Summary The primary reason for the dramatic rise in Bitcoin has been it being increasing used in portfolios of investors who previously avoided it. Modern Portfolio Theory shows that the most efficient portfolio is one that includes everything that possibly can be invested in, including such alternative assets as collectibles. Many adherents of Modern Portfolio Theory do not include alternative assets such as collectibles in their portfolios because high transaction and other costs and risks associated with them. Bitcoin does not have the high transaction and other costs and risks associated with many other alternative assets, which is why mainstream investors are including it pursuant to MPT. As the price of any asset such as Bitcoin rises, adherents to Modern Portfolio Theory should buy more to maintain its proportion in the Market Portfolio. Those who have profited from Bitcoin’s ( BTC-USD ) surge to over $100,000, owe their good fortune, more than any other factor, to Harry Markowitz whose 1952 paper Portfolio Selection for which he won the Nobel Prize in 1990, led to what is now referred to as Modern Portfolio Theory. As taught in finance courses, Modern Portfolio Theory says that the most efficient portfolio is the Market Portfolio, one that includes all assets. Students are sometimes surprised when told that everything that one can possibly invest in, including baseball cards and beanie babies should be included in the most efficient portfolio. This has created a situation where professional portfolio managers who might not include baseball cards and beanie babies in their portfolios might now include Bitcoin. Anyone who has taken a graduate finance course and many others are familiar with the work of Markowitz which led to Modern Portfolio Theory. This led to the Capital Asset Pricing Model and Jensen's alpha which is the Alpha in "Seeking Alpha." In my Seeking Alpha article 30% Yielding MORL, MORT And The mREITS: A Real World Application And Test Of Modern Portfolio Theory I gave a concise explanation of how and why Modern Portfolio Theory leads to the conclusion that the most efficient portfolio is one that includes all assets. I have reproduced it below. Those who are familiar with this topic may want to skip down to Why Bitcoin is the Perfect Asset to Benefit from Modern Portfolio Theory . The basis for the theory is that investors evaluate all assets in terms of expected return and risk. Risk can be quantified by standard deviation. Any asset is more efficient than another asset if it has a higher expected return than the other asset but no more risk or has the same expected return but less risk. Markowitz CAL frontier (Wikipedia) Markowitz frontier.jpg If all possible assets and portfolios of assets are plotted on a graph with expected return on the vertical axis and risk on the horizontal assets as shown above, there will be some assets and portfolios of assets that are more efficient than others. The most efficient assets and portfolios of assets, those which have the highest expected return for any given level of risk (standard deviation) form the Efficient Frontier. This, as shown above, is the line connecting those assets and portfolios of assets that are more efficient than those below then in terms of risk and return. Portfolios of assets will generally be more efficient than individual assets. Compare investing all of your money in one security that had an expected return of 10% with some level of risk, to a portfolio comprised of 20 securities each with an expected return of 10% with same level of risk as the single security. The portfolio would provide the exact same expected return of 10% but with less risk than the individual security. Thus, the portfolio is more efficient than any of the individual assets in the portfolio. This principle of diversification has led to the boom in index funds and ETFs. Markowitz demonstrated that the most efficient portfolio will be the Market Portfolio, which consists of all assets that anyone could invest in. That would include not just all domestic and international stocks and bonds but all other assets as well including art and collectibles such as baseball cards. In a model where a risk free interest rate exists at which all investors can borrow and lend, all investors should own the Market Portfolio, as the line labeled "Best possible CAL" on the graph indicates. The best possible capital asset allocation for any investor, regardless of risk preferences, lies along a capital asset line that connects the risk free rate with the Efficient Frontier. The risk or standard deviation of an investment at the risk free rate is zero. A line originating at the point of the risk free interest rate on the Expected return vertical axis and zero on the Standard Deviation axis can be drawn to tangency point on the Efficient Frontier. Any investor should invest at some point on that Best possible CAL. An extremely risk averse investor should invest only in the risk free asset. Someone slightly less risk averse should have most of their assets in the risk free asset with the remainder in the market portfolio. A risk seeking investor could have 200% of their assets in the Market portfolio by buying on margin by borrowing at the risk free rate. The important implication is that any point on the best possible CAL is more efficient than any individual asset or portfolio below that point, since it has a higher return with the same risk. Modern Portfolio Theory has had its ups and downs in both the financial and academic communities. Critics of the theory and model point to the difficulty in determining or creating a "market portfolio" and the assumption that investors can borrow and lend at a risk free rate. Many use the S&P 500 ( SPX ) as a proxy for the market portfolio and the T-bill rate as the risk free rate. There still remain numerous issues with the model. One could argue that the Wilshire 5000 is a better proxy than the S&P 500. Why Bitcoin is the Perfect Asset to Benefit from Modern Portfolio Theory. Some market participants who may be devoted adherents to Modern Portfolio Theory, probably do not include baseball cards, beanie babies and similar alternative assets in either their own portfolios or those they manage. Those adherents could cite various reasons for why certain risk and cost factors associated with alternative assets are sufficient to make one forgo the benefits of the Market Portfolio, which should include those alternative assets according to Modern Portfolio Theory. The risks associated with those alternative assets include what might be called fashion risk and the associated dual-use risk. Residential real estate and collectibles have dual uses, both as investments and that they can generate utility for their owners, separate from any returns they may generate as investments. Certainly, there are some who invest in art and other collectibles purely for investment purposes, and keep their collections locked in warehouses. However, those only