How Risky is Bitcoin?

An example of risk-scoring system: The Morningstar Risk Ecosystem

In July 2021, Morningstar launched its Risk Ecosystem, adopting a scoring scheme from 0 to 100 for investor risk tolerance and investment risk.

Figure 1: Morningstar risk scores showing an investor with a risk tolerance of 52 and risk comfort range of 44-64, and the risk scores for common portfolios. Source: Morningstar (link).

I couldn’t find a detailed explanation of Morningstar’s portfolio risk scores. So I set out to develop my own hypothesis. Since the average volatility of SPY (S&P 500) is close to 20, and it would be reasonable for SPY, which is 100% equity, to have a risk score of 100; a simple mapping would be to multiple the volatility by five.

To test this hypothesis, table 1 lists the volatility of common asset allocations with SPY and BND (Vanguard Total Bond Index). For example, the 20/80 portfolio has 20% SPY and 80% BND.

Table 1: Average volatility of common asset allocations with SPY and BND.

Comparing this to Morningstar’s risk scores, it suggests that Morningstar’s conservative portfolio is a classic 20/80 portfolio, moderate conservative 40/60, moderate 60/40, moderate aggressive 80/20, and aggressive, close to 100/0.

This is consistent with our common understanding, which validates my hypothesis that the risk score can be simply defined as five times the volatility.

The risk score of bitcoin

What is bitcoin’s risk score? It ought to be riskier than S&P 500, but does it make sense to have a risk score greater than 100?

Water freezes at zero degree and boils at 100 degrees in Celsius. There is hardly a better way to calibrate the temperature, but it doesn’t mean that the temperature can’t go above 100.

I downloaded the price history of bitcoin from Yahoo! Finance (ticker BTC-USD) for the past five years, and calculated that as of 2/10/22, the annualized 5-year return of bitcoin was 112.5%, and the annualized volatility was 79.6. Using the definition above, we can conclude that the risk score for bitcoin is 400.

As a point of reference, the volatility of SPY was 92 for the one-month period ending 3/30/22 and 94 for the one month ending 10/08/08. If you invest in bitcoin, you are living with financial instability every day.

But comparing bitcoin to S&P 500 is not fair. A single security should be riskier than S&P 500. How does bitcoin compare to TSLA (Tesla), one of the riskier stocks?

Bitcoin versus TSLA (Tesla)

For the five-year period ending 2/10/22, the annualized return for TSLA was 74%, and the annualized volatility was 61. If we apply the same definition, the risk score for TSLA is 300.

Bitcoin is riskier than TSLA, but not otherworldly.

Bitcoin and TSLA have one important difference. Bitcoin has 365 trading days in a year while TSLA has only 252. The formula for annualized volatility is the standard deviation of the daily return times the square root of the number of trading days, so I wondered how much of the difference in volatility can be attributed to the difference in the number of trading days.

If bitcoin were to have 252 trading days in a year, its annualized volatility would be 68, and annualized return 66%¹. Table 2 lists the numbers for easy comparison.

Table 2: Annualized return and volatility of BTC and TSLA for the 5-year period ending 2022/2/10.

Bitcoin and TSLA are in the same league in terms of their risk and return profile. And the differences mostly came from the fact that bitcoin has 365 trading days versus TSLA having 252.

I was surprised by this result. Looking at the price chart below, doesn’t bitcoin look a lot more volatile than TSLA?

Figure 2. Prices of bitcoin (orange line) and TSLA (blue line) for the 5-year period ending 2022/02/11. Source: Yahoo! Finance.

Could it be the scale of the chart? If we look at TSLA by itself (see figure 3), now the pattern looks a lot like bitcoin.

Figure 3. Prices of TSLA for the 5-year period ending 2022/02/11. Source: Yahoo! Finance.

Should financial advisors recommend bitcoin to clients?

What advice should financial advisors give to their clients about bitcoin?

Ric Edelman, founder of Edelman Financial Engine, argues that the crypto markets are like the internet 20 to 30 years ago (link), and he has been spreading his gospel tirelessly at every conference. When bitcoin makes headlines every day, fear of missing out (FOMO) is a powerful feeling.

If you have been advising against investing in crypto on the ground of high risk, you are still correct. But now that we know the risk of bitcoin is in the same ballpark as TSLA, you need a better reason to justify why it is fine to hold TSLA in the portfolio but not bitcoin.

Scott MacKillop, CEO of First Ascent Asset Management, argued that if you buy bitcoin, you own nothing (link). He stated that while the blockchain technology is valuable, owning bitcoin doesn’t give you any ownership rights in the blockchain technology.

