If you have followed the financial news in the past year, you may have heard a lot of buzz surrounding cryptocurrencies, including Bitcoin. And that buzz includes investors trying to determine how they can get in on the cryptocurrency investment train. Although there are literally thousands of cryptocurrencies in existence, the focus of this blog will be on Bitcoin as it is the most well-known and has the largest market capitalization in this area.
What is Bitcoin exactly?
Bitcoin (symbol BTC at Coinbase.com) is a decentralized digital currency, without a central bank or single administrator, that can be sent from user to user on the peer-to-peer Bitcoin network without the need for intermediaries. Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain. Bitcoins are created as a reward for a process known as mining. They can be exchanged for other currencies, products, and services. (This description is repeated verbatim from Wikipedia.org.) However, it provides a basis for what investors should know. Years ago, most people would have needed a “dummies guide” to understand Bitcoin. However, with the increasing coverage that cryptocurrencies, and Bitcoin specifically, have received in the financial media over the last few years, more and more people are becoming aware of them and how they work.
I like to describe Bitcoin simply as a digital currency because there is no physical currency involved. Some investors refer to it as digital gold and think it may one day replace physical gold as a store of value. The currency itself is created and exchanged through a decentralized computer network. Thus, there is no centralized control of the Bitcoin currency by one computer, company or country. As a result, there exists a fair amount of anonymity to transactions made in the currency. Unfortunately, this makes the currency ripe for use for illicit purposes, but it also provides a lack of transparency that many may find advantageous even when involved in legal business transactions.
Users who get involved in the transaction end of the Bitcoin marketplace are known as “miners” and they can receive payment (in Bitcoin, of course) for the computing power they provide to create and provide maintenance for the blockchain. The blockchain is the public log that records Bitcoin ownership currently as well in the past. Cryptography is used to protect the integrity of the blockchain.
Bitcoins were initially mined and created in January 2009, following a protocol outlined by an anonymous developer known as Satoshi Nakamoto. It is not publicly known who Nakamoto is or even if the name refers to an individual or a group of people. As of 2021, there are approximately 18 million Bitcoins in circulation and although additional Bitcoins are in the process of being created by miners, there is an upper limit of 21 million Bitcoin that may ever be created. According to Bitcoin.com, this limit would be reached by the year 2140. As you can see, the creation of Bitcoins is expected to slow dramatically as each year passes. The limit on how many Bitcoins can be mined is an important distinction between “digital gold” and physical gold. Physical gold technically has a finite limit, but we do not know what that limit is until all gold is mined. With Bitcoin, we know the limit and approximately when it will be reached. Many proponents of Bitcoin believe that the limited supply provides a hedge against inflation that the US dollar does not. As we have seen in 2020, the Fed can increase the supply of US dollars when needed to provide short-term liquidity for markets even though this may lead to higher inflation long-term.
There are a couple of ways to acquire Bitcoins directly either by acting as a miner, accepting Bitcoins in payment for goods or services (Tesla just announced they will accept Bitcoins) or the most common these days, which is buying Bitcoins from an exchange such as Coinbase.com, Gemini.com or Bitcoin.com. Some brokerage firms, such as Robinhood, also offer buying and selling of Bitcoins. Exchanges and brokers have different fees involved in purchasing and selling Bitcoin and it is important to understand the difference in costs.
Other digital currencies can compete with Bitcoin, including Ethereum, Litecoin and Bitcoin Cash to name a few of the more established currencies. However, several large institutions appear to have greater acceptance toward Bitcoin and have made investments including MassMutual and some mutual funds such as BlackRock have added language to allow their funds to invest in Bitcoin.
Bitcoin as an investment
The volatile price moves in Bitcoin are at the root of my concerns with them as a long-term investment. Bitcoin was worth $5,000 US in March of 2020 during the market sell-off. In the past year alone, the currency has appreciated to break its all-time high of $20,000 in late 2020 and then proceed to $40,000 and just recently $50,000. For Bitcoin to work effectively as a currency, it cannot have these kinds of dramatic fluctuations in price over short periods of time. These rapid price swings are, in my opinion, due to rampant speculation about the future value of the currency. If investors’ willingness to bid up the value of the currency declines, so will the price of Bitcoin. While the trend in the past 12 months has been wildly up, there is no guarantee that trend will continue. Some suggest that as the price rises higher it will eventually become less volatile, but only time will tell whether that is true.
Many questions exist about the stability and long-term viability of digital currencies and therefore, I recommend investors be cautious if they are considering an investment in Bitcoin or other cryptocurrencies. As a digital currency, Bitcoin has no revenues or earnings which makes it difficult to value. Some believe that the amount of activity on the blockchain or number of active nodes is a possible valuation metric. At the end of the day, the price of Bitcoin is based upon what others are willing to pay for it.
Bitcoin is not currently regulated by the SEC, Federal Reserve or any US government agency; although, in recent years cryptocurrencies have increasingly been on the radar of regulators and lawmakers. In late 2020, the founders of a cryptocurrency named Ripple (XRP) were sued by the SEC who claimed that Ripple is a security and not a currency. The SEC is alleging the founders of XRP did not properly register it as a security with the SEC. The outcome of this legal challenge will be very interesting to watch and will likely have an impact on other cryptocurrencies including Bitcoin.
At Bloom, we are currently not recommending or including Bitcoin in our asset allocation strategy. When we consider assets for inclusion in our strategies, our goal is to include assets that provide a solid risk adjusted return and to have a mix of assets that do not correlate highly to each other. This provides diversification within a portfolio. While Bitcoin would have added to returns over the last few years, it would have also increased the volatility and risk of portfolios substantially. As far as correlation, Bitcoin dropped more precipitously than stocks during the recent March 2020 correction, so they seem to add more risk to a portfolio and do not provide a benefit of non-correlation. Historically, the best way to control risk and return is to control the percentage of stocks vs. bonds in a portfolio. The more stocks you own, the greater risk and potential return, and the more bonds you own, typically the less return and risk you will have.
I believe that over time, some of our funds, the more growth-oriented ones, will likely invest into companies that are involved in the cryptocurrency industry if they believe the companies represent solid long-term growth opportunities. What I like about this alternative approach is that an investor can get involved in the potential opportunities of the cryptocurrency markets, but still do so through ownership of a physical company with revenues and earnings as opposed to owning the currencies directly, which tend to be much more volatile and have no underlying business. We will continue to monitor and evaluate the cryptocurrency area with much interest.
Just like with any other investment, you need to know what you are looking to accomplish with the investment, what risk you are willing to take, how to get in and out of the investment and what fees or other costs are involved. If an investor is determined to make an investment in Bitcoin or other cryptocurrencies, I recommend they expose no more than 1% of their portfolio to the area in order to limit their downside risk.