Bitcoin [BTC] Economics: 352% Expected Return on Bitcoin compared to S&P 500
Bitcoin is not for the faint-hearted. The volatility and risk associated with Bitcoin investment are inherent given its small market capitalization and lack of regulatory certainty.
Using a CAPM (Capital Asset Pricing Model) model, the cost of equity of an asset can be estimated. It measures the expected return on an asset based on the measured risk (volatility).
It compares the asset return with that of the average returns of the market. Hence, in the real world, it examines the opportunity cost and risk of investing in the asset, compared to an ideally diversified portfolio.
The model divides the volatility of the stock into two parts: specific risk and systematic risk. In my view, the specific risk accounts more for short term price movements than long-term. Moreover, it can be eliminated by diversifying the portfolio.
Systematic Risk of Investing in Bitcoin
What we are interested in is calculating the systematic risk. It is a measure of being exposed to the economy in general. The price of the asset depends only on the expected returns from the market.
While Bitcoin’s market is more than a decade old now, to clear the statistical noise, I have taken only the past five years for my calculation. Before 2015, the market was primarily led and controlled by fraudulent players and traders involving in unethical activities.
The average rate of return of Bitcoin since 2015 is 309.348%. The approximate return for 2019 is 150%. The average return on the S&P 500 since 2015 is 8.59. The price of Bitcoin on 1st January 2019 was about $3850.
Hence, by using the formula for systematic return, the beta for Bitcoin is around 33.
- where the variance of the Bitcoin market is calculated from 2015
It turns out to be 125.5.
- The co-variance between the Bitcoin returns and the S&P 500 return turned out to be 4153.98.
The cost of equity (systematic risk) undertaken by investors is found using the formula,
r = rate of risk-free return + beta X (risk premium)
The risk premium of the S&P 500 is (19-8.59)%. While the risk-free return is taken as the average return. Therefore, the cost of equity for Bitcoin turns out to be 204.55%.
The data is not accurate as one can quickly note,
- It is taken only for 5 years, where the return for 2019 is an approximation as well.
- The gearing/leverage ratio of the market is unknown. The high leveraged margin trading and lending facilities provide for an increased cost of equity.
It’s because of the development of lending and margin within the space in the said period. Before that, leverage wasn’t implemented to invest in it. However, we can know one thing, that increasing the gearing only increases the risk and return expectations.
Why is the data useful then?
It provides an approximation of the risk undertaken by “institutional” investors. It implies that the investor is generally looking at a rate of return higher than 200% from Bitcoin annually. The volatility and regulatory uncertainty add to the risk.
Furthermore, Bitcoin has already yielded equivalent gains in August and in October for buyers at the beginning of the year or even the 1st quarter. Nevertheless, this again adds a lot of ambiguity as the highs and lows have varied considerably for its entire history.
This is not a prediction, it is measure of the risk undertaken by investors. Higher Rewards call for higher risk. 200% asset growth with a Market capitalization of less 0.5% of the traditional markets. Is it possible? Surely, but with the cost of equity so high, I don’t think anybody else other than speculators or risk-takers (believers) would board the ship just yet.
With S&P 500 continuing its uptrend as the Fed continues to inject money. Will Bitcoin risk-on be paid at the expected risk? Please comment.