Yale, Harvard, Stanford, and MIT all invest in cryptocurrencies. A closer look at their research explains why: Crypto has outperformed all other asset classes over the past years. 

When taking investment advice, it’s usually a good idea to ask whether or not your advisor has invested in the recommended asset himself. In 2018, Yale economists conducted a study that found investors should allocate up to 6% of their portfolio assets to cryptocurrencies – a finding that is in line with other studies. And the university does follow its own advice: Yale’s $29.2 billion endowment fund has invested in cryptocurrencies as well. And so did their counterparts from Harvard, Standford, and MIT. The leading academic players backing the emerging asset class provides a strong endorsement.

Their investment decisions are based on their own research. Yale economists Yukun Liu and Aleh Tsyvinski produced an eye-catching study in July 2018, called “Risk and Return of Cryptocurrency.” It looks at the asset class from a traditional finance angle rather than a technical perspective and concludes that even conservative investors should hold cryptocurrencies in their portfolios. 

Tsyvinski said in an interview, “Most of the research on cryptocurrency comes from a computer-science perspective. A comprehensive economic analysis is, however, lacking. We’ve done something very simple. We said: Let’s use textbook finance tools to help us better understand cryptocurrency.”

Sharpe Ratio: Cryptocurrencies beat every other asset class 

The study examined the pricing patterns of the three leading cryptocurrencies Bitcoin, Ripple, and Ethereum, comparing them with traditional asset classes. The results show that cryptocurrencies do compensate for their high volatility with higher returns. Their Sharpe Ratio – a measure for the performance of an asset adjusted for its risk – of cryptocurrencies is higher compared to stocks and bonds. Thus, a cryptocurrency investor has to accept a higher risk, but he will yield a return that more than compensates for it. Tsyvinski comments, “If you just look at return versus volatility, cryptocurrency looks more or less normal.”

Other research arrived at similar conclusions. The below graph is based on market data from 2013 to 2019 and shows that the risk-return relation of Bitcoin has consistently outperformed traditional asset classes over the last years.

Source: INVAO Group Investment Thesis, www.invao.org

Cryptocurrency returns behave differently 

The study also looked at what factors are driving cryptocurrency returns and found the digital asset class is in no way comparable to other asset classes. This finding again underlines the value of crypto assets as portfolio diversification tools.

According to the study, none of the 155 potential risk factors that usually impact stock returns had any significant impact on cryptocurrency returns. Likewise, the study did not identify any similarities between the behavior of cryptocurrency and major fiat currencies. There also was no link between the price patterns of cryptocurrencies and precious metals such as gold, silver, or platinum. 

Interestingly, many of the crypto-specific factors that are often used by crypto analysts to predict future price movements also seem to have a minimal effect on prices. The researches found that the cost of mining does not predict cryptocurrency returns. Likewise, volatility had almost no impact on crypto prices. 

Effective price prediction frameworks 

As none of the traditional finance metrics drive crypto prices and even crypto-specific metrics did not provide much help, the researches went on to identify which frameworks actually do work to predict price movements. 

One method that turned out to be reliable is the so-called momentum effect, meaning if an asset increases in value, it will tend to rise even higher. Most traditional asset classes follow this pattern, and it also seems to work in crypto markets. Tsyvinski says, “We have designed a simple strategy that says an investor should buy Bitcoin if its value increases more than 20% in the previous week. This strategy generates outstanding returns and a very high Sharpe Ratio.” 

Likewise, investor attention seems to impact cryptocurrency prices significantly. That means if more people talk about cryptocurrencies, prices go up. Similarly, if there is bad press surrounding cryptocurrencies, prices tend to go down. 

There might be one reservation about these findings: The study is from mid-2018, looking at 2017 and 2018 price data. At that time, markets were dominated by retail investors, while 2019 has seen a dramatic increase in institutional demand. As the market structure has shifted, the frameworks identified by Yale’s researches might not work to the same effect anymore today as they did in 2018.

How much to invest?

The study concludes that Bitcoin should be part of every investment portfolio, in the range of 1% to 6%. Although from 2018, these conclusions are in line with more recent studies. A 2019 Binance Study looking at the portfolio diversification effects of Bitcoin also recommended a crypto allocation of at least 1% to 5% depending on the investor’s risk-aversion. 

And here is one more exciting figure: For folks who believe Bitcoin could nosedive to zero, the Yale study estimated Bitcoin’s default probability at 0.3%. That’s slightly higher than the leading fiat currencies but certainly lower than many stocks or real estate investments.