Originally published 2021-09-26.
In September 2021 The Economist's Buttonwood column, written by John O'Sullivan, argued that adding a small amount of Bitcoin to a mixed investment portfolio could improve its balance of risk and return. The reasoning came from Harry Markowitz's Nobel-winning portfolio theory: an asset can be volatile on its own yet still help a portfolio if it moves independently of everything else. In the column's own tests, the best-balanced portfolios held between 1% and 5% in Bitcoin.
The argument was widely shared by crypto fans as proof that a serious economics magazine had endorsed Bitcoin. It is more nuanced than that. Below we explain Markowitz's idea in plain terms, what the column actually tested, what changed soon afterwards, and the questions any investor should ask before applying it. Nothing here is personal financial advice.
Harry Markowitz and the idea of diversification
Harry Markowitz (1927–2023) was an American economist who, as a young graduate student, published a paper called "Portfolio Selection" in The Journal of Finance in March 1952. Before that, investors mostly judged each stock or bond on its own merits. Markowitz showed that what really matters is how assets behave together.
His starting point was that investors care about two things: expected return and risk, measured as the ups and downs of returns. He argued that sensible investors spread their money, writing that "diversification is both observed and sensible." The mathematical insight was that combining assets whose prices do not move in lockstep can lower the swings of the whole portfolio without giving up return.
From this he described the efficient frontier: the set of portfolios that offer the highest expected return for each level of risk. Anything below that line is leaving return on the table. In 1990 Markowitz shared the Nobel Memorial Prize in Economic Sciences with Merton Miller and William Sharpe for pioneering work in financial economics; his part of the award recognised the theory of portfolio choice.
Why correlation is the key number
Correlation measures how closely two assets move together on a scale from -1 to +1. At +1 they rise and fall in perfect step; at 0 there is no link; at -1 one rises when the other falls. In Markowitz's framework, an asset's own riskiness matters less than what it adds to the volatility of the total portfolio, and that depends largely on correlation.
The classic example is stocks and bonds. Shares have historically delivered higher long-term returns, while bonds have tended to lag but often hold up when stock markets fall. Because the two have usually been only weakly related, a mix of both has tended to give a smoother ride than either alone. That is the logic behind the familiar 60/40 portfolio.
What the Buttonwood column found
O'Sullivan applied the same reasoning to Bitcoin. The cryptocurrency was famously volatile, but in its short history it had also produced very high average returns. Crucially, he pointed out, it had moved fairly independently of other assets: from 2018 its correlation with stocks in every region had been roughly 0.2 to 0.3, weaker still over longer periods, and similarly low with property and bonds.
Buttonwood then tested four randomly chosen periods within the previous decade. In each one, the portfolio with the best trade-off between risk and return included a Bitcoin allocation of 1% to 5%. To check that this was not just a result of Bitcoin's spectacular rise, the column also looked at January 2018 to December 2019, when the price fell sharply. Even there, a 1% allocation produced better risk-adjusted results than leaving Bitcoin out.
The column was clear that past results and a short price history carry obvious limits, and part of the strong showing reflected Bitcoin's rapid gains rather than diversification alone.
What the Nobel link does and does not mean
Headlines described Bitcoin as a "Nobel prize-winning diversification strategy." That phrase is catchy but easy to misread. The Nobel committee honoured Markowitz's general theory in 1990, long before Bitcoin existed in 2009. Nobody on the committee evaluated or approved cryptocurrency. Applying portfolio theory to any asset is only as good as the assumptions fed into it: expected returns, volatility and, above all, correlations.
Those inputs are estimated from the past. If they change, the conclusion changes too. A model can recommend a 3% allocation one year and 0% the next simply because the data moved.
The correlation changed soon after
That is close to what happened. In January 2022, economists at the International Monetary Fund reported that the correlation between daily Bitcoin returns and the S&P 500 had climbed from about 0.01 in 2017–19 to 0.36 in 2020–21. The link with emerging-market shares rose to 0.34, roughly 17 times higher than before. By their estimate, Bitcoin's swings explained about a sixth of S&P 500 volatility during the pandemic.
The IMF warned that as crypto moved more in step with stocks, its value as a diversifier fell, and shocks could spread between the two markets. The crypto sell-off of 2022, which coincided with falling stock markets as interest rates rose, illustrated that point for many investors.
Questions to ask before following the idea
- Can you live with large drops? Bitcoin has repeatedly lost more than half its value in a matter of months. A small allocation limits the damage, but only if you do not panic-sell.
- Is the correlation still low? The whole case rests on it. Check recent data rather than figures from 2021.
- Will you rebalance? Portfolio theory assumes you trim winners and top up losers to keep target weights. Without that discipline, a 2% stake can quietly become 10%.
- Where will you hold it? Exchanges and lending platforms carry their own risks, from hacks to collapse. Understand custody before you buy.
- What are the costs and taxes? Fees, spreads and capital-gains rules vary by country and can eat into small positions.
For decisions about your own savings, talk to a qualified, independent financial adviser.
The bottom line
The Buttonwood column made a reasonable, carefully tested argument: on the data available in 2021, a small slice of Bitcoin improved the risk-adjusted performance of a diversified portfolio. Its foundation is sound, because Markowitz's insight about correlation is one of the most durable ideas in finance. The weak point is the input. Bitcoin's low correlation with stocks proved less stable than hoped, which is a useful lesson about any diversification strategy: it works only as long as the assets really behave differently.
If you are curious about crypto, the original Markowitz test is still a good one to apply. Ask not just how much an asset might rise, but how it behaves when everything else in your portfolio is falling.
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Sources: The Economist, Buttonwood: Why it is wise to add bitcoin to an investment portfolio (25 September 2021); CryptoGlobe summary of the column; Wikipedia: Harry Markowitz; IMF Blog: Crypto prices move more in sync with stocks, posing new risks (11 January 2022).
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