“What to Consider before Investing in Cryptocurrency”
Given the increase of recent news around Cryptocurrency in the market, I thought it was valuable to re-visit an article we published in May of this year. It’s important to keep grounded and ask yourself some critical questions before investing in any new asset class.
Over the past few months, I have received more and more questions regarding bitcoin, etherium, and various other cryptocurrencies. What exactly is cryptocurrency? Should I be investing money into cryptocurrency? Bitcoin and other cryptocurrencies have delivered eye-popping returns in 2020 and 2021, and while this has enticed new investors into the space it’s important to remember we are always dealing with historical data and past performance.
Perhaps a better question is, what will the future of bitcoin and cryptocurrency look like? Let’s be clear, this article should not be construed as specific advice on whether you should or should not be investing into bitcoin or other cryptocurrencies. These are simply some points to be aware of as you think through your options.
A Lightning-Round Primer on Cryptocurrencies
Cryptocurrencies are digital, deregulated currencies based on blockchain technology. You can use cryptocurrencies to buy and sell goods and services with any vendor or provider who accepts crypto as payment. Right now, however, most people trade cryptocurrency itself in hopes of securing a profit in a highly speculative market. There are thousands of cryptocurrencies, but Bitcoin is the original and best-known. The purpose of this article is not to tout Bitcoin specifically, or to take a stance on whether it’s better or worse than other cryptocurrencies that exist.
For simplicity’s sake, I’m going to focus the commentary here specifically on Bitcoin. You could accurately substitute the word “cryptocurrency” for “Bitcoin” in many instances throughout this article, but not all. With that out of the way, let’s take a look at the future of Bitcoin. There are a few specific shortcomings that should give any investor pause before buying.
The Case for Bitcoin as a Currency
For much of the past decade, the primary case for owning Bitcoin was that it would replace government money. Nearly all Bitcoin’s proponents now agree that is extremely unlikely.
Traditional currencies fulfill three purposes:
Medium of exchange (instrument or system used to facilitate the sale, purchase, or trade of goods between parties)
Unit of account (standard monetary unit of measurement of value, cost of goods, services, assets, liabilities, etc)
Store of value (function of an asset that can be saved, retrieved, and exchanged at a later date, and be predictably useful when retrieved; a store of value is anything that retains purchasing power into the future)
Bitcoin fails as a medium exchange for a number of reasons. For starters, it’s wildly volatile, which makes it impractical to use in most everyday transactions. Even worse, exchanging Bitcoin for goods and services triggers taxes. The IRS treats Bitcoin as property subject to short- and long-term capital gains. If you buy a pizza with Bitcoin that appreciated in value, you will owe capital gains tax. Short-term capital gains (for property held less than 12 months) is taxed at your ordinary income tax rate. Long-term capital gains apply to positions held more than 12 months and are taxed at 15% and 20% for married couples with income of at least $80,000.
Bitcoin is also not a viable unit of account because it’s not effectively used to quote prices or contracted amounts. And it’s status as a store of value is shaky at best. National currencies such as the U.S. dollar or Euro derive their prices from the underlying economic activity of countries that issue them. Bitcoin prices are not based on economic fundamentals, but rather depend on speculation about the adoption and use of cryptocurrencies. It’s also worth pointing out that a store of value, by definition, has an expected real rate of return equal to zero.
What About Investing in Bitcoin as a Bet on Blockchain?
Another popular narrative for Bitcoin buyers in the past decade is that the purchase represents a bet, either on blockchain or an early-stage investment in emerging technology that would change the way people buy and sell goods or transfer money internationally. This is compelling, until you consider Bitcoin is simply far too inefficient. It’s capacity to process payments is less than ten per second, which means it falls short of realistically meeting aspirations to become the next Visa or PayPal.
The idea of buying cryptocurrency to “buy blockchain” doesn’t really make sense either. Owning Bitcoin doesn’t give someone any ownership in the underlying blockchain. Even if it did, the blockchain technology that underlies Bitcoin does not power the same blockchains used by the wide range of governments, corporations, and financial institutions utilizing blockchain technology.
Should You Invest in Bitcoin To Diversify Your Portfolio?
Building a diversified portfolio requires you to combine exposures with various risk and return characteristics that behave differently over time. By combining exposures that zig with others that zag, the volatility of a portfolio’s overall returns is reduced. That, in turn, allows the portfolio’s returns to compound at higher rates.
(If you compare two portfolios with the same average return and different levels of volatility, the lower volatility portfolio will have higher compounded returns and a greater ending value than the portfolio with higher volatility.)
Bitcoin certainly behaves differently than traditional asset classes such as stocks and bonds, but it doesn’t offer any expected premium for bearing the risk of Bitcoin’s price movements. That increases the already high uncertainty around the net benefit from including such an exposure to a portfolio.
Because I’m generally more concerned with implementing a bad idea than missing out on a good one I’m not a believer in Bitcoin as a strategic diversifier.
If after considering some of these points you still are leaning towards investing into cryptocurrency then I encourage you to answer the following questions before diving in:
- What is my return objective?
- What is my time horizon?
- How will it change my life if the value goes up exponentially?
- How will it change my life if the value goes to zero?
“This is for informational purposes only and should not be construed as an investment recommendation. Crypto-currencies are subject to but not limited to substantial and ever changing regulatory, market, and operational risks”