The cryptocurrency Bitcoin has received considerable attention in the media recently, which is not surprising given that its price has rapidly risen in a very short period of time. New “assets” like this are intriguing, and many wonder: does this have a place in a diversified portfolio? Let’s explore some of the popular rationales for owning cryptocurrencies.
Currency of the Future
Many people buy Bitcoin because they believe that it will be used as currency in the future. Although Bitcoin is termed a cryptocurrency, it is not a currency in the traditional sense of the word, at least not for now. Currency, or money, has three characteristics: a store of value, a unit of account, and a medium of transaction. Bitcoin does not really fit any of these definitions. In fact, one of the primary reasons people are excited is because Bitcoin is rapidly rising in value. But, if Bitcoin has been known to fluctuate up and down by over 50% in a relatively short period of time, can it really be considered a store of value? And if it is expected to continue rising in value, then why would you choose to exchange Bitcoin for a good or service? Conversely, will product sellers and service providers be willing to price an item in Bitcoin if its price is changing frequently and rapidly?
It is ironic that for all the talk about Bitcoin taking over as a currency, if you were to ask someone what their Bitcoin is worth, they will almost certainly respond in dollars. So the dollar is clearly still the currency. If Bitcoin were truly a currency, then it would need to be far more stable and boring. The reality is that Bitcoin’s rise in price is based on hopes and speculation of what may or may not materialize, rather than a realistic assessment of its characteristics. From a logistical perspective, the Bitcoin network will need to be capable of processing many multiples of the transactions than it currently does. That is not to say such an outcome is impossible, but it certainly has a long way to go before it can be realistically considered a currency (and this even sets aside the ongoing debate about the efficiency and energy consumption of the network).
When one thinks about the long-term prospects for Bitcoin, it is extremely important to acknowledge that if Bitcoin begins to be utilized in a meaningful way, world governments will certainly step in to regulate it in order to maintain economic stability. In other words, if Bitcoin is to be considered a true currency, then it cannot be allowed to rise and fall like it currently does or else it will be devastating to society. Additionally, some governments have already been discussing the idea of creating their own digital currencies as an alternative to Bitcoin that is backed by a known entity. Even if governments don’t compete with Bitcoin, other cryptocurrencies can be quickly established, which should at least give one pause in their confidence regarding Bitcoin. Analogously, do you remember when MySpace seemed like it would be the dominant social media platform? Then came Facebook. Do you remember Beta video tapes? Then came VHS (if anyone even remembers that now)! These parallels are imperfect, but the point remains that Bitcoin’s future as a true currency remains far from certain and other cryptocurrencies could rise to prominence. (Case in point, consider that a few brief words from Elon Musk were able to put Dogecoin on the map.)
Gold is often held as a form of protection from inflation and/or currency devaluation (which usually occurs in inflationary environments). The argument is that hard assets like gold that have a relatively fixed supply will hold their value (or even appreciate in value), while the purchasing power of paper money declines. The foundation of this thesis assumes that the supply of the hard asset is fixed, or at least is slow to increase. (Gold can be mined to increase supply, but only at a measured pace). The crossover in rationale between Bitcoin enthusiasts and “goldbugs” is striking (and many traditional goldbugs have converted to Bitcoin).
The supply of Bitcoin is fixed at 21 million, and proponents often argue that it is even better than gold for this reason. Before blindly trusting this supposition though, it would be wise to consider a few questions. Who created Bitcoin in the first place, and can you trust that the supply will remain fixed? While some may not trust their own government to prudently regulate its own money supply, does that mean that one should trust what essentially amounts to a computer code (which may be subject to change)? If Bitcoin is not currently regulated by anyone, who will hold it accountable to its commitments?
Consider as well that some die hard advocates of gold or cryptocurrency hold their reserves out of concern for extreme economic conditions, such as currency debasement by the government, inflation (or hyperinflation), or an outright collapse in society as we know it. In such an extreme situation, one has to consider whether the power grid would remain intact to charge a device that enables access to spend Bitcoin, or more important still, to maintain Bitcoin’s network, which presently requires as much power as a small country. (Before you dismiss this as an outlandish issue, consider whether you ever thought a toilet paper shortage would be possible.)
