Bitcoin and bandwagons

Bitcoin and bandwagons

Over the past few weeks and months, it may have appeared that making big money in markets is easy – just buy Tesla or Bitcoin and you are sure to double your money! These are certainly not recommendations; this is a case of confusing gambling with sensible investing.

Bitcoin – boom, bubble or bust?

The world was introduced to Cryptocurrency back in October 2008, when an anonymous author published a mysterious white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. The main attraction of this “crypto cash” compared to traditional currency was the blockchain technology behind it, allowing Bitcoin to provide a decentralised way for two parties to exchange value. For this reason, Bitcoin needs no governing body, does not rely on central banks and is merely a digital balance sheet that facilitates and records transactions for the parties involved. The blockchain ledger is run using advanced mathematical procedures ensure that falsifying Bitcoin transactions is highly unlikely with today’s technology(although never say never!).

Figure 1 The cryptocurrency market value is small relative to the global equity market.

1Bitcoin.org (2008) Bitcoin: A Peer-to-Peer Electronic Cash System. https://bitcoin.org/bitcoin.pdf
2Forbes (2020) Can All of Bitcoin Be Hacked? https://www.forbes.com/sites/baldwin/2020/02…
Data source: CoinMarketCap.com, MSCI ACWI Factsheet. Figures as at 28/01/2021.

Over a decade on and literally thousands of alternative ‘altcoins’, have come to market in the cryptocurrency space, all trying to improve upon the blueprint set by Bitcoin. One of the biggest challenges is scalability – VISA executed ≈500m per day in 2019 whereas Bitcoin can only handle a measly 350,000 daily transactions. Bitcoin also requires warehouses packed full of energy-sucking computing power to keep it going, making it less than attractive in our increasingly sustainability-focused lives. One tool built by the University of Cambridge estimated that the Bitcoin network currently consumes roughly the same energy as the Netherlands each year!

Despite the apparent issues, the value of many crypto currencies has skyrocketed recently which always leads to a lot of excited chatter amongst retail investors (or rather gamblers, in this case). Presently, the one thing we are sure of when it comes to investing in cryptocurrency is that it is highly speculative.

Perhaps the logical thing to do is to consider things from a portfolio management perspective. If we first look at the more traditional assets in your portfolio and re-examine why they are there.

As an investor of Stock in a company, you are staking a claim on residual future profits of that company in the form of dividends and/or an increase in the price of your stock.

Bonds can also be issued by companies to raise capital, in which case your future income stream is pre-determined, so they are considered less risky than buying stock. If all goes to plan the company repays your principle when the bond matures. Buying Government bonds also provide promised cash flows and often with another level of security, reducing the uncertainty associated with corporate bonds and equities.

The pricing of these two assets reflects the perceived risk investors are willing to accept to exchange their ready cash today for a greater amount at some point in the future. These securities play a crucial role in your investment portfolios as they provide a positive expected return on capital employed, by allowing participation in the future profits of global corporations.

On the flip side, Bitcoin is not a capital asset, like cash it does not pay you dividends, coupons or rent and therefore does not provide an expected future cash flow. One dollar in your pocket today, or one Bitcoin in your digital wallet, does not entitle you to more dollars or coins in the future. Positive returns can only come from being able to predict when one currency will appreciate or depreciate relative to others, yet academic research overwhelmingly suggests that short-term currency movements are entirely unpredictable, digital currencies included.

Therefore, positive investment experiences with cryptocurrencies (getting on the right side of the volatility) are luck, not judgement.

Many attribute long-term expected price increases to demand outstripping supply, there is after all a finite limit to the total number of Bitcoins, although investors are quick to forget that the future expectation of demand is already factored into the current price. There are currently 18.6 million.

3Statista (2019) Number of purchase transactions on payment cards worldwide in 2019.
4Research Affiliates (2021) Bitcoin: Magic Internet Money.
5University of Cambridge (2021) Bitcoin Electricity Consumption Index https://www.cbeci.org/

Bitcoins in existence, yet the sale of 150 coins recently resulted in a price drop of 10% showing the lack of depth and/or liquidity to the market.

6Jemma Kelly (07 Jan 2021), No, bitcoin is not “the ninth-most-valuable asset in the world” Time for some realism. FT.com
7https://blog.kaiko.com/volatility-and-correlation-bitcoin-vs-gold-fiat-and-equity-markets-4a32fe282994

Based on this framework we could argue that holding Bitcoin is a store of value like holding cash; it can be used to pay for goods and services. However, this comes with its own problems, first and foremost that most goods and services are not priced in bitcoins. Secondly, the prices of most ‘coins’, Bitcoin included, are so volatile that going to sleep and waking up 10% (or more) richer/poorer is commonplace (see Figure 2). This volatility implies uncertainty, so that even in the short term the amount of goods and services your bitcoins can purchase is unpredictable. Coupled with possibly high transaction costs this suggests that cryptocurrency currently falls short as a store of value to manage near-term known expenses.

Of course, there is the possibility that one day we may have transitioned to a world where cryptocurrency is adopted by the masses; Blockchain is clearly a powerful and useable technology. The question is if, and then which cryptocurrency will tick all the boxes for practical application in our day to day lives?

As financial planners, when we are designing client portfolios, we always start with one’s goals. Combined with an understanding of the above characteristics of each eligible security type, this provides a good framework to decide which securities deserve a place in a portfolio how big or small a slice of the pie they warrant.

Unlike stocks and corporate bonds, it is currently unclear whether bitcoins offer investors positive expected returns to grow wealth. Unlike Government bonds, they do not provide clarity about one’s future wealth. And, unlike holding cash, they do not provide an efficient means to pay for a wide range of day-to-day expenditures.  Without offering any assistance to meeting these investment goals, we fail to believe that Bitcoin, or cryptocurrencies in general, currently warrant a place in a portfolio designed to meet one or more of such goals. A goals-based approach such as this, based on stocks, bonds, and traditional currencies, considering the drivers of expected returns, has been helping investors effectively pursue their goals for decades.

If an investor decides bitcoins are a good investment, perhaps as a hedge against them ticking the boxes above, we suggest following the same framework used for our portfolio asset allocation. Compared to global stocks, bonds and traditional currency, the market value of cryptocurrencies remains less than 1%, therefore we believe their weight in a well-diversified portfolio should also generally be commensurate with this.

As with all developments in the markets, we continuously monitor and analyse new opportunities as they arise. Assets with positive expected returns, which can be captured efficiently and consistently will find their way into our portfolios in due course.