Modern portfolio theory bitcoin

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The invention of the digital currencies in , and a sharp increase in the prices of Bitcoin during the year , sparked immense criticism around this trend in the global financial and economic circles.

The individuals who invested in the digital currencies, by buying or earning the coins, gained tremendous rewards during this period. The investment into, or the allocation of money to benefit from a financial initiative in the future is a common trait in human behavior, as an attempt to secure oneself against any uncertainty that one might face. To many, investing and managing an investment portfolio is a profession. To some, however, it is a hobby, and to many, these investments provide financial security after retirement. Most often, employees in different companies are allowed to invest in retirement or provident funds.

These funds are developed and managed to earn good rewards while also keeping their risks low in order to avoid any significant losses. Moreover, non-profit organizations utilize additional income from the endowment fund investments in order to operate and manage their activities. Investment, therefore, becomes a societal need, especially when it comes to managing or investing for one's retirement or endowment funds. As we are hovering in the fourth industrial revolution, the investments and their management has become an even more challenging task, especially with the advent of innovative technologies and sound financial systems.

It is imperative to take advantage of the technological revolution, the upcoming financial systems, and the worldwide web in order to make wise investments to secure bright financial prospects and for the betterment of the society. However, firstly, we need to get down to the basics of what cryptocurrencies are.

The basic definition of cryptocurrencies states that it is a medium of exchange, but unlike traditional currency, it is independent of national borders and central banks Maese et al. Cryptocurrencies are strings of complicated computational bits and blockchains that are designed to work as a means of payment or exchange of value. These blockchains that were first introduced by Nakamoto , function as building blocks of the digital money system s , with usually no central authority overseeing the ledgers, wealth creation processes or the security systems, and also have negligible counterparty risks involved.

How Bitcoin Can Fit Into and Benefit a Portfolio

Cryptocurrencies have caught much attention from industry participants, individuals, and experts. Interestingly, Bitcoin has taken the lead, as of now, with a market capitalization of billion USD, making it the most popular cryptocurrency available in the market. The cryptocurrencies and the blockchain technology, which make the digital currencies, are disrupting and challenging the traditional financial systems in many ways. The high costs of financial intermediaries, transactional delays, and paperwork, act as an added burden on the consumers.

The technological advancements, that the currencies offer, not only do not require an intermediary to verify the transactions or identities of individuals, but also reduce the time required for these transactions, hence providing a transparent system for recording the data and information. In the same stride, the blockchain technologies are changing the banking system by possessing the capacity to facilitate smart contracts, electronic banking ledgers, and money remittances, that too on a global level Peters and Panayi, Effective electronic business models are now being proposed using blockchain's peer to peer transaction mode Su et al.

In addition to this, the blockchain technology also allows firms, of any size, to raise funds through peer-to-peer, globally distributed share offerings, or the initial coin offerings. The initial coin offerings not only brings the global investors together but also removes the requirement of any intermediaries, investment bankers, or auditors, which automatically reduces the costs incurred to the relevant companies.

In the year alone, a staggering amount of million USD was raised through initial coin offerings ICO , a figure that was higher than the amount raised through any traditional channels Perez et al.

The technical algorithm that makes the blockchain can reduce transactional costs for stakeholders, eliminate the third-party intermediaries, and also improve the entrepreneurial financing ecosystem Ahluwalia et al. With a new form of crowdfunding undertaken through the advent of cryptocurrencies, the factors that drive the ICO returns are also studied in detail. Domingo et al. This study reported that bitcoin spot and futures returns tend to have a positive effect on the ICO returns.

Over the years, the increase in the research conducted on cryptocurrencies and the underlying blockchain technology has been profound. While individuals are fearlessly using the currency for payments, mining to earn rewards, or direct buying and selling for investment purposes, the experts are skeptical of the different aspects of the currency, and its subsequent future. With the skepticism, hype, and investments in the cryptocurrencies, the researchers have been exploring and investigating the universe of digital currencies.

Cryptocurrencies, Bitcoin, and blockchain are also considered to be a significant part of the evolving FinTech. Although the focus of the research conducted in the diameter of FinTech, from the years of to , was on the business models and mobile payments, researchers were putting in more effort into studying the blockchain and bitcoins from the year and onwards Liu et al. While many researchers focused their research on the positives of the cryptocurrencies and blockchains, some suggested moderating the expectations regarding their benefits to the society, and the potential value that they might possess, along with the high potential of illicit use anywhere along the way Corbet et al.

Furthermore, it is not just the technology behind the cryptocurrencies and the digital currencies that is disruptive for the financial systems. The leading cryptocurrency Bitcoin, and the blockchain technology, had given way to 30 percent cumulated average abnormal returns when the companies changed their names to include the buzzwords that were related to cryptocurrencies Sharma et al.