interested in capital gains from collectibles, may have to bid against buyers who love the objects in question and have no compunction about paying too much. More importantly what might be called fashion risk can occur if the objects in question fall out of favor with collectors. Some collectibles now have various metrics that can lend themselves to evaluation that comes closer to that of securities such as stocks and bonds, which have metrics such as earnings, yields and ratings, However, even those collectibles that have metrics that can lend themselves to evaluation have fashion risk. Coins are an example of collectibles that now have various metrics that can lend themselves to evaluation that comes closer to that of securities but have fashion risk. Rarity and condition are metrics that can be used to evaluate coins. The mintage number of any American coin is known and there are a number of professional rating agencies that can assign a number from 1 to 70 for any coin, where 70 is the highest grade indicating a pristine flawless coin. Any coin graded 60 or above is in the uncirculated category. However, just knowing the mintage and condition of a coin does not necessarily mean that you know its relative value. For example, there were only 3,700 gold US one dollar coins minted in 1865 and 52,000 Standing Liberty quarters minted in 1916. However, in any given condition, a1916 Standing Liberty quarter is worth considerably more than an 1865 gold dollar. In terms of investment outcomes, in 1916, an 1865 gold dollar was already a collector item and could have been purchased in uncirculated condition for about $10, according to Gemini 1.5. For $10, in 1916 someone could have acquired 40 uncirculated Standing Liberty quarters, each of which is now worth about $70,000 in grade 67 according to pgcs-coinfacts . The same service shows an 1865 gold dollar in grade 67 at $42,500 . Diamonds are dual use and still in many investment portfolios. However, lab-grown diamonds, which cannot be differentiated from natural diamonds, without extremely sophisticated equipment, if at all, now are taking an estimated 50% of the bridal diamond market . A similar situation occurred when the development of cultured pearls caused a massive decline in the value of natural pearls. Alternative investments such as oil and metals, which can have transactions costs as low as securities, have considerable custodian costs, including insurance. Crude oil for spot delivery actually went negative during the pandemic as there was no capacity to store it. Many collectibles have enormous transaction costs. For example, in the Sotheby’s auction sale NY7617 NYC June 4, 2001, I sold a small bench that I had been using as a seat to take off muddy shoes in my summer home, when I sold the home. I had bought It from the artist for $1,200 in 1987. It had faded from being exposed to the sun through a skylight and someone had left a cold can of soda on it, which left a noticeable ring. Sotheby's included it in the June 4, 2001 catalog and gave it an estimate of $4,000-6,000. It sold for $12,000. However, I received only $7,200, even though I had absolutely minimized the costs involved, by taking it to Sotheby's in my own car. Later that year I saw an identical bench from that artist in a store in Santa Fe NM, in much better condition offered at $4,000. Bitcoin has none of the transaction or custodial costs associated with other alternative assets. It really cannot now be considered a dual use asset like collectibles and residential real estate. At one point it was thought that it would have some use for transactions, especially those involving illicit activities, that does not seem to be materializing. In my 2018 articles The Cryptocurrency Craze May Be Not So Crazy and Cryptos Revisited I pointed out that in a blockchain, all transactions are recorded by all participants of the blockchain, this could lead to digital cryptocurrency eventually replacing money as we know it today. But before this could occur, I also suggested that government could take control of the cryptocurrency universe. The government would then know the exact real identity of all blockchain wallet owners, giving government knowledge of all transactions. Possibly, the individuals in a group known as DarkSide which extorted a ransomware payment from Colonial Pipeline in May 2021 did not read my articles, since on June 7, 2021, a press release from the Department of Justice included: WASHINGTON - The Department of Justice today announced that it has seized 63.7 bitcoins currently valued at approximately $2.3 million. These funds allegedly represent the proceeds of a May 8, ransom payment to individuals in a group known as DarkSide, which had targeted Colonial Pipeline, resulting in critical infrastructure being taken out of operation. The seizure warrant was authorized earlier today by the Honorable Laurel Beeler, U.S. Magistrate Judge for the Northern District of California. “Following the money remains one of the most basic, yet powerful tools we have,” said Deputy Attorney General Lisa O. Monaco for the U.S. Department of Justice. Where Does That Leave Bitcoin? While in the future, Bitcoin will probably not be used in transactions any more than gold is today, that doesn't mean that, like gold, it will not inexorably be included increasingly in institutional and professionally managed portfolios. Those adhering to Modern Portfolio Theory, which increasing seem to be including the vast majority of portfolio managers who have not been able to consistently beat the S&P 500, do not have any of the reasons that limit their investments in collectibles, to preclude their including some of the 21 million Bitcoin in their market portfolios. That does not mean that Bitcoin will not continue to be very volatile and subject to event risk. However, just as Madoff on Enron did not permanently impair the stock market, various scandals and exchange collapses such as FTX will not permanently impair the Bitcoin market. One feature of the Modern Portfolio Theory conclusion that the total market portfolio will be the most efficient portfolio for all investors regardless of their risk aversion or risk seeking, is that since the weighting of an individual asset or asset class in the market portfolio, is that asset’s proportion of the total market value of all assets. Thus, as an asset class increases in price, adherence to Modern Portfolio Theory requires that more of it be purchased. In the short term there may be some disappointment when it becomes obvious that the USA has no business having a sovereign wealth fund and especially that the American government should not buy Bitcoin, anymore that the US Government should buy dollars for investment purposes. However, it is possible that countries for whom having sovereign wealth funds makes sense, they might increasingly be buying Bitcoin, since those running those funds probably studied Modern Portfolio Theory in whatever college or university they attended.
