Advisors have been dismissive of crypto ever since bitcoin came on the scene in 2009. And understandably so: Due to regulatory restrictions, advisors can’t simply log on to Kraken, Gemini, or Coinbase and add a small sprinkling of crypto to their clients’ portfolios, some of which they’ve been managing for decades.
“Advisors can’t touch those retail exchanges with a 10-foot pole,” says Ben Cruikshank, the head of Flourish, a crypto platform for registered investment advisors (RIA). “They don’t have something like a big exchange where people can sign up in five minutes and open an account.”
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Furthermore, the classic “if it isn’t broke, don’t fix it” mentality also keeps advisors from putting their clients’ retirement investments – and their companies’ reputations – on the line.
“Advisors have very successful practices and they’re managing a lot of money,” says Ric Edelman, the founder of the Digital Assets Council of Financial Professionals (DACFP). “They’re managing hundreds of millions of dollars, often billions of dollars – and they are doing very well.”
For the most part, investment returns have been favorable, Edelman argues – just look at the performance of the stock market in the last three years, averaging somewhere around 20% a year.
“Why disrupt that?” explains Edelman. “The advisors have a stable, steady practice.”
But then came bitcoin’s epic all-time high of over $68,000 in October and consumers couldn’t ignore their crypto curiosity anymore. However, crypto is unlike any asset class that’s ever existed, which means advisors can’t follow the same old rules.
Historic allocation rules of thumb
Advisors’ notions of proper portfolio management is rooted in modern portfolio theory, says Edelman. This theory was shaped by Nobel Prize-winning philosophies from the likes of economists such as Harry Markowitz, William Sharpe and Eugene Fama. Behavioral finance research says this: If you aren’t going to make a material allocation in your portfolio, you shouldn’t make an allocation at all.
“No financial advisor would ever say to a client, ‘Buy one share of Microsoft,’” Edelman explains. “What’s the point? If you’re not going to make a meaningful allocation, it’s not going to move the needle.”
This way of thinking is part of the reason why common asset allocations include a rough minimum of 10% for a certain type of security. “Advisors routinely tell their clients to put 60% of assets into stocks and 40% into bonds,” Edelman says. “They don’t tell clients to buy 1% of stocks.”
But what about when it comes to crypto?
Crypto allocation recommendations
A 2019 Yale study found that 4% to 6% is an appropriate amount of a portfolio to allocate to crypto. The study included all cryptos, naming bitcoin, XRP and ether specifically. Financial advisors, certified financial planners and other money experts are increasingly beginning to rally around a 1% to 5% asset allocation recommendation for crypto. And interestingly, the Brazilian city of Rio de Janeiro invested 1% of its treasury reserves in crypto last month, which will make for an important case study on a governmental level.
A 1% allocation, according to Edelman, is something of a magic sweet spot. It’s small enough that a market crash would be almost undetectable while still exposing average investors to potentially double the returns they would see without it. While the amount of institutional investment in crypto seems to be making a total collapse less and less likely, consumers and advisors are understandably still holding their breath. Therefore, Edelman notes, 1% is enough of a contribution to be considered “material.”
Edelman plugged this pattern into a hypothetical scenario involving what he describes as a typical portfolio containing a 60/40 asset mix. Historic data from around the time of bitcoin’s historic 2017 bull run shows a 1,500% rise in bitcoin’s price, followed by a dip of 84%. A portfolio with no bitcoin would see returns of around 7% in one year (estimated conservatively) and, thanks to compound interest, 14.5% in two years. But changing that asset allocation slightly to 59/40/1 – a 1% addition of crypto – the potential gains could jump to 22% in year 1 and 15.4% in year 2 (with the 85% dip), ultimately coming out ahead.
And in the rare event that crypto crashes entirely, the 59/40/1 allocation still results in a 6% return in year 1 and 13.4% in year 2, says Edelman.
“This shows that the allocation can materially improve the return but the downside risk is insignificant,” he says.
While crypto is still a nascent asset class, a growing number of advisors are invested in finding credible information to share with their clients. Financial professionals arguably need to stay knowledgeable about the digital asset ecosystem and remember there’s often better advice to give to a crypto-curious client than to just avoid the asset class altogether.
For clients who are interested in adding a small but material allocation of crypto to their portfolio, advisors can start with just 1%, always thinking about the potential risks compared to the possible rewards. In fact, some argue that 1% is not only a safe place to start but the best allocation for most everyday investors.
UPDATE (Feb. 18, 18:37 UTC): Corrects Ric Edelman’s title and affiliation in fifth paragraph.
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