What is the value of diversification? We can visualize it using a simple three-asset portfolio, observing how the risk-adjusted performance changes when varying the correlation. Correlation measures the degree to which two variables move in relation to each other, and serves as a guide as to how well assets can diversify each other1.
In the visual below, we show all possible weight combinations of a theoretical three-asset portfolio. The x axis is the stock weight, the y axis is the bond weight, and any remaining weight is our third asset class, in this case, digital assets, which the recently launched STOXX Digital Asset Blue Chip index sets out to measure. This means the bottom right corner is 100% stocks, the upper left corner is 100% bonds, and the bottom left corner is 100% crypto. Using volatility, return and correlation assumptions, we shade where the Sharpe ratio is the highest, indicated by the darkest red. We show scenarios varying the stock/bond correlation from -0.5, as an investor only aware of the last two decades may expect, and another at +0.5 at the other end of the spectrum.
As we can see, with stock/bond correlations at -0.5, the diversifying impact of crypto is minimal – the max Sharpe portfolio contains no crypto at all. At +0.5, however, it is a different story. We now see a healthy crypto allocation in the max Sharpe portfolio. These figures will be highly sensitive to assumptions, but clearly illustrate the benefits of diversifying assets.
As investors contend with the current era of reliably negative stock/bond correlations potentially ending, seeking diversifying allocations – such as those to digital assets – may contribute to better overall outcomes.
1 Investors must also be concerned with the stability of correlations in different market environments.