Posted: Thursday, October 15th, 2020
Estimated Reading Time: 2 minutes
Understanding Bitcoin correlations play a key role for portfolio managers in gaining diversification benefits. Since its inception, Bitcoin experienced various correlation levels against different asset classes. Before looking at the history of some of the most important Bitcoin correlations, let us consider what a correlation degree represents.
Two types of correlations exist – positive and negative. Number 1 denotes a perfectly positive correlation between two assets. Naturally, number -1 shows a perfectly negative correlation.
Therefore, two assets experiencing a correlation of 1, move hand in hand. Or two assets that experience a correlation of -1, move in totally opposite directions. Examples exist in all markets. For instance, the EURUSD and the USDCHF pairs have a negative correlation. At some point, while the Swiss National Bank (SNB) held the EURCHF exchange rate floor at 1.20, the correlation reached closed to -1. Other examples exist too.
The rule of thumb in portfolio management calls for adding to a portfolio only assets with a correlation between -0.5 and 0.5. More precisely, the more uncorrelated the new asset is with the overall portfolio, the better. Therefore, the ideal asset has no correlation whatsoever with the portfolio’s assets.
The table above shows Bitcoin correlations with some asset classes in the last five years. Bitcoin proved to be the best asset to add to a portfolio to obtain diversification benefits. That is, the best after gold.
The coronavirus pandemic brought some interesting changes in Bitcoin correlations with other financial markets. More precisely, the correlations increased above 0.5 or fell below -0.5 for many of the markets listed in the table above.
More notably, gold and bitcoin correlation increased dramatically. From levels close to zero, it exceeded 0.5 in the few months the pandemic reached the Western world. Therefore, as an investor faced a tough call. What asset to add to the portfolio? A classic or a digital alternative investment?
Also, another correlation exceeded the 0.5 level – the one between Bitcoin and U.S. stocks. Any trader opening the S&P500 chart (i.e., the broad market) and compares it with Bitcoin will notice the positive correlation. At some points, the two moved hand in hand during the trading day.
To sum up, correlations do change. In the case of Bitcoin, they changed only in the last few months. Therefore, when interpreting a table like the one here, one needs to know at least two things. First, as Bitcoin correlations showed, the relationship between two markets do change. Second, an investor must know how to use correlations (i.e., add and eliminate assets) in a portfolio context.
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