What Should Investors Make of Bitcoin Mania?
Investors everywhere have seen Bitcoin in the headlines of most major media outlets recently. Here at CCMI we have been getting questions about the digital currency and wanted to share this informative article adapted from a Dimensional Fund Advisors (DFA) article explaining what Bitcoin is, how it’s created, and how or if you should view it from an investment perspective.
Cryptocurrencies, such as bitcoin and others like it, have emerged in the last decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or country stands behind it.
Instead, cryptocurrencies are a form of programing code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million bitcoins, of which more than 16 million are currently in circulation. Transactions are recorded on a public ledger called blockchain. The blockchain keeps a complete record of all bitcoin transactions worldwide, forever.
People can earn bitcoins in several ways, including buying them using traditional currencies or by “mining” them. Mining involves receiving newly created bitcoins as payment for using powerful computers to compile recent transactions into new blocks of the transaction chain (“blockchain”) through solving a highly complex mathematical puzzle. This practice of mining allows Bitcoin to work securely, consistently, and anonymously, and it serves as a way for computer experts to earn more bitcoin and increase its circulation.
What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply and most recently has quickly declined in value. What about its future value?
EXPECTED RETURNS
Holding cash, whether a cryptocurrency or traditional currency, 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 other currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.
The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies.
With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins.
A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with high transaction costs of 4% to 10% to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.
WHAT TO EXPECT
So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. The laws of supply and demand apply to Bitcoin, just as they do to other currencies, but there is an argument to be made that there could be an unlimited supply of cryptocurrencies if several different types go into circulation.
We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.
Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in traditional currencies, they don’t provide the means to plan for a wide range of near-term known expenditures.
If, however, you believe bitcoin is well suited to fit some other investment goal, consider the following. When compared to global stocks, bonds, and traditional currency, the cryptocurrency market value is tiny. So, if for some reason an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny.
Because bitcoin is being sold in some media outlets as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.
CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
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