While it is harder to imagine some of the use cases in developed markets, there are certainly areas where instability in monetary, political, and social systems may create a more compelling case for a digital store of wealth. Though in this situation, such an asset only needs to be digital (taking the place of a physical currency), not necessarily Bitcoin or a cryptocurrency.
If Bitcoin owners are truly honest, then most would admit that the real reason that they own Bitcoin is because they see it going up in price and want to benefit from that if the trend continues. Put simply, it’s speculation. And frankly, there is nothing inherently wrong with this because price momentum is a well-documented phenomenon and speculation is rooted in human behavior. The fear of missing out is real, but so is the fear of making it to the exit in time when the building is on fire. As a friend of mine once said, “Momentum is your friend…until it’s not.” This statement was made in application to making it down the hill on a mountain bike, but it is just as easily applied to any other situation where things are moving fast, either as a car accelerates, or in financial markets. Momentum works both ways, is subject to change rapidly, and often ends in crashes.
Humans are naturally attracted to optimistic narratives, and cryptocurrencies provide a variety of narratives that appeal to many different people for different reasons. One fairly obvious issue with narratives though is becoming overly confident in the expected outcome, which may lead to excessive risk taking. It is all too common to see popular stories disintegrate, and in hindsight their flaws seem so obvious. A classic example occurred in 1636, when Europeans speculated wildly on the value of decorative new varieties of tulip bulbs. Historian Charles Mackay summarized this as follows,
“Many individuals suddenly became rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Everyone imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them…Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clotheswomen, dabbled in tulips.”
This frenzy came crashing down in February 1637, and tulip bulbs have still not recovered to the highs they reached at that time. While it may seem ridiculous to speculate on the value of flowers (except maybe on the price increases that occur on Valentine’s Day every year), this tulip madness was very real and this example is still taught today as basic coursework for upcoming investment managers. The simple truth remains that while people may speculate about different things at different times, the human tendency to speculate does not change. Examples in more recent memory include the inherent value that was attributed to Cabbage Patch dolls in the 1980’s or to Beanie Babies in the 1990’s. This may seem rather comical, but at the time there was pretty serious speculation on the ability to continue increasing in value.
To point out some notable, relatively recent, examples in financial markets, in the late 1980’s investors speculated wildly on Japanese companies with the expectation that Japan’s business practices would soon take over the corporate world. This was rooted in the very real fact that Japanese companies were indeed very efficient at producing things, which was raising the bar for manufacturing companies around the world. But the speculation far exceeded the reality, and Japan’s stock market values came crashing down. They are only now recovering after around 30 years of being underwater. In the late 1990’s similar speculation existed around the newly invented internet. While the internet did indeed change our lives forever, the value of many of the companies that people speculated on at that time have completely disappeared. Sadly, many investors, or rather speculators, lost their fortunes. Making money on speculation is extremely alluring since fortunes can be made quickly, but it is impossible to know when the music may stop, and the party is over.
Time will tell the usefulness of Bitcoin to society and therefore its true investment value. It is difficult to assess many of the narratives surrounding it simply because it has only existed for a short amount of time and therefore has not been exposed to the very environments in which it is supposed to demonstrate its valuable properties. (For instance, while one can easily draw similarities to gold, we still don’t know how Bitcoin will actually behave in different macroeconomic environments.) Whatever its future potential, Bitcoin has certainly not yet gained sufficient scale to make accurate judgements about its usefulness and value.
Cautions aside, there is nothing wrong with buying some Bitcoin as long as one recognizes the speculative aspects and controls risks accordingly. If you keep the position size relatively small, this will avoid derailing your financial plan if it turns into a significant or total loss. If you buy and it keeps going up, you will have a positive return if you choose to sell at the right time. And if not, you will still have a good story to tell.
If you do choose to buy Bitcoin, remember that its current lack of regulation means that investor financial projections do not exist. As opposed to traditional banks and brokerage firms that you are familiar dealing with, there is little, if any, recourse in the event of fraud or other security issues.
Paracle Personal Financial Management is an independent financial planning firm founded in 2004 with an honest desire to help people optimize their finances by providing unbiased financial planning and investment advice that puts their clients first. Paracle specializes in delivering expert, comprehensive wealth management services to busy families. Their expertise integrates financial planning with investment management to ensure their clients experience confidence in every aspect of their plan so they can focus on what matters most. To learn more about Paracle, connect with them on LinkedIn.