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Bitcoin Volatility Continues to Decrease, Long-Term Returns Stabilizing

The Impact of COVID is Fading

By WEEX GlobalPublished 6 months ago 3 min read

As a financial asset, Bitcoin possesses two important attributes that make it valuable in portfolio construction: firstly, its risk-adjusted high returns (discussed below), and secondly, its low correlation with other asset classes. These attributes allow Bitcoin to contribute to investment returns while reducing the overall risk of the portfolio.

However, over the past three years, as the correlation with stocks soared, one of Bitcoin's crucial attributes, its hedging ability, has been questioned. Although the correlation between Bitcoin and stocks is currently decreasing, understanding the origins of this correlation remains crucial for our assessment of future prospects.

There are two distinct phases regarding the correlation between Bitcoin and stocks: Before the currency and fiscal response to the COVID-19 medical crisis (BC), and after (AC).

During the BC era, the correlation between Bitcoin and stocks, as well as all other major asset classes, was essentially zero. We focus on the correlation between Bitcoin and stocks (S&P 500 Total Return Index) simply because the majority of portfolio risk stems from equity risk exposure, making diversification beneficial for investors. We use a 3-month rolling correlation to demonstrate that correlation is not static and can provide insights from peaks, troughs, and averages rather than a long-term indicator.

As seen in the chart below, Bitcoin exhibited weak correlation with peaks and troughs ranging from +0.4 to -0.3, with an average close to 0.0 during the BC era (orange area). In this phase, Bitcoin's correlation with other asset classes appeared very similar.

However, as observed in the AC era, marked by the yellow box starting from March 2020 when fiscal and monetary policies responded to COVID, the correlation between Bitcoin and stocks underwent a significant change. We can describe this stage as a period of high correlation, with a peak close to 0.7 and an overall positive correlation, averaging 0.4, which is much higher than the BC era's average of 0.0.

Not only did the correlation between Bitcoin and stocks change, but its correlation with most other asset classes also experienced shifts. The chart below illustrates the changes in Bitcoin's correlation with stocks, gold, and the U.S. dollar, showing higher highs, lower lows, and higher absolute averages.

Who should be held accountable for this change in state? Our speculation is that due to the actions of global central banks (monetary stimulus) and governments (fiscal stimulus), the global money supply surged. During that period, not only did M2 money supply increase significantly, but the circulation of money was also disorderly. In other words, most of the newly issued currency likely flowed into financial assets (Bitcoin, stocks, bonds, gold, etc.) and capital investments (real estate) rather than being used for driving GDP through goods and services consumption. Naturally, the result of injecting all of these funds into the financial market at once is an increase in the correlation among these asset classes, including the correlation between Bitcoin and stocks.

WEEX Note: Correlation plays a crucial role in modern portfolio theory for determining the weightings of investments within a portfolio. This allocation of weights is achieved through mean-variance optimization. Specifically, correlation refers to the degree of relationship between different assets, helping investors understand the interactions and risk transmission between assets. When constructing a portfolio, investors tend to choose assets with lower correlation to achieve better risk diversification and returns. Mean-variance optimization is a mathematical model used to find the optimal portfolio weightings that achieve the maximum expected returns given a certain risk level. By incorporating correlation into the weight calculations, investors can construct optimized portfolios more accurately, achieving the best risk-return balance.

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About the Creator

WEEX Global

WEEX is one of the world's top futures exchanges in terms of trading depth, aimed at providing the most professional, secure, and private futures trading services.

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