The 60/40 Portfolio Is Dead. Introducing the 33/33/33 Crypto Mix
For nearly seven decades, financial advisors have recommended the 60/40 portfolio to investors seeking to balance risk versus returns.
The 60/40 rule originated in a time when bond yields were 8% and the stock market returned 12%. The rule is based on Modern Portfolio Theory: by diversifying into uncorrelated assets (60% stocks, 40% bonds), it is possible to reduce risk at only a small impact on returns.
But the 60/40 rule is dead – killed by inflation. Since the Great Recession, bonds significantly underperformed stocks. Adjusted for inflation, bond yields are negative. Furthermore, while bonds traditionally rally when markets sell off, the yields are so low that it is not nearly enough to offset the losses. Bond yields are likely to get worse in the future since interest rates are likely to stay low (due to the size of the national debt), while inflation is likely to rise.
So what should replace the 60/40 rule?
The 33/33/33 Mix: Stocks, Debt, & Alternatives
A portfolio should have two goals: capital preservation (keep what you have) and appreciation (increase the value of your assets). By diversifying your portfolio into both inflation-sheltered and income-producing investments, we can balance both goals. The 33/33/33 portfolio achieves this with stocks, debt, and alternatives.
Stocks provide protection from inflation (both because they represent ownership of real assets and because they are the prime recipient of monetary expansion) and appreciation (because economic growth increases the value of businesses).
Low-interest debt is a safe way to protect yourself from inflation. If the interest rate you pay is 4%, but inflation is 8%, you are paid 4% to take on the debt. Any debt less than the real inflation rate is likely to be profitable, whether it’s a mortgage, business loan, auto loan, or line of credit.
Alternatives include anything that’s not a stock or bond: venture capital, real estate, commodities, or private equity. The point of investing in alternatives is to reduce some of the risks from stocks by investing in uncorrelated assets. It’s difficult for most people to invest in quality alternative investments, with one exception: Bitcoin. Bitcoin’s limited supply provides protection from inflation, and its adoption has historically led to a very high price appreciation rate - 164% per year over 10 years.
Note: In 2021, Bitcoin saw massive adoption by private equity (aka hedge funds), which made it increasingly correlated with the stock market, but I believe that this link will eventually decline as Bitcoin adoption for savings and commerce grows.
Balancing Risk vs Reward in Crypto
Why focus on Bitcoin? And how can you protect yourself from the volatility of crypto markets? Let’s build a $1 million crypto portfolio to explore options for balancing risk versus reward. First, though, we need to understand how crypto markets differ from traditional securities markets.
The Dangerous Myth of Crypto Diversification
One of the most dangerous myths in crypto is the idea that a diverse portfolio is safer than betting everything on a single asset. The truth is the opposite: betting on the most likely winner is the safest bet while betting on multiple assets can increase returns but at the expense of additional risk. Why?
Because a single asset - Bitcoin - is likely to capture the vast majority of the market share in this space. (I explain my belief in the dominance of Bitcoin here.)
The market share of the runner-ups is highly uncertain, and the top ten altcoins have historically changed dramatically from year to year. When you buy altcoins, you are betting on a long shot. The vast majority of altcoins will fail, so by holding altcoins, you are either picking winners or trying to time the market and sell before it crashes. Both are risky propositions.
Crypto Markets Are Not Like The Stock Market
The crypto ecosystem differs from the stock market in three ways:
First, companies are generally valued based on their earnings. While it is likely that all businesses will eventually fail or decline, stock valuations generally have a strong relationship with earnings, so most businesses are likely to stick around for some time. By contrast, crypto prices are based almost entirely on speculation about future adoption, or simply future prices. This means that market share and price growth are not reliable indicators of future value.
Second, the vast majority of cryptocurrencies are competing for the same business model. Basically, cryptocurrencies are either trying to be money or smart contract platforms. These are natural monopolies, so there is likely to be only one money and one smart contract platform. This means that the vast majority of altcoins will fail.
Third, the long-term appreciation of Bitcoin far exceeds income-generating altcoins. Stocks provide a 7% (after inflation) long-term return. By contrast, Bitcoin’s 10-year price growth has averaged 164% per year - nearly tripling your money each year. For those seeking additional risk in crypto, a 20% APY on stablecoins, yield farming, or lending is actually far lower than the return from simply holding Bitcoin. This changes the risks/benefit equation of holding versus active yield-generation strategies.
What this means is that the standard practice of diversifying into multiple assets or buying an index fund is not a good approach in crypto. A better approach is to focus on one winner, and then think about hedging your bets and possibly adding a little alpha with riskier investments.
Let’s put these principles into practice:
A $1 Million Crypto Portfolio
A $1 million crypto portfolio
Starting with $1 million:
1: $500K Bitcoin in Cold Storage
Put 50% of the portfolio in Bitcoin held on your Trezor hardware wallet. This is your cold storage wallet. This balance should not be touched until you need to buy something and have no alternative means of paying – ideally, this should be in retirement.
2: $250K Bitcoin in Crypto Lending
Invest 25% of your Bitcoin into a crypto lending platform. At $40K, this is 6.25 Bitcoin. Celsius Networks, Nexo, and Voyager Digital will pay 3-6% APR on your holdings.
Your actual APR will be: Celsius: 6.2% * .25+(Nexo:) 1.5*5.25%+(Celsius) 3.5*3.05% + Voyager: 1*4.75% = 3.976% average APY.
