How much “Weed” or “Cryptocurrency” is good for you (as an investment)?Jun 1, 2018

The investor’s dilemma, if considering a potentially risky investment theme, is to balance the potential upside participation if the theme plays out with the downside risk if the idea falters. Striking that balance is challenging. In this discussion, we’ll provide some ideas on how to better manage that conflict—and explain how we manage risk in our portfolios.

A quick note: the topic today will not be to debate the investment merits of more speculative investment themes such as weed stocks or crypto currencies. Rather, we’ll assume that an investor has made up his or her mind and wants that particular exposure, so we’ll discuss methods to answer the question of how much is too much for investors with long-term investment goals, such as saving for retirement or a child’s education.

Budget where risk is distributed throughout a portfolio

We’ll assume the investor (who may be working with a financial advisor, which is highly recommended) has created a long-term asset allocation that will give the investor a good chance to achieve long-term financial goals. The portfolio allocation will likely include a mix of stocks, bonds, commodities and currencies, as we do in our Quotential portfolios. Having the flexibility to allocate more or less to a certain asset class, region, sector, currency, etc. can help manage and take advantage of market volatility, and help limit downside risk.

For both tactical and strategic asset allocation, one of our key tenets is ensuring these active risks taken in a portfolio are intentional and sized appropriately. The concept is to ensure if we have multiple active bets in the portfolio that are less related or correlated to one another, we are not ruined by any one bet going against us. This is called risk budgeting, and this is how we manage our portfolios relative to our long-term benchmarks.

The example below is for illustrative purposes only, and we don’t condone an investment in cryptocurrency for the average long-term investor outside of a ‘play money’ account. But for argument’s sake, let’s say an investor believes in the cryptocurrency theme and wants exposure to it in his or her main portfolio. The table below shows the contribution to and detraction from returns of having had a cryptocurrency investment in a portfolio at different weights recently.

We can see at higher weights, the cryptocurrency becomes a bigger influence on returns (regardless of direction) and the overall volatility (standard deviation) increases significantly.

Returns are very uncertain in the short term, so the above may not be enough to help in the weighting decision. Risk and correlation tend to be more stable over time and may better help us in the weighting decision. The next table shows how a cryptocurrency holding contributes to the overall risk of the portfolio.

As the weight rises, the cryptocurrency (in this case, Bitcoin) begins to dominate the total risk of the portfolio. This one position starts to be the biggest determinant of future returns and if it moves in the wrong direction, the holding could really put the overall portfolio in jeopardy.

How much is too much?

When facing a prospective speculative investment that has a high-risk high-reward profile, such as our cryptocurrency example, it is better to focus on the risk contribution when making sizing decisions rather than the highly speculative upside. Future returns are extremely uncertain, but risk and correlations are relatively more stable. The weighting decision can then be formed based on a conviction level coupled with the appropriate level of risk contribution of the investment idea.

For example, one might be comfortable with having no more than 10% of overall portfolio risk coming from a thematic investment such as cryptocurrencies. Using an analysis such as in the table above, we can back into a potential weighting that makes sense for the desired level of expected risk contribution.

A sizing process centered on contribution to risk is a sensible way to ensure a speculative investment can be included in a portfolio if the investor insists, but does not dominate the overall portfolio’s risk profile to the point where long-term goals are put in jeopardy.

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.