At the Insider’s Forum in October of 2021, Bob Veres sat down with securities and compliance attorney Tom Giachetti. Giachetti pointedly asked, “as a fiduciary, you don’t know exactly where this crypto is, it is not regulated, but you want to give advice of some sort and charge on it?” You can read the entire conversation here.

Bitcoin is indeed fundamentally different from TSLA. You can see people driving Teslas and perhaps drive one yourself. But have you seen anyone driving, eating, wearing, or looking at a bitcoin?

My biggest problem with bitcoin, however, was that I had a hard time understanding bitcoin mining. How do you mine something that doesn’t exist?

I studied electrical engineering in college and my track, semiconductors, had a rigorous physics curriculum in addition to the usual classes. After quantum mechanics, there were three more levels. With that kind of training, I never hesitated to sacrifice a few brain cells to get to the bottom of something. But nobody could give me an explanation that made complete sense until I chanced into a YouTube video two years ago², which I will summarize for you.

What is bitcoin mining?

Blockchain is a de-centralized record keeping system. Every 10 minutes, transactions are packaged into a block, which is chained with earlier blocks (hence the term blockchain), and the person who does the packaging is rewarded with bitcoins for their work.

When blockchain was first introduced in 2008, the packager was rewarded 50 bitcoins for each block. Every four years in May, the reward was cut in half. So, in 2012, it was halved to 25 bitcoins per block. In 2016, it was halved again to 12.5 bitcoins per block. On May 11, 2020, it was halved yet again to 6.25 bitcoins per block, with the next one expected to happen in 2024.

Who gets to be a packager? You will have to prove your worthiness by solving a math problem³. This is not the Math Olympiad where advanced math skills and brain power win. Instead, it takes repeated random guesses using a computer, and whoever gets it first or closest will have the right to package the block. An analogy would be to guess a password; there are no smart ways to do it; you will just need to guess the combinations one by one to see which one works.

When more miners join the network, the level of difficulty of the math problem needs to increase to select only one winner. Using the analogy of guessing a password, you can adjust the level of difficulty by simply adjusting the number of digits in the password.

The process of bitcoin mining is an artificial hurdle to select a winner. It delivers zero real value while wasting a lot of computing power and electricity.

How many bitcoins are there?

For the first four years, 50 coins were created every 10 minutes, so the total number of bitcoins released during the first four years was:

50 bitcoins * 6 times each hour * 24 hours in a day * 365 days in a year * 4 years = 10,512,000

Every four years, this number halves, and the total is:

10,512,000 * (1 + 0.5 + 0.25 + 0.125 + …) = 10,512,000 * 2 = 21,024,000

Since the first four-year period was not a full four years⁴, the actual total was slightly less than 21 million, out of which 19 million bitcoins have already been mined.

Figure 4: Number of bitcoins to be mined from 2009 to 2020. Source: Investopedia.com

Can I have some fun with bitcoin?

This is not to say that people can’t have some fun with bitcoin as pure speculation. Buying bitcoin seems less foolish than buying lottery tickets, not to mention that being foolish can be a blessing sometimes. As an entrepreneur, I can’t be more grateful for the foolishness of my friends who invested in my company when we had not much more than a set of ideas and mockups.

If the client is so inclined, it is fine to allocate a small percentage of their assets to a sandbox, where they can invest (play) in bitcoins, options, or anything they fancy, knowing that they could lose everything in the sandbox without jeopardizing their financial goals.

But if clients come to your office with a risk tolerance score in the 50s or even the 70s, you might make them aware that their bitcoin holdings are going to expose them to portfolio risks a few standard deviations off the far end of the spectrum.

Helen Yang, CFA, is the founder and CEO of Andes Wealth Technologies, a Lexington, MA-based provider of technology solutions for financial advisors.

¹For bitcoin, a 5-year period has 1825 trading days, which is equivalent to 7.24 years for common stock.

²Here is the link for the YouTube video (in Chinese): https://www.youtube.com/watch?v=g_fSistU3MQ.

³The math problem involves the hash function, which is difficult to solve hence often used in encryption.

⁴The word bitcoin was defined in a white paper published on 31 October 2008. It is not clear why May 11th, 2008 was chosen as the start date of bitcoin; it could be the date of an early draft. The first coin was mined by Satoshi Nakamoto, the mysterious inventor, on January 3, 2009. No bitcoins were created from May 11, 2008, to January 3, 2009.

Read more articles by Helen Yang