This is why bitcoin won’t ‘diversify’ your 401(k)

And if Uncle Sam is poised to pass an anti-inflation bill so amazing it even works retroactively…why would anyone still need bitcoin, which, as we all remember from Finance 101, is a “safe haven” against inflation and monetary debasement?

Right?

This may sound as hallucinogenic and ridiculous as Lucy in the Sky with Diamonds, but it wasn’t long ago that crypto bros were churning out arguments almost as goofy as this, and possibly more so.

One of the less ridiculous, and more persistent, was the argument that bitcoin and other cryptocurrencies would somehow “diversify” your 401(k), IRA or other retirement accounts, because they would perform as asset classes differently from stocks, bonds and the like. Such arguments can be dangerously seductive, because they can be technically true without being helpful. For example, lottery tickets are a “diversifying” asset, because the returns on a fistful of lottery tickets have absolutely no correlation with, or connection to, the stock or bond markets. But that doesn’t change the fact that lottery tickets are terrible investments.

So it was timely that not long ago finance professors Luciano Somoza and Antoine Didisheim of the University of Lausanne and the Swiss Finance Institute produced a research paper, “The End of the Crypto-Diversification Myth,” that exploded this fallacy.

“One of the key rationales for the inclusion of cryptocurrencies into long-horizon portfolios is the promise of diversification from the stock market,” they write. “Indeed, since none of the suggested—and much debated—fundamental values behind crypto-assets have a clear relationship with equity returns, it is reasonable to assume that the two asset classes should be uncorrelated.”

Or rather, they add, it was reasonable to think that. Until the last couple of years. Because, they report, “since 2020, the correlation between bitcoin and the S&P 500 has been consistently positive, reaching values as high as 60%.”

And, they add, there is a simple reason for this—and if any crypto trader wants to know what that reason is, they should…er…look in the mirror. “We argue theoretically and empirically that this correlation is largely caused by the trading habits of retail investors. Namely, the fact that crypto-oriented retail investors tend to trade cryptocurrencies and stocks at the same time and in the same direction.”

Somoza and Didisheim got access to trading data from SwissQuote, Switzerland’s leading platform for online trading, which allowed crypto and traditional stock trading from the same platform and the same accounts or online “wallets.” They were able to compare the individual daily trades in stocks and cryptocurrencies of tens of thousands of customers. 

Their findings: “Retail investors do engage in cross-asset buying and selling sprees and that this behavior became prominent in early 2020.” And, they add, “looking at the stocks favored by agents [i.e., clients] who hold cryptocurrencies, we observe a strong preference for growth stocks and speculative assets. When agents open a cryptocurrency wallet, their overall portfolio becomes riskier.” Actually, “this new group of traders seems to perceive cryptocurrencies as some kind of tech-stock, well suited for short-term speculation.”

They also found that cryptocurrency trading didn’t just jump on the speculative bandwagon, but helped get it rolling. When SwissQuote clients opened a cryptocurrency wallet, Somoza and Didisheim found, they were more likely to log in to their accounts more often and trade more frequently in general.

It is hardly a coincidence that bitcoin BTCUSD, -0.86% peaked in November last year—just around the same time as the Nasdaq Composite COMP, -2.01%.  Or that it plunged for the first half of this year, along with the Nasdaq and the S&P 500 SPX, -1.29%.  Or that it has rallied somewhat since mid-June—again, with the stock market.

bitcoin didn’t rally during the first few months of the year. Not even when war broke out in Europe and when inflation—and inflation expectations—rocketed.

Turns out it has behaved just like a tech stock on speed. Don’t believe me? Direxion, a mutual-fund company, is best known for its extra volatile exchange-traded funds. Among them is the Direxion Daily Technology Bull 3x fund TECL, -5.47%, which uses derivatives to try to give you 300% of the performance, up or down, of the technology sector every day.

Over the past 5 years bitcoin has risen from $4,400 to $23,300, or about 430%. But during the same period TECL has risen by almost exactly the same amount. (Actually a bit more.)

In other words, bitcoin hasn’t been “diversified” at all. It’s just been yet another speculative, leveraged gamble on the tech bubble.