Key Takeaways
Cryptocurrency offers the potential for strong returns, but with exceptionally high volatility and steep potential declines in value.
Consider limiting crypto exposure to 2%-4% in moderate to aggressive growth-oriented portfolios and zero exposure in more conservative portfolios.
Regular portfolio rebalancing is crucial to help manage the outsized risk of an allocation to crypto.
Cryptocurrency has captured the imagination of trillion, it has gained traction within the corridors of Washington and become widely available to investors with the advent of crypto exchange-traded products (ETPs).
So, how should you think about cryptocurrency?
In a new report, Morgan Stanley’s Global Investment Committee looks at the potential role of crypto in a diversified portfolio and how to consider sizing a position responsibly. A key takeaway for many investors: Proceed with caution. Unlike other asset classes, cryptocurrency has a limited track record, marked by strong returns but also exceptionally high volatility.
Here’s more on why a measured approach may be warranted.
Understanding Crypto’s Role in a Portfolio
Views on cryptocurrency’s potential role in a portfolio vary.
Some investors see bitcoin—currently the largest cryptocurrency by market cap—as a type of “digital gold,” due to its scarcity and potential as a hedge against inflation. Others compare Ethereum, the second-largest, to a fast-moving tech stock because of its potential to disrupt industries through innovations such as decentralized apps. Still others see crypto as a diversifying investment, helping reduce portfolio risk by not moving in tandem with other investments—although there is evidence that crypto’s correlations with risky assets like stocks have risen over time.
The Global Investment Committee categorizes crypto as a “real asset,” alongside commodities. Like gold, for instance, its value is often driven by broad economic factors, such as inflation expectations or monetary policy shifts, as well as technical market dynamics like changes in supply and demand, but not the financial health of an underlying business, as with stocks and bonds. Also like some commodities, crypto does not directly generate income through dividends or interest.
Risks and Rewards
The Global Investment Committee expects cryptocurrency to deliver strong compound returns of around 6% over a seven-year horizon, but with significant risk to investors: Crypto’s annualized volatility is about 55%—which is approximately four times that of the S&P 500 Index.
This volatility means that crypto can experience dramatic price swings, including potential drawdowns of up to 70% over a 12-month period. A deeper dive shows that since 2010, the Bloomberg Bitcoin Galaxy Index has experienced a maximum drawdown of at least:
10% in each rolling six-month period,
30% in half of such periods and,
50% in 30% of such periods.
In addition, because major cryptocurrencies increasingly tend to move in tandem with other risky assets, they do not always provide the diversification investors might seek.
Crypto’s limited history also means that investors may be “driving blind” when trying to forecast future performance for any market conditions that differ from the past five to seven years. For example, while bitcoin has tended to generate higher returns amid more favorable financial conditions, it’s unclear how it might fare in an environment of persistently higher interest rates, tighter financial conditions or lower liquidity.
Portfolio Implications
Even small allocations to crypto can have an outsized impact on overall portfolio risk. For example, adding just a 6% position in crypto to a growth-oriented portfolio nearly doubled overall volatility in our simulations. In some scenarios, the position swelled far beyond its target allocation due to rapid price increases, leaving the portfolio more susceptible to losses in the event of steep declines in the crypto allocation.
This underscores the need for disciplined portfolio rebalancing to periodically return a crypto allocation back to its target size.
With that in mind, we recommend limiting crypto allocations to:
Up to 4% in aggressive, “opportunistic growth” portfolios, which generally seek higher returns from short-term market opportunities.
3% in “market growth” portfolios, which often appeal to investors with a moderate-to-aggressive risk tolerance.
2% for “balanced growth” portfolios, which seek a mix of capital appreciation and income.
Zero exposure for more conservative investors focused on income or wealth preservation.
Also, consider funding any crypto position from risky assets, not cash, and using ETPs, where possible. The key is balance, grounded in thoughtful position sizing, regular rebalancing and a clear understanding of the risks.
For the most current insights and guidance, consult with your Morgan Stanley Financial Advisor and request a copy of the Global Investment Committee special report, Asset Allocation Considerations for Cryptocurrency.
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Risk Considerations
Virtual Currency Products (Cryptocurrencies)
Buying, selling, and transacting in Bitcoin, Ethereum or other digital assets (“Digital Assets”), and related funds and products, is highly speculative and may result in a loss of the entire investment. Risks and considerations include but are not limited to:
Digital Assets have only been in existence for a short period of time and historical trading prices for Digital Assets have been highly volatile. The price of Digital Assets could decline rapidly, and investors could lose their entire investment.
Although any Digital Asset product and its service providers have in place significant safeguards against loss, theft, destruction and inaccessibility, there is nonetheless a risk that some or all of a product’s Digital Asset could be permanently lost, stolen, destroyed or inaccessible by virtue of, among other things, the loss or theft of the “private keys” necessary to access a product’s Digital Asset.
Digital Assets may not have an established track record of credibility and trust. Further, any performance data relating to Digital Asset products may not be verifiable as pricing models are not uniform.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Companies paying dividends can reduce or cut payouts at any time.
Alternative investments may be either traditional alternative investment vehicles, such as hedge funds, fund of hedge funds, private equity, private real estate and managed futures or, non-traditional products such as mutual funds and exchange-traded funds that also seek alternative-like exposure but have significant differences from traditional alternative investments. The risks of traditional alternative investments may include: can be highly illiquid, speculative and not appropriate for all investors, loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than open-end mutual funds, and risks associated with the operations, personnel and processes of the manager. Non-traditional alternative strategy products may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. These investments are subject to the risks normally associated with debt instruments and also carry substantial additional risks. Investors could lose all or a substantial amount of their investment. These investments typically have higher fees or expenses than traditional investments.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
Nondiversification: For a portfolio that holds a concentrated or limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Portfolios that invest a large percentage of assets in only one industry sector (or in only a few sectors) are more vulnerable to price fluctuation than those that diversify among a broad range of sectors.
Environmental, Social and Governance (“ESG”) investments in a portfolio may experience performance that is lower or higher than a portfolio not employing such practices. Portfolios with ESG restrictions and strategies as well as ESG investments may not be able to take advantage of the same opportunities or market trends as portfolios where ESG criteria is not applied. There are inconsistent ESG definitions and criteria within the industry, as well as multiple ESG ratings providers that provide ESG ratings of the same subject companies and/or securities that vary among the providers. Certain issuers of investments may have differing and inconsistent views concerning ESG criteria where the ESG claims made in offering documents or other literature may overstate ESG impact. ESG designations are as of the date of this material, and no assurance is provided that the underlying assets have maintained or will maintain and such designation or any stated ESG compliance. As a result, it is difficult to compare ESG investment products or to evaluate an ESG investment product in comparison to one that does not focus on ESG. Investors should also independently consider whether the ESG investment product meets their own ESG objectives or criteria. There is no assurance that an ESG investing strategy or techniques employed will be successful. Past performance is not a guarantee or a dependable measure of future results.
Disclosures
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance.
Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation.
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