Practical Applications of Asset Allocation with Crypto: Application of Preferences for Positive Skewness

In Asset Allocation with Crypto: Application of Preferences for Positive Skewness, from the Spring 2023 issue of The Journal of Alternative Investments, Andrew Ang, Tom Morris, and Raffaele Savi, all at Black Rock, find that investors with certain types of utility functions should favor investments with lottery-like characteristics—a low probability of a very high payoff. They investigate bitcoin (BTC) returns, which they model as a mixture of two normal distributions. One distribution represents a small chance of very high returns, which they call the “bliss regime,” and the other has a low average return and large variance. Using various investor preference frameworks and assumptions, they determine the optimum BTC allocations for investors. Including BTC in a stock–bond portfolio is warranted in realistic cases. Even when the probability of the bliss regime is very small, BTC allocations are still warranted despite BTC’s unconditional mean return being negative and its extreme volatility. The authors also assert that their approach may be applicable to finding optimal allocations to other alternative asset classes with return distributions that are skewed or have other nonnormal characteristics.