful. You can wrack up a huge tax bill before you realize it if your unfamiliar with the tax laws, especially around short term capital gains, short term capital losses, and the wash rule. One way to minimize these problems is not to sell an asset within one year of buying it. If you plan to trade more often, seriously get some tax help.

For more information on investing, check out Ep 63 Crypto Currency, Ep 57 Risk Profile, Ep 52 Stocks, Ep 45 Rebalance, and Ep 44 Capital Gains.

Transcript

Announcer: 0:14

Welcome to the Money Pilot Financial Advisor podcast, where you team up with Money Pilot founder, former Army helicopter pilot and your host Katie Cannon to put your money where your heart is. Together we'll tackle issues big and small so you can take charge and land your financial lif.

Kathleen Cannon: 0:53

Hello, and welcome back to the podcast. In Episode 63 I talked a little bit about cryptocurrency, which you may remember I compared to your high school health teacher cautioning you about safe sex. Most of you already know that digital assets like Bitcoin, or Aetherium, and non fungible tokens or NFT's experience huge price swings or volatility. Of course, the possibility of those big up swings are what make them so alluring. Hmm, but those negative nosedives that result in a big loss are also a reality. If you go all in, and literally put all your money in the digital asset basket, you could be in for a very wild ride. But what if you're not an all or nothing investor, but sane and wondering if there's a place for digital assets in your investments. So the main focus today is diversification of your portfolio and digital assets. And diversification is literally the opposite of putting all your eggs in one basket. It's a general principle in investing that the best way to both maximize your return or overall profit, and minimize your chances of having to sell just as the prices bottom out. The hope is if prices of some of your investments are down, some of your other investments are up. When you design your investment portfolio, and choose from among different investment options, you diversify. You likely already started doing this by investing in mutual funds or exchange traded funds through a workplace retirement plan, like the Thrift Savings Plan or a 401k. Or you may invest directly through a fun company like Vanguard or iShares. With these funds, you buy one share of the fund, which owns a wide array of assets. In this way, you own a teeny tiny slice of many other investments. So for example, if you buy a share and an S&P 500 fund like the TSP C as in Charlie fund, you own a tiny part of the stock of 500 largest corporations traded in the United States. Bam, that's some good diversification. The hope is if one sector of the economy is doing bad, like maybe vehicle manufacturing, and the stocks of those companies are down, maybe another sector, like health care has shown a lot of growth recently, and those stocks are up. This diversification helps smooth out the value of your overall investment portfolio over time. If you had put your whole bet on just the vehicle manufacturing, you're in for a rocky ride. In this example, I've just been talking about stocks, you can diversify even more if you put some of your investments in a different type of asset, like bonds. In general, bonds are much less volatile than stocks. Stocks generally give you a better return that is more profit on your investment. But it can be a stormy sea. bond bonds generally earn less but are more predictable and provide smoother sailing. So it makes sense that if you want to reduce the volatility of your overall investment portfolio, you add in some of the more steady eddy bonds into the mix. Let's say you already have a portfolio of stock and maybe bond funds. What happens to your portfolio if you add in very volatile digital assets, and the hope earning a bigger return or profit, the stormy seas will turn into a tsunami of risk volatility right? Not necessarily. And that's because of correlation. The tendency of different investments to swing up and down together, magnifying the peaks and troughs. Guy love this stuff, I'm gonna get a little nerdy on Yeah, but hang in with me, this is good info. We say two investments have a correlation of one, or are perfectly correlated, if they go up and down together. If the value of investment A goes up, investment B also always goes up. If the value of investment b goes down, investment A goes down to like a mirror. It doesn't imply any cause and effect, just that for whatever reason, they move up and down perfectly in sync. Great when they're both up, your portfolio's flying. But if the value of a is down, so as investment be in your whole portfolio is taking a big hit. This could be the stormy seas turned to Nami scenario. If you need that invested money for something else, whether you sell investment A or B out of your portfolio, you're going to take a loss if the values are down. If two investments have a correlation of negative one, they are perfectly negatively correlated. When one investment goes up, the other always goes down, and vice versa. This is the unicorn of diversification, the ups and downs start to cancel each other out for a smoother ride, you would still get the overall returns or profit from both with much less overall volatility risk. Yeah. But just like unicorns, perfect negative correlation, pretty much never