Bitcoin Price Tomorrow? Ask Dr. Markowitz!

Dr. Markowitz, "Father of Modern Portfolio Theory"

According to the modern portfolio theory (1952), you need to include assets with high profitability, low volatility, or/and low correlations with other assets in your portfolio if you want to maximize Sharpe ratio (a ratio of expected reward to risk you take). Recent studies show Bitcoin helps increase Sharpe ratio of your portfolio because of its low correlation with stocks despite its extreme volatility and uncertain profitability. However, the correlation between Bitcoin and stocks has fluctuated a lot since early 2018, and portfolio-optimizing investors have continually adjusted their portfolios according to time-varying correlation.

Institutional Investors’ Trading Practices and Price Pressure

For example, when correlation increases, diversification benefits shrink, and the portfolio theory says you need to decrease your position on Bitcoin. Therefore, an increase in correlation (estimate) acts as a sell signal to all portfolio-optimizing investors simultaneously; therefore, Bitcoin experiences downward price pressure. However, if an optimal portfolio position on Bitcoin is re-calculated today at closing, traders will execute the portfolio-rebalancing order during the next trading day while splitting the order and timing for better prices to exploit intraday volatility. This time lag creates an opportunity to predict daily Bitcoin returns.

Footprints on Bitcoin: Diversification Efforts and Predictable Returns

Quantitatively, days with top 25% of correlation “decrease” have (on average) 0.7% higher next day returns than days with top 25% of correlation “increase”. (Conversely, portfolio-optimizing investors are paying higher prices for Bitcoin by that much.) The same return-predictability pattern universally appears in global equity markets and other cryptocurrencies such as Ethereum, Ripple, and Litecoin. You can find more information in Section 4 and 5 of the following article posted at SSRN.

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