Why this particular allocation?
First, most platforms have a bonus rate for a fixed quantity and a much lower rate for the rest. We are maxing out the peak rate before moving on to the next platform. Second, we are decreasing the risk of a total loss event by spreading assets across multiple platforms. Some platforms have much higher returns than this, and some platforms have very high or no limit for the highest-rate tier. The security team at Celsius is bigger than the entire staff of most other lending platforms, so it’s my recommended choice for the bulk of your holdings.
Note: Before you take this step, an important consideration for you is Bitcoin’s 164% growth over 10 years. Is it worth risking a total loss for an additional 4% APY? That depends on how long you plan to invest. At 4% APY, it will take about 18 years to double your Bitcoin. If Bitcoin sustains a high growth rate in the meantime, that would make a large difference in the total value. If you only plan to keep lending for 5 years, your lending will only get you about 20% more Bitcoin, so the risk is much higher relative to the return.
3: $150K in Ethereum
While Bitcoin is money, Ethereum is a decentralized smart contract platform. These are different business models, and there is room for both business models in the cryptocurrency space. I don’t believe that Ethereum will ever become money or that Bitcoin will ever become a smart contract platform. (I could be wrong about Bitcoin though because there are already smart contract platforms based on Bitcoin such as Sovryn and RSK.)
While I think Ethereum is the probable winner of the smart contract race, it faces very strong competition from competitors such as Solana, Terra, Polkadot, Polygon, and more. The leaderboard changes day by day, so picking a winner here is risky, and I believe that the current prices of these chains are poor indications of long-term success.
While you’re taking a gamble on Ethereum, place it in Celsius (up to 30 ETH) and Nexo for an additional 6% APY.
4: Invest $50K in DeFi:
We have 10% or $100K left. If you are an enthusiast of a particular project, you can use this portion for more speculative investments. We are going to go with CAKE. CAKE is the platform token of PancakeSwap, the dominant DeFi platform on the Binance Smart Chain.
CAKE can be staked on PancakeSwap for a 67% APY in the Auto-CAKE pool. The “auto” part means that the yield on your stake is automatically reinvested.
How does PancakeSwap provide such a high return? It’s essentially a Ponzi scheme: by buying CAKE, you provide capital to PancakeSwap. The yield can only be sustained by continued high growth, so it will inevitably collapse when growth tapers off. However, the exchange itself provides tangible value to users, so hopefully, the price of CAKE itself won’t.
There are many other ways to earn income in DeFi. I just picked one of the easiest. A safer option would be liquidity mining. For example, the APY for CAKE-USDT is 57%. This limits exposure to downturns in the price of CAKE. ETH-USDC is 17% on both Uniswap and PancakeSwap, which is good if you are already holding ETH and USDC.
5: $50K in USDC Lending:
The last $50K is invested in stablecoin lending. One reason to do this is to preserve some dollar-pegged assets to pay taxes on crypto gains. If you’re actively trading crypto and the crypto market falls 80% (as it has), it’s possible to owe more taxes than what your portfolio is worth. Holding back some assets in a dollar-pegged stablecoin provides cash to pay taxes without liquidating your portfolio.
Another reason to hold stablecoins is to pay for everyday expenses and emergencies. If you suddenly need cash, it’s much better to sell your stablecoin than to bet that crypto is not in a recession at that time.
Why USDC? USDC is a fully reserved dollar-backed stablecoin that is publicly audited, so it’s relatively safe. There are many stablecoins, and some of them have much higher returns than USDC, namely synthetic stablecoins such as TerraUSD and DAI. “Synthetic” stablecoins are decentralized and are not backed by real dollars in a bank account. Instead, they use complex mechanisms to maintain the peg. But there is no free lunch: higher returns denote higher levels of risk. A big enough market crash could cause the peg to fail and the value of a synthetic stablecoin to drop to nothing.
You can currently get 8.5-9% APY on USDC from the major lending platforms.
Total annual income:
$500K Bitcoin in cold storage: $0
$250K Bitcoin lent out at 4%: $10K
$150K Ethereum lent out at 6%: $9
$50K Auto-CAKE at 67%: $33.5K
$50K in USDC at 8.5%: $4.25K
Total income: $56,750 per year. Of course, we are betting that Bitcoin and Ethereum will appreciate far more than we are earning.
This portfolio is not meant to be a universal formula. It’s an exercise in thinking about risk versus reward. The safest and simplest option is simply to hold a 100% Bitcoin portfolio in cold storage.
How To Build Your Crypto Portfolio
I will conclude with the practical mechanics of creating your crypto portfolio. You will need:
A hardware wallet: buy it from Trezor
The MetaMask browser extension
Here’s the process:
Deposit USD to Gemini from your bank.
Buy Bitcoin, Ethereum, and USDC with your USD.
Withdraw your cold storage Bitcoin to your Trezor
Withdraw some Bitcoin, Ethereum, and USDC to Celsius, Nexo, and Voyager.
Withdraw any remaining Ethereum to your Trezor
You’re set! Your lending platforms will pay automatically, and your CAKE will auto-reinvest. If doing yield farming, you will need to harvest yield and reinvest manually.
I had the pleasure to speak about Bitcoin and cryptocurrencies at The Secular Foxhole podcast:
Quickly and easily listen to The Secular Foxhole for free!