Cryptocurrencies and blockchain technologies are shaping the financial systems, and are a significant part of the ongoing global financial innovation. Khraisha and Arthur defined financial innovation as a process that is carried out by any institution involving the creation and adoption of new products and platforms. The latest products and platforms enable technologies to introduce innovative ways in which financial activities can be carried out.

They further suggested that blockchain and PayPal are financial innovations that have been introduced by non-financial institutions. Bianchetti et al. These innovations included the technology behind the blockchain or ledgers and the decentralized ways of governance. Many authors have argued that the blockchain technology that works behind the cryptocurrencies is a potential breakthrough in financial innovation Glaser and Bezzenberger, ; Su et al.

In addition to financial innovation, blockchain technologies and cryptocurrencies also help in developing financial inclusion. Financial inclusion is a process that guarantees availability, ease of access, and usage of formal financial systems, for all the members of a particular economy, Moreover, it also entails the use of financial services Allen et al. Rodima-Taylor and Grimes Rodima-Taylor and Grimes, argued that remittances through cryptocurrencies and mobile transfers could facilitate a shift in paradigm in financial inclusion and locally innovative ecosystems.

They also suggest that digital financial inclusion would be likely to provide solutions to a significant chunk of the unbanked people so that they can effectively communicate with the formal financial systems. It may, therefore, be argued that the digitalization of financial systems, through financial innovation in the form of blockchain and cryptocurrencies, provides financial inclusiveness to the marginal components of the society.

In the extant literature, various authors have discussed the effects of financial innovation on the portfolio risk diversification. The financial innovations have not only brought down the costs associated with the traditional financial systems, but have also provided a broader range of technologically sophisticated, and innovative products into the market.

Allen and Gale Franklin and Douglas, also had a traditional point of view, wherein they believe that the financial innovations facilitate the risk minimization of the portfolios, by providing better diversification features. In contrast, Simsek a , b argued that due to the speculative trading, innovative instruments, increase the riskiness of the portfolios.

With the rise in the prices, interest rates, and the attention is given to cryptocurrencies and other financial innovations during the Fourth industrial revolution, research on the prospects of diversification of the products is indeed the need of the hour. The classification of cryptocurrencies as currencies, financial assets, commodities, or other forms of a financial product, has raised a considerable amount of discussion, as well as criticism with researchers, who have varied opinions on this matter.

Efficient Frontier

Empirical studies in the past have shown that uninformed users have approached the cryptocurrencies as an alternative form of an investment vehicle, instead of an alternative transactional vehicle Glaser et al. Studies show that Bitcoin does not correlate with traditional assets, such as stock and bonds, and is primarily used as a speculative investment, rather than a medium of exchange Baur et al.

Some researchers argue that Bitcoin does not behave like a conventional currency, asset, or security. However, it somewhat resembles a technology-driven product, a bubble event, or even an emerging asset class White et al. They argued that the magnitude of the long-term appreciation of Bitcoin is much higher than the paper currencies.

They further discussed that the characteristics of the risk and return, and the inverse correlation with other currencies could make Bitcoin, a potentially viable portfolio investment. Researchers undertook further research, on the efficiency of the cryptocurrencies Tran and Leirvik, ; Urquhart, ; Hu et al.

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The investments in cryptocurrencies saw a rise during the year when Bitcoin was brought into the limelight by an upsurge in its price. On the other hand, the experts were criticizing the speculative nature of these currencies. This emerging technological currency opened many avenues for researchers who were interested in the financial markets. It was observed that while investing in a single cryptocurrency was considered to be a riskier deal, the fund managers and researchers explored the diversification through portfolio investment, which somewhat buffered the risk factor.

They concluded that if Bitcoin is included in the portfolio, even if representing it in a relatively smaller proportion, it may significantly improve the risk and return profile of a well-diversified portfolio.

Review of Portfolio Theory

Platanakis et al. Brauneis and Mestel applied the Markowitz's mean-variance analysis, in order to test the risk and return benefits of a portfolio of the top cryptocurrencies, according to the market capitalization Brauneis and Mestel, They also provided a comparative analysis of the different portfolios, based on the data available from January to December The inclusion of Bitcoin, in a traditional hedging portfolio of gold, oil, and equities, reduces the risk of the portfolio by a considerable level.

Guesmi et al. The inclusion of Bitcoin, in a well-diversified portfolio which comprises of different asset classes, provides certain significant statistical benefits when it comes to diversification Symitsi and Chalvatzis, Symitsi and Chalvatzis provided an extensive analysis of the economic value of Bitcoin and suggested that the decrease in the portfolio risk comes from the low correlations between the assets and Bitcoin. Also, further contributing to the literature, Platanakis and Urquhart highlighted that, given the higher potential estimation error in a portfolio of cryptocurrencies, the portfolio theory might face significant difficulties Platanakis and Urquhart, Moreover, Trimborn et al.

Using the mean-variance optimization, and the risk-parity on a data of cryptocurrencies, spanning from January to December , Petukhina et al.

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