October 6, 2021
When it comes to investing, if you can’t clearly define what you are buying, you probably shouldn’t buy it. That has been a core element of my investing philosophy for a long time. It’s something I learned the hard way early in my career by purchasing investments I thought I understood but realized too late that I didn’t.
Therefore, when it comes to deciding whether I should buy Bitcoin, or any other cryptocurrency, the first and most important question to address is, “What exactly am I buying?”
Since Bitcoin is labeled as a “cryptocurrency”, let’s start there. Does Bitcoin behave like a viable currency? A currency is a medium of exchange. It facilitates the movement of goods and services among buyers and sellers. In that regard, one of the most important characteristics of a reliable currency is the ability to easily convert it to goods and services. Since Bitcoin can’t be used in most day-to-day transactions, it is difficult to argue that Bitcoin meets the standard for convertibility.
For a currency to qualify as a reliable medium of exchange, stability is also critical. A unit of currency that can buy you three loaves of bread today shouldn’t be able to buy you five loaves next week and two loaves the week after that. Bitcoin’s volatility is well documented. In each of the first nine months of 2021, the difference between Bitcoin’s high and low price for the month was more than 20%. In May alone, the price ranged from a low of just over $34,000 to a high of just over $59,000.1 This degree of price volatility is more akin to what would be seen in an emerging markets currency during a crisis period than to a stable medium of exchange.
So, despite the fact that the word “currency” is embedded in “cryptocurrency”, it seems like a stretch to view Bitcoin as a currency in the traditional sense. It’s possible that will change over time with growing acceptance and more stability in the “exchange rate” with the U.S. dollar and other developed market currencies. But there is little sign of that happening anytime soon.
So, despite the fact that the word “currency” is embedded in “cryptocurrency”, it seems like a stretch to view Bitcoin as a currency in the traditional sense. It’s possible that will change over time with growing acceptance and more stability in the “exchange rate” with the U.S. dollar and other developed market currencies. But there is little sign of that happening anytime soon.
Commodities in the precious metals, energy, and agriculture categories are used by investors to diversify their overall portfolio risk by shifting some assets away from stocks and bonds. Commodities like gold are viewed by many as a store of value and a hedge against inflation. Proponents of Bitcoin point to these same potential benefits as a reason for owning it, particularly as the level of debt issuance in developed market economies spurs concerns about the devaluation of fiat currencies.
Like other commodities (and unlike stocks and bonds), Bitcoin does not directly produce recurring earnings and cash flows and does not pay interest or dividends. Bitcoin’s price volatility also fits at least a little bit better with the commodity category, as prices for oil and other commodities occasionally experience large price moves over short time periods.
However, there is one thing that bothers me about putting Bitcoin in the commodity category.
Most commodities have two common characteristics. The first is utility, meaning that they can be consumed in a way that provides some type of basic benefit to humans. Agricultural commodities can be turned into food. Energy commodities can be used for fuel. Precious metals can be used to build or make something of value. Bitcoin does not have any practical use case in that context.
The second is scarcity. Commodities derive some of their value from the fact that supply is, or can be, limited. In some cases, there is simply a finite amount of the commodity available on the planet, while in others, factors like weather can greatly limit supply for extended periods.
In theory, Bitcoin meets the scarcity test. There will only ever be 21 million Bitcoins mined, and none will be mined after 2040.2 With a well-defined and limited supply, there should be meaningful scarcity value.
However, I think this depends on how supply is defined. If one confines it to just Bitcoin, then yes, scarcity value clearly exists. However, if one moves up a single level and defines it as the overall supply of cryptocurrencies, supply becomes essentially unlimited because there is little to prevent the creation of new coins. While data regarding the number of digital currencies in existence varies by source, it is likely that there are about 6,000, if not more, as of August 2021. And that number is up almost 50% in 2021 alone.3
Admittedly, the largest coins still dominate the market, and Bitcoin is far more established than most. But if there is enough demand, economic interest generally causes humans to produce the necessary supply to meet it. I’m concerned that the mass-production of digital assets will eventually have a negative “crowding out” impact on the scarcity argument for Bitcoin. It’s also possible that a better mousetrap will come along and turn Bitcoin into the “Palm Pilot” of cryptocurrencies.
Returning to the original question then, if I buy Bitcoin, what exactly am I buying? For now, the best I can do is that it feels like I’m buying a piece of digital airspace which has a value derived mostly from what the next person is willing to pay for it. In other words, it actually looks, walks and quacks like a purely speculative instrument. For that reason, I don’t own Bitcoin and have no plans to own it. We also do not purchase Bitcoin in our clients’ portfolios.4
As someone who has been in the investment business for a long time, one of my greatest fears is turning into “the cranky old guy who just doesn’t get it.” Experience can be a great asset, but it can also be a liability if it leads to dogmatic thinking.
One simple reason that I might be wrong is that after a certain point, perception can become reality. In other words, if enough people believe Bitcoin has value and are willing to act on that belief, it becomes true. In some ways, that’s the case with gold today. Certainly, gold has value as a metal and has scarcity on its side. But realistically, if 100 people were handed a bar of gold, the first thing 99 of them would probably think about is “Who can I sell this to?”. As a financial market asset, gold has value mostly because enough people say it does.
That may become true of Bitcoin as well, if it is not already. As large financial institutions create investment products and trading infrastructure around crypto assets, an element of legitimacy is leant to the space as a whole. While some may resent government interference, reasonable regulation would also bring with it credibility and a greater sense of permanence.
Further, the blockchain technology that underpins Bitcoin has the potential to be transformative, and the idea of a medium of exchange that isn’t subject to devaluation through money-printing is an attractive one. Bitcoin has a long way to go on that front, but technology and regulation may develop in a way that helps solve issues around reliability.
As mentioned previously, we don’t recommend owning Bitcoin as an investment, and we do not include Bitcoin or other cryptocurrencies in the portfolios we manage for clients. However, to state the obvious, there are plenty of highly intelligent and thoughtful people who are taking the opposite view.
If Bitcoin’s proponents are correct, it represents the future of finance. But the market for crypto assets is still fairly nascent, and until a more well-defined use case for Bitcoin exists, the range of potential outcomes is very wide. A terminal value of zero can’t be ruled out at this point. It is also worth remembering that most of Bitcoin’s run-up has been experienced during a period of general asset price inflation and greater-than-average speculative behavior.
Therefore, my advice for those who still want to buy Bitcoin is to think about it as completely separate from your core investment portfolio and to allocate only some portion of your assets that you can afford to lose. That way, regardless of the ultimate outcome, you will not be jeopardizing your long-term financial goals.
1. Bitcoin historical price data from Nasdaq.com
2. "How Many Bitcoins are Left?" coincentral.com, September 27, 2021
3. AnalyticsInsight.net, August 31, 2021
4. As part of our normal investment process, we do purchase broadly diversified exchange-traded index funds, some of which include companies that have business exposure to cryptocurrencies.
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