Returning to the regularly scheduled bitcoin and stocks portfolio series after my rant about the market yesterday, let’s start by looking at a really simple graph of daily returns between bitcoin and stocks:
Usually, returns are shown as a cumulative line (i.e. a stock price going up over time). Reason being, that chart above is super noisy. It kind of works for this short timeframe but don’t try visualizing it for years and years of data. Or, ignore my advice, try it yourself, and feel the pain of messy-looking data.
What we do see here is that bitcoin has a lot more big spikes beyond the average daily changes. It also appears to have larger daily changes than stocks on average. That explains the larger standard deviation we measured previously.
But, really, the main reason I wanted to show this chart is pretty simple. If you look carefully, you’ll see an important behavior. On some days, stocks and bitcoin move in opposite directions. One goes up and one goes down.
That opposite movement is a very simple example of the power that uncorrelated investments possess. Because, when you combine these two investments into a portfolio, the resulting return combination will be somewhere in between those opposing movements. Returns will be steadier and standard deviation will be reduced.
You get this reduced standard deviation benefit of diversification when investments aren’t perfectly correlated. They don’t even need to move in opposite directions to get this benefit, so long as they aren’t moving in exactly the same way! And in the next post, we will look at an even better way to show that and measure it.