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Courtesy of Matt Sauer, MFSWNB Investments:

One of the challenges of integrating Bitcoin into a diversified portfolio is one of investor expectations. A fellow investor recently told me that his firm’s compliance department is wary of permitting the addition of Bitcoin in a portfolio because of the fear of the client’s reaction to the volatility. The angst associated with a purchase followed by a 40% correction is a compliance department nightmare. Should it be? A reframing of the problem is needed.

Equity mutual funds are purchased for the purpose of becoming diversified day one, a perfect testament to Modern Portfolio Theory. Within that portfolio there will be individual stocks that have the same volatility as Bitcoin yet are not judged solely on their volatility. Additionally, there will be stocks with stealth volatility where a flat return throughout a decade of market gains is costly.

If the purpose of the portfolio is diversification, why rule out an asset that further accomplishes the task? The price of oil has had substantial price swings and oil stocks follow the commodity price while finding a home in value portfolios. We can anticipate the argument that oil stocks have intrinsic value and Bitcoin does not, therefor buying oils stocks is more prudent. What is the intrinsic value of an oil company when oil is priced below the variable cost of production? The natural gas industry just went through this phase for a considerable period. Individual stocks have fluctuating intrinsic values, a fact underappreciated by equity investors.

If Bitcoin is judged solely against its previous price and not viewed as a diversifying asset, then it will never gain a place in a portfolio. However, it may be the most powerful diversifying tool to hedge the risk of a deterioration in bond prices. As we have mentioned before, the 60/40 portfolio will have return patterns in the future that are different from the past. 10-year bonds now have the duration of 30 -year bonds from 40 years ago. If a rate shock took the 10-year bond to 4%, then there would be a loss of principal approaching 30%. The era of interest rates gliding down is over. Meanwhile, that economic environment would favor Bitcoin and a move would most likely be to the upside. How do you like it now?

Emerging asset classes have always been viewed as volatile, including stocks, high-yield bonds and gold. Bitcoin added to a portfolio should be better than the equity picker’s 50th best idea, why not accept it for what it is rather than what we fear?