The contribution of cryptocurrencies to portfolio diversification

Abstract

Cryptocurrencies have attracted significant attention due to their high risk, extreme volatility, regulatory controversies, and scandals. Investors and policymakers are drawn to them for their potential to enhance diversification and deliver high returns. This study examines the impact of incorporating cryptocurrencies into investment portfolios, focusing on their ability to improve risk-adjusted returns and diversification. A rolling asset allocation strategy employing the maximum Sharpe Ratio within a Markowitz framework was applied to weekly data from 2018 to April 2024. The analysis compares two unconstrained portfolios and two constrained portfolios, which impose a concentration limit on cryptocurrency investments. Results reveal that in 70% of the rolling periods examined, portfolios with cryptocurrency allocations outperformed non-cryptocurrency portfolios in terms of Sharpe Ratios. However, the heightened volatility of cryptocurrencies significantly increased portfolio risk, with annualized weekly standard deviations ranging from 18% to 25%, compared to 12% to 15% for portfolios without cryptocurrency exposure. These findings illustrate the dual nature of cryptocurrencies: they can act as both a source of instability and an opportunity for diversification. The study underscores the necessity of a cautious and strategic approach to incorporating cryptocurrencies into investment plans, given their inherent risks and unpredictable behavior