Blog: Correlation between cryptocurrencies and stock markets
Bitcoin and cryptocurrencies are often considered unique asset classes that do not closely relate to stock markets. How high is the correlation between cryptocurrencies and stock markets, and can cryptocurrencies offer diversification benefits to more traditional investment portfolios?
What does correlation mean?
First let’s go through what correlation between different assets mean. Correlation describes the relation between two assets, i.e. how alike the prices of those two assets change over time. The correlation coefficient can have values between -1 and 1 with 1 meaning that prices are perfectly correlated. If an asset has a negative or close to zero correlation coefficient to the current portfolio it gives a good diversification benefit, and if the coefficient is over 0.6 the benefit is low. According to modern portfolio theory, by diversifying investments into several investment assets that have little or no correlation with each other, the risk-return ratio of the portfolio can be improved. If the correlation of investment assets is too high, the diversification benefit drops. For example, if a portfolio is made up completely of Finnish stocks can a foreign stock provide better diversification benefits than a new Finnish stock, because shocks happening inside Finland doesn’t affect foreign stocks as much. Lower the correlation to other assets in the portfolio and the higher the expected return a new asset has the better. This is why Bitcoin and other cryptocurrencies have been a great investment also in more traditional portfolios in the last decade.
The year 2022 has been thus far historically bad for stocks and cryptocurrencies alike. Even though historically the correlation coefficient between Bitcoin and the S&P500 stock index of U.S stock market has been around 0.15, in 2022 it has risen to new highs even going over 0.5. The correlation between cryptocurrencies and the tech stock index Nasdaq Composite has been even higher than that.
What is causing this historically high correlation? Despite for example Bitcoin being closer to a digital gold like asset from its fundamentals, institutional investors who have entered the cryptocurrency market in the last couple of years have treated cryptocurrencies more like risky tech stocks. Thus as big macroeconomic factors have brought uncertainty to the markets in 2022, many investors have tried to lower the riskiness of their portfolios by lowering their investments in cryptocurrencies just like tech stocks.
Do cryptocurrencies provide diversification benefits?
According to data, investing in cryptocurrencies makes it possible to achieve a significant diversification benefit. For this blog I calculated the average returns and correlations between stock markets and Bitcoin by using data going back to 2014. The time frame and Bitcoin for cryptocurrency were simply selected to get the longest possible data. In that time frame stock markets have had good average annual returns: The OMX25 index of Helsinki with over 7.5 %, the world stock index MSCI WORLD with over 6.5 %, and the Nasdaq Composite index over 14 %. While the returns for the stocks have been good, especially considering the large drop this year, they fall way behind Bitcoin’s average annual return of more than 120 %.
Bitcoin’s long-term correlation from that time has been highest with the Nasdaq Composite index (less than 0.17). However, the correlation coefficients between those stock indices range from around 0.59 to 0.92. So from this data, it is easy to see that Bitcoin and cryptocurrencies have been very good investments for diversification, for also more traditional portfolios. In addition, even though cryptomarkets are known for big price volatility, Bitcoin's Sharpe ratio, which describes the risk-to-return ratio, is over 1.6, whereas from the stock indices the Nasdaq has the highest value with a bit over 0.65. So although the high volatility makes Bitcoin feel very risky, its risk-to-return ratio has been way better than with stock markets.
In the end diversification benefits also come from the fundamentals. Stocks represent ownership of a company and the profit it makes, whereas for example Bitcoin’s and Ethereum’s value comes from their properties and the use cases they enable. For example Ethereum is a decentralized blockchain platform for smart contracts and decentralized applications. This means there isn’t a single company or entity managing Ethereum's governance and its value if formed by the ecosystem of several different applications built on top of it.
The high correlation between cryptocurrencies and the stock market has surprised many in 2022 but based on historical data it is very likely that in the long term the correlation comes down to lower levels. Of course, history is not a guarantee for the future, but because for example, Bitcoin is such a different asset class from its fundamentals than stocks, it is hard to see that it would have a high correlation with the stock markets in the long run. It is not surprising that year after year the investment and research fields have started looking at cryptocurrencies as a better diversification tool for investment portfolios.Manu Isto Cryptocurrency specialist