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What I Care About This Week | 2021 Nov 8

Photo by Stacey Gabrielle Koenitz Rozells on

by Franklin J. Parker, CFA

The Summary

The Details

I spent some time analyzing the price returns of bitcoin late last week. Partly because I field lots of questions on the topic, but also because the nature of a financial asset’s return distribution is a major contributor to the role it plays in an overall portfolio.

Now, I don’t want to get too technical here. Suffice it to say, in portfolio construction, returns are assumed to be statistically normal (remember that bell curve from college? That is the “normal” curve). This assumption, while not true in practice, is close enough to allow us to use some tools to mix and match investments in a reasonable way.

However, when we look at the daily returns of bitcoin, what we find is that returns are not even close to the normal distribution (in the chart below, blue is statically normal, and red is bitcoin’s actual distribution).

Daily returns of bitcoin since 2014, compared to normal distribution.

What we find is that not much happens considerably more often than we would expect, and huge moves—both up and down—happen much more often than we would expect. The problem with this is that it evades our intuition of how financial assets behave. In short, our experience investing in other assets does not well inform our experience in bitcoin.

There are, of course, models which do closely match bitcoin’s actual return distribution, but those models are not well behaved. In fact, we currently have almost no tools for building portfolios of assets with distributions like that! That said, we can use the model to generate some future expectations for the asset, namely its risk profile. Given the parameters of the observed data, we should expect a 1-day loss of:

In short, bitcoin is a tough asset to place in a portfolio—we don’t really have tools to know how much to buy, when to buy, etc. Moreover, it has the potential to realize considerable losses—the worst of which have yet to be seen! Given that the worst 1-day return of bitcoin has been 37% since 2014, there are some really bad days not seen in the historical data, but which are predicted by the distribution model.

Of course, good days can happen, too (about the same metrics apply to the upside of the distribution), and that is the exciting part.

My advice is what it has always been: bitcoin is a bit of a gamble, so you should only invest what you can afford to lose!

Chart of the Week

One interesting outcome of the Covid recession has been that incomes have jumped for lower-income workers. The bottom and penultimate quartile of incomes saw higher gains over the past year while the highest and second-highest quartile of incomes saw smaller gains over the past year. While a stark increase, this has been part of a larger trend—lower-income-earners have seen their wages rise faster than higher-income-earners since about 2016. This is the first time that has happened since the 1990s.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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