Is it worth adding cryptos to portfolio?

There has been a renewed interest in crypto investing, post the pandemic crash. It's estimated that about 1.5 crore Indians have invested or traded in cryptocurrencies, showing the interest and intensity of the participation. This is a staggering number, if true, considering a very high proportion of traditional assets like real estate, gold and bank fixed deposits. According to another report, Indians have exposed over $6.5 billion in various crypto based investing vehicles.

The total cryptocurrency market is currently valued at about $2 trillion with over 11,415 cryptocurrencies being traded with over 45 per cent of it is concentrated in the most popular and the pioneer, Bitcoin followed by Ethereum. This is now being taken notice by institutional investors who're warming up to these options, just to juxtapose, the traditional forex market (fiat/govt) is about $7 trillion. All cryptocurrencies, are however, run by private networks based on blockchain (decentralized database) technology.

So, the valuation of each of these vary according to not just the demand-supply dynamics, but also the functionality and network effect. Functionality refers to the usage or which part of the trilemma of blockchain technology is either compromised or enhanced. I've discussed in detail about this in my earlier posts but simply put the three pillars of blockchain tech are: decentralization, scalability and security. Developers encounter these hurdles or principles over which their derivative is designed upon. So, for instance, Bitcoin (BTC) is high on decentralization and security, the overall possible BTC is pre-fixed or limited making it not scalable beyond that number. Whereas Ethereum (ETH) is highly scalable and decentralized but have concerns over the security relative to BTC. It doesn't mean that ETH is insecure but in relative terms it falls a tad bit lower.

The network effect is not entirely related to blockchain or cryptocurrencies. It's an economic phenomenon which defines the value of a goods or service depending upon the number of users of the compatible products. Through network effect, the user generally derives better value due to the higher acceptance or seamless execution/transaction. Mentioning about network effects, James Currier has identified 13 distinctive types which fall under five broader categories. He claims that network effects in digital world are not viral effects. While network effects are about creating defensibility viral effects are about getting users for free. They've totally different objectives and playbook.

A survey conducted earlier this year among 114,500 BuyUcoin users revealed that most of the ether (a crypto coin) investors in India belong to 18-34 age group. Over 36 per cent of the total users belong to 25-34 age band while, 18-24 age group form about 30 per cent. The 35-44 age range consists of 17.36 per cent and 45-54 group contribute about 5 per cent, while just around 3 per cent are aged over 65. In another survey cryptocurrency exchange CoinDCX has shown the gender distribution with 85 per cent to 15 per cent in Dec'20 respectively to men-women has improved to 80-20 by March 2021 indicating the increased enthusiasm among female investors in India.

If beauty lies in the eyes of the beholder, value lies in the eyes of the valuator. Most of my childhood was spent in boarding schools and those days we'd restrictions in pursuing some of our passions like Philately (collecting stamps), trading cards (collectibles like that of Pokemon cards, WWF, etc), while they begin as fun and innocuous turn into feuds, fights and a source of jealousy among the children. So, the school administration used to come up with restrictions or banning their activity altogether. My own stamp collection began on an accident note when I'd received a rare (which no one else in the campus had) stamp along with a greeting card from one of my cousins. All the while, which stood as a fringe interest turned into a serious pursuit with the sudden attention I've received. It ended in a disaster when someone stole my entire collection and with increased frequency of such events occurring in the dorms, the school ultimately banned such activities.

By now, you get where I'm treading to but I'm not ridiculing or belittling anything about cryptocurrencies. The underlying blockchain technology is revolutionary and most promising across various fields and particularly in finance and trade. The decentralized ledger could permanently erase multiple hurdles in designing contracts. Another area of its ease and importance is in the remittance space. As per the World Bank, the official remittance flows to low and middle-income countries reached $540 billion in 2020 which is dominated by traditional banks making an average of 6.38 per cent as fees. Cryptocurrencies have become the favorite vehicles to bypass these costs and also at locations where banks have struggled to penetrate or regions of conflict.

The otherwise private 'digital barter' system got a boost this week. El Salvador has just moved to BTC as their legal tender i.e., accepted it as their official currency. Strategically, this is the biggest move by a government accepting the private network as not just legal but official. This comes after many institutions began to accept and acquire crytos as either assets or currencies since last year. The bumpy first week was hit by traffic snarls (processing hurdles) and tech issues, while, I've remained a doubter about the crypto phenomenon, always embraced merits of the underlying technology.

Now, it all boils down to the whether one wants to trade/invest in these and how could one define them i.e, assets or currency, etc. I don't want to add further to that debate. What interested me was a recent research paper on the role of cryptocurrencies in the investor portfolios. A working paper by MIT Sloan School tried to answer the questions on the diversification potential to these in the short and long-term horizon, also on the optimal allocation. The academic insights revealed that there was no potential for portfolio protection over short term, but it changed in recent times, though. There was a structural shift in correlation since mid-2018. While assessing the optimal allocation from the existing data, investors require at least a return of 30 per cent on cryptos to allocate at least one per cent of the portfolio.

(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])