occurs. Now, if you have two investments with a correlation of zero, not one, not negative one, but zero, there is no correlation. If investment A goes up, investment, b has an equal chance of going up going down or not changing at all, they completely do their own thing. So let's take a look at an example. Let's say you have a portfolio with one mutual fund or ETF that invests in the entire US stock market. And one fund that invests in a very wide variety of US bonds. Historically, the correlation of your bond fund to your stock fund has been around negative point 02. So that's pretty close to zero correlation. So if the stock fund went up, it would be slightly more likely that your bond fund would go down as opposed to going up or staying the same. So adding bonds to your stock portfolio lowers the overall risk or volatility. But bonds typically earn a lower return or profit. So mixing in bonds lowers the risk or that volatility storminess. But on average, it also only earns a lower return overall than an all stock portfolio. So what about adding digital assets to your portfolio? That volatility or price swings of digital assets is very high, much stormier than even stocks. But overall, the average return or profit from digital assets so far, has also been higher than stocks. So if you chase that higher return by adding a digital asset like Bitcoin to your portfolio, how does it affect the risk and reward of your portfolio? If they were perfectly correlated, it would be the tsunami of portfolio price swings and an innovation crypto and it could be disaster movie scale correlation of these with stock prices. Fortunately, digital assets are not perfectly correlated to stocks or any other assets. digital assets are still a new investment choice and its correlation to stocks has varied from somewhat negative to somewhat positive. In the early years, Bitcoin for example, very Between negative point three and positive point three. So we'd say it has a relatively weak correlation to stocks. Remember, plus one or minus one would be perfectly correlated, and zero is no correlation. So Bitcoin historically has also had a very weak positive correlation to bonds. In plain English, most of the time, digital asset values do their own thing and fluctuate in ways that do not match stocks and bonds. So where am I going with all this? digital assets like Bitcoin and Aetherium are very volatile. That is they have very large swings in price. And although bitcoin is almost a decade old, and many investors have jumped on the digital asset bandwagon, the digital asset market is still more like the wild west than traditional investments. I focused today's talk on One positive aspect of adding digital assets to an investment portfolio. But in addition to wild price swings, digital assets are also under regulated. Consumer protection regulations and insurance programs that help protect investors of traditional assets haven't developed yet for digital assets. And fees associated with buying, trading and holding digital assets can be high, and are often buried in the fine print. If you do invest in digital assets, you literally need to be prepared for the possibility you can lose your entire investment. Don't bet the farm don't bet the rent and don't bet your children's lunch money. But if you already made your mind to jump in, because digital asset prices are not strongly correlated to other assets, like stocks and bonds, they could be beneficial to a broader portfolio. But be careful. Adding too much digital assets to a portfolio can have the effect of the tail wagging the dog because they are so volatile, and have the potential for higher returns. Adding just a small amount of digital assets can provide an opportunity to boost your return. While the weak correlation to other assets helps dampen the total portfolio price swings. How much are we talking about? Depending on your tolerance for risk taking with your investments, probably in the one to 5% range? Yeah, that's just one to 5% of your overall portfolio. Yes, that small amount could make a meaningful difference in your portfolio's return while managing the risk of price volatility, and the very real uncertainty of the new investment type overall. There's so much more that I haven't had time to cover today. And one thing I always mentioned is keep very detailed records of any trading activity like buying and selling your digital assets. They are treated as property by the IRS for taxes, and you are responsible for reporting and paying taxes on your profits and losses. If you're a hodler that buys and never sells. You won't owe taxes until you eventually do trade or sell your digital assets. If you're an active trader, be very careful. You can rack up a huge tax bill before you realize it. If you're unfamiliar with the tax laws, especially around short term capital gains, short term capital losses and the wash sale rule. One way to minimize these problems is not to sell an asset within one year buying it. If you plan to trade more often, seriously, get some tax help. And for more information on investing, check out episode 63 cryptocurrency episode 57 risk profile episode 52 stocks, Episode 45 rebalance and episode 44 capital gains and we'll talk with you again next week.

Announcer: 14:37

Thank you for joining today's podcast. Like to find out more? Visit us at www.moneypilotadvisor.com Let's team up and land your financial life.