A Crash Course in Cryptocurrency
Cryptocurrencies like Bitcoin are receiving intense media coverage. Do these new types of electronic money deserve a place in your portfolio?
Before we dive in, here are brief definitions of concepts you’ll need to know to understand cryptocurrencies.
- Cryptocurrencies were developed in 2009 during the Great Recession due to a high distrust of traditional banks. Unlike traditional money, no paper notes or metal coins are involved with crypto. No central bank issues the currency, and no regulator or nation-state stands behind it. It is mined using special software and stored in a digital wallet. Popular types are Bitcoin, Ethereum, and Litecoin.
- Blockchain was developed as a ledger for virtual currencies and is the big story behind crypto. Blockchains are digitized, decentralized, permanent public ledgers. This 6-minute video does a good job of explaining how a blockchain works and how it ensures data is verified.
For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. The assets are extremely volatile. For example, in mid-December 2017 the market value was $19,783 per Bitcoin1 and the total value of Bitcoin in circulation was less than one tenth of 1% of the aggregate value of global stocks and bonds; at the time of this writing in July 2018, the value of a Bitcoin has dropped to less than $6,7002, with a finite supply of 21 million3 and more than 16 million4 in circulation.
Bitcoins can be earned several ways. Some people buy them using traditional fiat currencies5. Others “mine” them, receiving newly created Bitcoins by using powerful computers to solve highly complex mathematical puzzles to compile recent transactions into new blocks of the transaction chain.
What are investors to make of all this media attention—and volatility? What place does Bitcoin play in a diversified portfolio? Can we predict its future value?
We can approach these questions by examining the role that stocks, bonds, and cash play in your portfolio.
Stocks, Bonds & Bitcoin
Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. Holding these securities in a portfolio provides positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.
Holding cash does not provide an expected stream of future cash flow. One U.S. dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat 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. Holding cash in local currency provides a store of value that you can use to manage near-term known expenditures, such as a car purchase or emergency reserve.
With this framework in mind, one could argue that holding Bitcoins is like holding cash; they can be used to pay for some goods and services. However, most goods and services are not priced in Bitcoins.
The price volatility of cryptocurrency implies uncertainty in the amount of future goods and services it can purchase. This uncertainty, combined with possibly high transaction costs to convert Bitcoins into usable currency, suggests that crypto 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 with Bitcoins.
Supply and Demand
The price of a Bitcoin is tied to supply and demand. Although the Bitcoin supply is slowly rising, it may reach an upper limit, which could imply limited future supply. The future supply of all cryptocurrencies, however, may be very flexible, as new types are developed and tech innovation makes many of them close substitutes for each another, implying the quantity of future supply might be unlimited.
Future regulation adds to this uncertainty. In a note to investors in 2014, the U.S. Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns6.
Initial Coin Offering (ICO) is a way for startups to raise money for new crypto ventures. Beware that ICOs are not regulated in the ways that traditional IPOs are.
Today’s Bitcoin price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in Bitcoin’s price today.
What to Expect
Should we expect the value of Bitcoins to appreciate? Maybe. But as with traditional currencies, there is no reliable way to predict how much or when. 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 (like with bonds), and they don’t entitle the holder to a residual claim on the future profits of global corporations (like with stocks). And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term expenditures. Because Bitcoin does not help to achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more such goals.
None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of Bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.
Top 4 Things to Know About Investing in Cryptocurrencies
- Invest only what you are willing to lose. While FOMO (fear of missing out) can be tough to avoid, we consider crypto similar to loading up on one individual stock: a diversified portfolio is the best way to achieve your financial goals.
- The IRS views cryptocurrencies as capital assets. If you sell a cryptocurrency, you’ll recognize a gain or loss that you must report on your tax return—whether the exchange you sell on issued you a Form 1099 or not.
- Make sure your heirs know your passwords. Leave passwords for online wallets and accounts in a secure place, such as a safe deposit box. Do not include the passwords in your will, since wills become public record upon death.
- Make sure your estate documents note where you want crypto assets to go upon death. Crypto is considered personal property and as such is part of the value of your personal estate.
When it comes to designing a portfolio, begin with your goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of your portfolio to allocate to that security.
Compared to global stocks, bonds, and traditional currency, Bitcoin’s market value is tiny. So, if for some reason an investor wants to hold Bitcoins, we believe their weight in a well-diversified portfolio should generally be tiny, too7.
For cryptocurrencies to have a permanent place in commerce going forward, they may need to become regulated, easier to use, and less volatile.
- Per Fortune, “Bitcoin Hits a New Record High, But Stops Short of $20,000,” accessed July 16, 2018.
- As of July 16, 2018. Source: CoinDesk.com.
- Source: Bitcoin.org
- As of December 14, 2017. Source: Coinmarketcap.com.
- A currency declared by a government to be legal tender.
- “Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014.
- Investors should discuss the risks and other attributes of any security or currency with their advisor prior to making any investment.
The opinions expressed are those of the author and are subject to change. The commentary above pertains to bitcoin and other cryptocurrency. Certain bitcoin offerings may be considered a security and may have different attributes than those described in this paper. Our firm does not offer bitcoin.
This material is not to be construed as investment advice or a recommendation to buy or sell any security or currency. Investing involves risks including possible loss of principal. Stocks are subject to market fluctuation and other risks. Bonds are subject to increased risk of loss of principal during periods of rising interest rates and other risks. There is no assurance that any investment strategy will be successful. Diversification does not assure a profit or protect against loss.
With thanks to Dimensional Fund Advisors.