Should You Put 5% of Your Portfolio in Bitcoin? Here's What the Numbers Say.

Bitcoin (CRYPTO: BTC) isn't just for crypto enthusiasts anymore.

Thanks to the launch of spot Bitcoin ETFs several years ago, crypto has become widely adopted as a legitimate asset class in portfolios. Funds such as the iShares Bitcoin Trust (NASDAQ: IBIT) and the Fidelity Wise Origin Bitcoin Fund mean investors don't have to open separate crypto wallets to gain exposure. Spot Bitcoin ETFs now manage roughly $100 billion.

That's an incredible evolution for something that was considered to be a fringe asset class not long ago.

But if cryptocurrency is to be given equal consideration to other asset classes like gold, real estate, and commodities, we need to figure out how it fits within a broader portfolio and what allocation it deserves.

I think a 5% allocation is a good starting point. That would provide meaningful exposure without significantly altering the portfolio's risk/return profile.

But the numbers suggest the decision might not be quite that simple.

Image source: Getty Images.

A 5% allocation can actually make a surprisingly big difference

It probably goes without saying that Bitcoin is more volatile than the S&P 500 (SNPINDEX: ^GSPC). Therefore, any money you pull away from stocks (or any other asset class for that matter) is likely to increase the overall volatility in your portfolio.

But the math can be a little complicated.

Not all volatility necessarily increases portfolio risk. That's the basic case for diversification. Two assets can be volatile in isolation. But if they have a low correlation in moving in different directions and magnitudes, pairing them can actually make the combination less volatile overall.

History shows that the iShares Bitcoin ETF has been roughly 2.5 times more volatile than the Vanguard S&P 500 ETF (NYSEMKT: VOO). But the correlation between the two funds is only 0.4. In other words, adding Bitcoin to stocks is very likely to make the combination of the two more volatile than just owning the S&P 500 alone. But the lower correlation could offset some of that.

Let's imagine an investor with 100% of his portfolio in the Vanguard S&P 500 ETF decides to shift 5% of the portfolio to the iShares Bitcoin Trust.

A historical analysis of this two-ETF portfolio shows that the 5% allocation to Bitcoin would have contributed 7.35% of the overall risk. The addition of Bitcoin made the new portfolio more volatile, as expected, but the lower correlation mitigated some of the added risk.

The takeaway: Even small allocations to Bitcoin in a broader portfolio would definitely increase the amount of risk you'd see.

Should you put 5% of your portfolio in Bitcoin?

For a more aggressive investor with a longer time horizon, I think a 5% portfolio allocation is easily defensible. It increases overall volatility, but not egregiously so.

For more conservative or newer investors, an allocation of 1% to 3% could be a better starting point. It's enough that it allows you to participate in Bitcoin's upside, but you're unlikely to see a significant portfolio impact even if the price drops in half.

The iShares Bitcoin ETF is probably the best way to add exposure to your portfolio. The 0.25% expense ratio is minor in relation to its price movements. Plus, it's the most liquid and tradable ETF in this space.

As is the case with any volatile investment, time horizon will be an important factor. The longer you're able to ride out the short-term volatility, the better chance you'll have at capturing longer-term gains.

Bitcoin may still be in the early stages of its growth cycle. It's evolved enough that even smaller retail investors should consider adding it to their portfolios.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bitcoin, Vanguard S&P 500 ETF, and iShares Bitcoin Trust. The Motley Fool has a disclosure policy.