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Good morning everyone,

Most investors would argue that bitcoin is a risky asset. When they think of bitcoin, they think of the wild price swings, and they see those price swings as a risk. In investing, we call those price swings volatility.

However, enduring volatility is a prerequisite for generating returns. Warren Buffet says that the stock market is a device for transferring money from the impatient to the patient. The same is true of bitcoin. As I have pointed out here, holding bitcoin for 4 years has never resulted in a negative return.

So is it really that risky to simply hold bitcoin for 4 years and ride out the volatility?

A very popular way of thinking about risk in investing is the risk-on-risk-off (RORO) framework. It's an investment paradigm that assumes that investors' risk tolerance and investment choices change according to the economic environment in which they find themselves.

According to this logic, a risk-off environment can be caused by disappointing corporate earnings (an "earnings miss"), contracting or slowing economic data, and uncertain central bank policy. The RORO framework suggests that in such an environment, investors will seek refuge in assets that are perceived as safe havens and have low volatility, such as government bonds, gold, and cold hard cash.

Conversely, a risk-on environment can be supported by rising corporate earnings, an optimistic economic outlook, and accommodative central bank policies such as low interest rates. When market fundamentals are strong, the argument goes, investors become more accepting of risk and tend to move into more volatile assets, such as shares.

Based on this framework, many investors would argue that because of its volatility, bitcoin is a risk-on asset that should be avoided in a risk-off environment and should only be considered in a risk-on environment.

Would you agree with that?

It just so happens that BlackRock, the world's largest asset manager with US$10 trillion in assets under management, doesn't agree.

A few days ago, the company published a report entitled "Bitcoin: A Unique Diversifier. Why bitcoin's appeal to investors lies in its detachment from traditional risk and return drivers".

In the report, BlackRock argues that while there are risks to investing in bitcoin (sorry for the clickbait headline, please pray for me so I can still go to headline heaven!), the risk and return drivers behind bitcoin are very different from traditional assets and their risk and return frameworks.

DISCLAIMER: This newsletter is not financial advice. It does not take into account your financial situation, is general in nature, and is for educational purposes only.

Also, this newsletter contains affiliate links. This means that I may receive a commission from them. But for Crypto Down Under, I only choose products I use myself and can recommend wholeheartedly. Don’t forget to do your own research.

1. Bitcoin doesn't correlate with risk assets

Let's assume for the sake of argument that bitcoin is a risk-on asset. That would mean that bitcoin should correlate with other risk-on assets such as shares, right?

But it doesn't.

Instead, bitcoin has outperformed all major asset classes in 7 of the last 10 years, resulting in an extraordinary annualized return of over 100% over the last decade.

On the flip side, bitcoin was also the worst-performing asset in the other 3 of those 10 years, with 4 drawdowns of more than 50%.

Remarkably, over these historical cycles, bitcoin has shown the ability to bounce back from such drawdowns and make new highs despite extended bear markets.

2. Bitcoin has a different set of risk and return drivers

Because bitcoin has little correlation to traditional risk assets, BlackRock argues that traditional risk-return frameworks don't apply to bitcoin and that it is driven by a different set of risk and return drivers. In BlackRock's words:

So if the RORO framework is inappropriate, what are the drivers of risk and return in bitcoin? Again, BlackRock:

This is very interesting for two reasons.

1. Bitcoin is driven by a different set of risk-return drivers, namely global, monetary, geopolitical, and US fiscal and political stability. This means that over the long term, bitcoin's adoption trajectory is likely to be driven by the degree to which people are concerned about these risk factors. In other words, you can think of bitcoin as an index of global and US monetary, fiscal, and political instability. When that instability rises, bitcoin rises.

2. These drivers are also the exact opposite of what is driving traditional risk assets. For example: If a systemically important bank were to fail, it would be bad for traditional risk assets. But bitcoin would most likely soar in that scenario because it is a global, decentralized, fixed supply, non-sovereign asset that can exist outside the banking system. Or if the US was drowning in debt and couldn't service it, that would be bad for the US dollar as the global reserve currency and for US dollar-based assets like bonds and cash. Bitcoin would very likely go through the roof in that scenario because, again, it is a global, decentralised, fixed supply, non-sovereign asset that can exist outside of US dollar hegemony.

With this in mind, one could argue that bitcoin is the ultimate risk-off asset. This is why Blackrock calls it the "ultimate diversifier".

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3. How does bitcoin perform in risk-off environments?

So how has bitcoin performed historically in risk-off environments?

BlackRock looked at the major geopolitical events since 2020 and compared the short-term (10 days) and medium-term (60 days) returns of the risk-on asset S&P 500, the risk-off asset gold, and bitcoin.

As you can see, in some cases (US-Iran escalation, US election challenges, and US regional banking crisis), bitcoin showed an immediate positive reaction and delivered returns when the other two assets struggled.

In other cases (COVID outbreak, Russia's invasion of Ukraine) bitcoin had a temporary negative reaction before rallying.

BlackRock explains the temporary negative reaction by:

1. The fact that bitcoin is a 24/7 trading asset, making it a highly liquid asset during periods of stress in traditional markets, particularly at weekends.

2. A function of the still immature nature of bitcoin and crypto asset markets and investors' understanding of them.

4. So what are the unique risks of bitcoin?

BlackRock is not suggesting that bitcoin is risk-free.

Bitcoin is an emerging technology that is still early in its adoption journey toward potentially becoming a global payment asset and store of value. It is also subject to myriad risks that include regulatory challenges, uncertainty over the path of adoption, and a still immature ecosystem.

The key point, however, is that these risks are unique to bitcoin and not specifically shared by other traditional investment assets. Bitcoin as such is a particularly poignant case study of why the RORO framework can lack the nuance to be broadly useful.

Have a great weekend, everyone!

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