As financial professionals over the years evaluate the investment market’s performance during the pandemic and try to explain why the market has risen and fallen so much, a key story is the popularity of cryptocurrencies, particularly Bitcoin, as an investment. Whether it’s the story of a professional athlete making money with Bitcoin, or a high-profile CEO extolling the virtues of Bitcoin on Twitter, or the stock price of a publicly traded company taking a big hit when analysts find that a large portion of their quarterly gains come from a timely sale of Bitcoin, the perception once Bitcoin was not mainstream is no longer true. What is an investor to do with so many competing narratives about cryptocurrencies?
What is Bitcoin?
To begin with, Bitcoin is the best-known cryptocurrency – a digital currency that exists only in virtual form – and is often used as an acronym for all cryptocurrencies in general. Cryptocurrencies are created, tracked and traded through decentralized digital ledgers which, thanks to blockchain technology, are constantly open to all owners and users of the currency. In fact, when Bitcoin was launched in 2009, its creators envisioned it as an efficient payment mechanism that allowed a buyer and seller to transact without government or central bank regulation. Since its introduction, approximately 89% of all Bitcoins have been “mined” and put into circulation. However, according to SoFi, there will be as many as 10,000 different cryptocurrencies by April 2021, so the supply of these means of payment is far from limited.
Since the inception of Bitcoin, investors have been interested in its properties as an investment vehicle. It can be purchased and held separately, like a stock or bond, in brokerage accounts. It can also be purchased from a fund, which can be decentralized (holds Bitcoin and other cryptocurrencies) or non-decentralized (holds only Bitcoin). Several indices similar to the Dow Jones Industrial Average or the S&P 500 have been developed to track the performance of cryptocurrencies and other metrics, and those performances have been breathtaking and volatile. In 2017, Bitcoin rose 1,331%, then fell 73% in 2018, 95% in 2019 and 301% in 2020, and the bullish and bearish swings of 2021 have been similarly volatile thus far. Such returns have naturally attracted the attention of the investment community.
How are cryptocurrencies suitable for investing?
How should we approach Bitcoin and other cryptocurrencies in the investment market? I think an important factor is determining whether cryptocurrencies are better suited as trading instruments intended to be held for only a short period of time rather than as investment vehicles or stores of value designed to be held for the medium to long term. As a trading tool, I think Bitcoin in particular is excellent. Trading volumes are high, price volatility is high, and there are several exchanges and trading platforms available for both retail and institutional investors.
Let’s look at the case of cryptocurrency as an investment vehicle and store of value. In a 2018 study, Yukun Liu and Aleh Tsyvinski concluded that investors should hold 6%, 4% or 1% of their portfolios in cryptocurrencies, depending on whether they believe future returns will be at least half or worse of, in the Past. performance, respectively. As recently as early 2021, the global market value of stocks and bonds was estimated at $200 trillion, while the global market value of cryptocurrencies is around $1.75 trillion. Therefore, some might argue that all wallets should contain at least 0.5% of Bitcoin and other cryptocurrencies to adequately reflect the diverse investment landscape and growing demand and growing market capitalization of cryptocurrencies.
How are cryptocurrencies different from other investments?
When considering Bitcoin as an investment, we should view it differently from other common investments such as stocks and bonds. Stocks, of course, are an ownership interest in a company that has assets and presumably generates cash flow for the owners. Investors have different views on the value of cash-generating assets that cause price changes, but ultimately, there is an economic basis for determining a company’s value. The same cannot be said of Bitcoin, for example. Bitcoin is compared to digital gold. Like gold and other commodities, Bitcoin does not generate cash flows and its value is determined primarily by its limited supply and growing demand, and by what investors collectively refer to as its value. Therefore, the volatility of prices is much higher than that of the stock market. So far, traders and investors have been richly rewarded for taking the biggest risk of investing in Bitcoin.
As you know, traders and investors are notoriously fickle when it comes to pricing assets. In times of panic, a company’s ability to generate future cash flows limits the decline in its stock price. There is no comparable mechanism to slow the downward spiral in the case of gold and other commodities, or in the case of cryptocurrencies like Bitcoin. These issues could be overlooked if investors were confident that adding Bitcoin to their investment portfolios would provide a real diversification benefit. For example, gold is often held in portfolios based on long-term evidence that gold is a hedge against inflation and will often rise when stocks fall and vice versa. So far, we have seen no consistent evidence of Bitcoin’s comparable performance in falling stock markets that would fully justify its diversification or hedging potential.
I don’t want to crown Bitcoin and other cryptocurrencies as the “next big thing” in modern diversified portfolio management. Perhaps more acceptance by more investors is needed for these investment vehicles to mature and develop into a true investment asset class. We may need a longer time horizon and at least a few investment cycles to learn the characteristics of cryptocurrencies during the bull and bear markets and the ups and downs of our global economy to reveal the real value of adding them to a well-diversified pool. suitcases. Until then, I believe the buying and selling of Bitcoin and other cryptocurrencies will likely remain speculative trading, not sound investment strategy and long-term financial planning.