What To Make of Bitcoin?
Prior to GameStop and Reddit hitting the financial news last week, Bitcoin was the hot topic. Yes, Bitcoin is back in the news as it briefly traded near $42,000 per coin! To put that in perspective, one coin was worth closer to $400 five years ago. Anytime you get movement like that in an asset, it’s going to get headlines whether it’s an individual stock, commodity, real estate, etc.
If you follow an evidence-based approach to investing, of course, you should immediately be skeptical of claims that this is a new normal. But skepticism does not mean outright dismissal, so first let’s explore.
What is Bitcoin?
Bitcoin is currently the dominant “cryptocurrency” although there are many others. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it. Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of Bitcoin, there is a finite supply of 21 million, of which more than 18.6 million are currently in circulation. Transactions are recorded on a public ledger called blockchain. People can earn bitcoins in several ways including buying them using traditional fiat currencies or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.
You may have even heard there are entire companies built around purchasing computing power near cheap energy sources to “mine” bitcoin. In this, it is like gold. If the price of gold is worth the cost to dig it out of the ground, then people will do so. If the price of bitcoin is worth the cost of the power to run enough computers to solve the algorithm, then people will do so.
Bitcoin and other cryptocurrencies are often hyped by digital enthusiasts and people who believe the age of fiat currencies is coming to an end. In other words, many believe owning an asset outside of any one government’s control will have long-term benefits and provide an inflation hedge. They also take comfort in the idea that a government can’t “artificially monkey wrench” the value. This creates another source of demand that is important to keep in mind.
Bitcoin and other cryptocurrencies remain relatively niche, however. Despite the recent boom, the total value of cryptocurrencies is still less than one half of one percent of the total value of all stocks and bonds worldwide.
Should Bitcoin Be a Part of My Portfolio?
When it comes to any investment in a portfolio, you must address two issues:
- What is my goal?
- Is the investment I’m considering a good solution?
Take the case of stocks or bonds. To answer the first question, one goal most people have is to grow their wealth to enable greater future consumption—you want to turn your savings today into wealth you can use down the road. Are stocks and bonds a good way to achieve that?
Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. So yes, by investing in stocks and bonds today you expect to grow your wealth and enable greater consumption tomorrow.
With that framework, let’s explore some possible goals and if Bitcoin is a fit.
Long-Term Expected Returns
Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies and holding bitcoins in a digital wallet. We should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others. That makes Bitcoin speculative.
A speculative investment is not a good candidate for a permanent long-term holding. The academic literature overwhelmingly suggests that short-term currency movement are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency.
Substitute for Cash
The point of cash is to provide a store of value for near-term expenditures. You know the dollar you have in the bank is going to be worth a dollar tomorrow. Many of those owning Bitcoin do so with the idea that it is the future of cash. I won’t necessarily dispute that—it may or may not be—but it certainly has a long way to go before it gets there. There are two main issues.
First, though it is becoming more mainstream, Bitcoin is still not accepted as payment for most goods and services. When I want to pay for something then, it’s likely I have to convert into a local currency that can come with high transaction costs.
Second, and more importantly, it’s not a consistent store of value. I mentioned earlier that Bitcoin climbed to nearly $42,000 per coin a few weeks back. As I write this, it’s currently worth closer to $32,000. That’s a drop of 23% in a couple of weeks! I can’t use something with that much volatility as a store of value for my near-term expenditures.
Hedge Against Inflation or the Dollar’s Collapse
One of the arguments frequently made for Bitcoin is the limited supply. Without getting too technical, the algorithm was set up to have a finite supply of 21 million coins. Thus, the argument goes, the value should rise with inflation at the very least as we’re approaching the point where there will be no more supply. This discounts the possibility of other cryptocurrency substitutes, however. Indeed, there are already multiple well-regarded substitutes and if cryptocurrencies do change the future of money, there may, in fact, be a pretty flexible supply of substitutes.
As for the dollar’s collapse, that’s a speculative guess and a bit more driven by ideology than any evidence. A speculative guess of that magnitude that reorders the financial (and real) world could definitely lead to an opportunity for profits, but only because it’s very unexpected. What are the actual odds that happens? And how sure would you be that Bitcoin would necessarily be the benefactor? I’m not so sure that the world’s financial systems would rush to “digital wallets” in the event of the dollar’s collapse when they have other fiat currency options or gold. You can never rule any scenario completely out, but the odds would appear to be so low as to be of no value in planning.
Speculation vs. Evidence
None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge. The reality is that it’s hard to know what the future holds for Bitcoin as an asset. Like any “new thing,” you should be skeptical until the evidence starts to bear real fruit one way or another.
The first thought when considering any addition to a portfolio has to be about the bigger picture. What are my goals? We have a trove of evidence that a well-diversified portfolio of stocks, bonds, and traditional currencies has always been the best help to investors pursuing those goals.
