Correlation is a Bitch!

"Much of how successfully crypto assets can be properly integrated into conventional investment portfolios will depend on how tools from modern portfolio theory (MPT) can be utilized."

Fidelio Tata

January 26, 2022

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Data source: Yahoo Finance; author's own calculations

Much of how successfully crypto assets can be properly integrated into conventional investment portfolios will depend on how tools from modern portfolio theory (MPT) can be utilized. MPT goes all the way back to the 1950s, when Harry Markowitz proposed that any asset’s risk/return profile should not be considered in isolation, but evaluated by how it affects the overall portfolio's risk and return. Numerically, this is done by utilizing correlation, a measure borrowed from the field of statistics that quantifies the statistical relationship, whether causal or not, between two random variables.

The assumption of being able to predict expected (i.e., future) correlation between assets has always been a weak spot of MPT, but with crypto assets the problem appears even more pronounced. Historical correlation, often used for assuming future correlation, is hardly a useful guide, given how unstable it has been in past years. This is illustrated by a comparison of Bitcoin and Google. Historical correlation has been extremely high at times (close to +1, which is highest possible measure the correlation coefficient can take), arguably because both Google and Bitcoin are technology-driven investments. However, historical correlation has also dropped to low, even negative, levels at other times.

Conventional portfolio management struggles with risk/return profiles of asset classes that do not fit nicely into the theoretical models used for supposedly “rational” investment allocations. Time will tell how MPT will deal with crypto currencies, NFTs and other crypto assets. For the time being, modern portfolio theory has become, maybe, a not-so-modern portfolio theory…

Fidelio Tata is a Professor of Corporate Finance, author of Palgrave Macmillan's "Corporate and Investment Banking", and a former Executive on Wall Street.