The New Digital Gold: Analyzing Cryptocurrency as an Inflation Hedge and Portfolio Diversifier using Markowitz Portfolio Theory

Abstract

After the inception of Bitcoin in 2009, there was widespread skepticism regarding the potential value of digital currencies. In each subsequent year, however, a rising number of individuals and institutions have recognized cryptocurrencies as purchasing instruments. This increase caused investors to consider cryptocurrency more seriously as a potential investment vehicle. While more and more academics and financial professionals are adopting the view that cryptocurrencies will be a prevalent part of our future, their possible uses and benefits are still often the subject of discord. Compared to traditional financial assets, cryptocurrencies are still relatively young. While growth investors have leaned heavily into cryptocurrencies as assets, many value investors, have chosen to steer clear. Decentralized and digital, cryptocurrency behaves differently than traditional financial assets, making questions regarding its intrinsic value, stability, or lack thereof, extremely relevant. As a result, the extent to which it can be used as a financial instrument is still up for debate. Historically, investors have seen digital currencies significantly surge and drop in value. By analyzing how portfolios react to the addition of various cryptocurrencies, I will quantify the risk versus return possibilities associated with investing in cryptocurrency. To examine the question of cryptocurrencies’ role in the investment world, I will first investigate whether or not portfolios of solely digital assets can provide an attractive risk to reward ratio to investors. I will then look into how investors can best incorporate cryptocurrency into their portfolios. Further, I will analyze the potential diversification benefits of investing in multiple cryptocurrency assets by examining the different characteristics of each and how those affect price movement. Lastly, I will analyze historical data to see if cryptocurrencies serve as a hedge for inflation or storage value through comparison of pricing behavior to gold, a well known inflation hedge. In early 2021, Americans saw the most significant 12-month increase in the consumer price index since August 2008, the dawn of the Great Recession. Simply put, inflation is the process by which a country’s currency loses value and consumers experience a decline in purchasing power. The sharp inflation rate increase in 2021 caught the immediate attention of investors as the two primary asset classes, equity and bond markets, alike, do not tend to perform as well in those periods. In the past, commodities with intrinsic value, like gold, have been used by investors to hedge against inflation. It is increasingly important for investors to continue to develop new ways to hedge against inflation by extending into alternative asset classes. Alternative asset classes offer additional benefits through diversification and potential for even higher returns. I will investigate whether or not cryptocurrency can be deployed to hedge against U.S. inflation. I will also investigate the potential of cryptocurrency as a storage value and new potential digital gold standard. If cryptocurrency has potential benefits as an investment asset, it will also be essential to consider whether this can extend more broadly.