There's no single conventional recommended cryptocurrency allocation but any amount will likely add volatility to a client's portfolio, Schwab noted in a new report.
"Regardless of which approach you take, any investor adding cryptocurrency to their portfolio will be adding investment risk. Cryptocurrencies also come with other risks, including the possibility of potential encryption breaking and increased risk of loss," Schwab said in a report outlining two strategies to including crypto.
"Even small allocations to bitcoin or ether can significantly affect portfolio performance," the financial services behemoth wrote.
Bitcoin has experienced a drawdown as high as 73.4%, while ether saw an 87.8% maximum drawdown, both far greater than stocks and bonds, the report noted.
"Investors who want to add cryptocurrency to their portfolios should give careful consideration to their high volatility and speculative nature, and consider how much crypto-derived portfolio risk they feel comfortable with," the firm said.
Schwab outlined two ways to consider how cryptocurrency might affect a portfolio — a traditional approach using return expectations and a risk-budgeting-based approach.
"Given bitcoin and ether's historical volatility, the suggested allocations are relatively small," the report noted.
Most portfolio construction and asset allocation approaches are based on assumptions about expected returns, volatility and correlations, the firm wrote.
So an investor could make assumptions for expected returns while using historical volatility and correlations to figure how much cryptocurrency could fit in a portfolio, but there are risks, including the potentially outsize effect on performance in either direction.
Schwab said its research shows that an investor using a traditional approach might assume that bitcoin would return 15% annually, suggesting a 1% weight in a conservative, 8% equity-92% fixed income portfolio, a 6.6% weight in a moderate, 64% equity-36% fixed income portfolio and an 8.8% weight in an aggressive, 96% equity-4% fixed income portfolio.
These figures, the firm explained, are examples and not recommendations.
The report includes a chart with potential allocations based on return assumptions and portfolio type.
"Our research suggests that cryptocurrencies may not offer a large enough risk-adjusted return to justify a meaningful allocation if return expectations are less than 10%, even for an aggressive investor. Also, 'optimal' allocations are highly dependent on an investor's subjective view on expected return.
"For example, a moderate investor's exposure with a 25% expected return from bitcoin suggests a 16.9% allocation, based on our analysis, versus only 1.5% if the investor expects a 10% return," Schwab said.
A risk-budgeting-based approach designates a desired risk level for each asset class and allocates accordingly. Rather than relying much on an asset performance estimate, this method focuses on the investor's comfort level with risk, Schwab explained.
"While it may help investors to focus on a 'known' variable — risk tolerance — rather than an unknown variable like expected asset performance, it's worth remembering that no approach is foolproof and that cryptocurrencies' historical volatility could result in greater-than-expected declines," the firm noted.
Schwab chose three risk levels to be contributed from cryptocurrency and assumed that the weighting to bitcoin or ether would be drawn from the portfolio's equity portion.
"Even a small allocation represents a large percentage of portfolio risk," it said.
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