I wrote the article below in December 2017. With wild price swings, peak-to-trough losses of -70%+ in bitcoin (and more in other digital currencies), major bankruptcies, and seeming frauds in the crypto space, I thought a look back may be timely. Not much has changed on my thinking on digital currency as an investment since then. However, there are many applications of the underlying blockchain technology making improvements to the global economy, which should provide positive changes for years to come.
Cryptocurrencies such as bitcoin emerged only in the past decade. 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 computer code stored in a digital wallet. Transactions are recorded on a public ledger called a blockchain. Bitcoins are earned by “mining” them — receiving newly created bitcoins in exchange for compiling recent transactions into new blocks of the transaction chain. You can also buy bitcoin just like you buy a foreign country’s currency with US dollars when traveling abroad.
Cryptocurrencies were the domain of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. It is moving beyond this niche appeal as the sharp rise in the market value of bitcoins over the past weeks and months has contributed to intense media attention. So should you buy bitcoin?
A good place to begin answering this question is by examining the roles that stocks, bonds, and cash play in your portfolio. Companies may seek external sources of capital to finance projects they believe will generate profits in the future. Financing generally comes in the form of equity (stock) or debt (bond).
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 priority claim and a 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.
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 bitcoins in a digital wallet.
Empirical evidence overwhelmingly suggests that shorter-term currency movements are unpredictable, implying there is no reliable way to earn a positive return just by holding cash, regardless of its currency. Rather, cash is a store of value that can be used to manage near-term known expenditures. Yet, bitcoin is not like cash. Most goods and services are not priced in bitcoin, and bitcoin prices are highly volatile relative to traditional currencies like the US dollar. And if you have a near-term expense, you prefer certainty that the expense relative to the payment form is not volatile.
By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow. It is not clear that bitcoins offer investors similar positive expected returns. And, unlike holding cash, bitcoin doesn’t provide the means to reliably plan for a wide range of near-term expenses. Because bitcoin does not help achieve investment goals, Bitcoin does not warrant a place in a portfolio.
Future regulation adds to bitcoin’s uncertainty. It is still largely unused by most financial institutions and has been the subject of scrutiny by regulators. It is unclear what impact future laws and regulations may have on bitcoin. Many other types of cryptocurrencies also present competition to bitcoin.
If you decide to buy bitcoin, do so with the realization that you are speculating (gambling) and deriving entertainment value from doing so … just like those that enjoy pulling the one-armed bandit or engaging with their brethren at the casino.
Kevin Kroskey, CFP®, MBA | February 2023
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