Should You Invest in Bitcoin?

Innovation never sleeps and in the age of technology, it seems like the moment you rest your eyes, you miss another leap forward. You wake up to new technologies and innovations and the new rules they play by and new rules they demand you understand in order to play along. One of those innovations that you might feel out of touch with is cryptocurrency. And there is no missing that news surrounding this recent leap forward. With its recent rise in adoption and whirlwind of information, we wanted to take a deeper dive to make sense of all the news that's swirling around.

We’re going to just focus on Bitcoin. But, in the end, if any cryptocurrency achieves mainstream adoption, the outcome will be similar. Also, given the short time horizon and strong adoption of Bitcoin, it has the most and highest quality data available. It’s important to note, not all digital assets are the same. Just like other software, there are many distinctions and use cases. Bitcoin, at this time, is competing to be a store of value and a borderless currency. 

So… is it even real money?

The most common thing we hear when discussing cryptocurrency is a lack of trust; “it makes no sense, it's hard to understand, and it isn't real.” Let’s start with the latter and quickly explain what fiat money is and what makes it “real.”

Fiat money is a type of money that is backed by a country’s government and not by any physical commodity such as gold or silver, and that is typically declared by a government to be legal tender. Most coin and paper currencies used around the world are fiat money, including the British pound, the Indian rupee, the euro, and yes, the U.S. dollar.

Since 1971, when we left the gold standard, the dollar's value is based on supply and demand. While intuition would suggest the demand for money is unlimited, we must keep in mind that demand is fluid and always changing. The more a U.S. dollar will buy relative to other countries, the higher the demand and vice versa.

A currency's strength is determined by many factors: supply, interest rates, monetary policy, trust in the government, etc. All factors that the issuer (i.e., the government) can control and thus manipulate. If manipulation was occurring, that would be obvious, right? Of all the dollars in circulation, it's estimated that only ~11% exist in physical form (i.e., bills and coins). This is because vast amounts of money are created through a system called fractional reserves, not the Fed printing money. This is a system in which banks loan more money than the physical cash they have in the vault. When the money "created" by that loan makes its way to another bank, they too can lend out more than what was deposited and so on. And, you guessed it, since there's no physical cash, it's all digital. It's hard enough to wrap your mind around the supply of money in the U.S., and that is only one factor in the dollar's value.

The first form of exchanging goods came in the form of bartering. While that worked, using precious metal coins was much more efficient. Quite frankly, if not for the internet, that system would still likely be the best alternative. But since you cannot pay someone with physical money online, the system had to change.

Money has evolved over time

Enter the first cryptocurrency, Bitcoin. A currency created based on rules of its code, which everyone has complete access to, and has a finite supply of 21 million coins. With this, everyone knows how it's made, no one person can manipulate the process, and the supply is constant. It created a system of transactions based strictly on supply and demand. With a fixed supply, its value isn’t devalued by an increasing supply (i.e., inflation). Also, since there’s no central authority, the only way to eliminate access is to cut off the internet. It levels the playing field for citizens whether under a corrupt regime or a superpower. And just as importantly, it reduces the need for more expensive financial intermediaries, like banks. 

Cryptocurrencies eliminate the need for the more expensive middlemen. When you swipe your credit card, the company pays the bill and charges what is known as a swipe fee for it. These banks have to keep records of who owes what, make the payments, collect on debts, etc. All of which require a lot of time and money to do. With cryptocurrencies, you can pay another user directly, cutting out many of these unnecessary fees.

Is it worth investing in?

The million-dollar question. Since fiat money is not going away any time soon (possibly ever), should we consider Bitcoin as an investment?

Like most things with investing and cryptocurrencies, logic does not always prevail. Given that cryptocurrencies are one of the highest risk assets, you would think the only way it would make sense is if it adds more return than it does risk, in turn, creating a higher return portfolio with larger price swings. But, historically, that's not the case. The amount of risk added by anyone asset depends on not just its individual risk but how it behaves compared to the overall portfolio's risk. In laymen's terms, if its price swings coincide with the current portfolios, then its addition will only affect the portfolio marginally. However, if it swings in the opposite direction, it dampens the strength of the swings (smaller swings = less risk). This is why you hold both stocks and bonds. 

In the case of bonds, not only do they lower the risk of a stock portfolio, but they also lower the expected return. Historically, this is because their gross risk and return are both lower than stocks. Cryptocurrencies on the other hand could increase expected return while lowering risk. Why? In the past, they had higher returns than bonds, and their price was not correlated to stocks. Cryptocurrencies could reduce the risk and increase the expected return of a stock portfolio and they could do the same for a diversified portfolio as well.

If it's that simple, why aren't all asset managers adding it to their portfolios? The math is that simple. If you apply a historical return, standard deviation, and correlation, it absolutely makes sense to invest in Bitcoin. However, the issue is not what happened in the past, but what is expected in the future. Given that Bitcoin's utility is less intrinsic than that of other stocks, bonds, gold, etc., it's much more difficult to calculate an expected return and correlation. 

Takeaway

Overall, cryptocurrencies could reduce the risk and increase the expected return of a stock portfolio and they could do the same for a mixed portfolio as well. 

Bitcoin could be a good investment to add to a diversified portfolio, or at least should be considered for its potential. However, we must keep in mind that quality data for this asset only goes back to 2011. With such a short time horizon, it's impossible to know the long-term trends or if the data is skewed in one direction or the other.

Cryptocurrencies, born just over a decade ago, disrupted everything we are comfortable with and redefined the rules. Of course, there are naysayers. Especially when the incumbents (i.e., banks and other financial intermediaries) have so much to lose. It's simply human instinct. Blockbuster didn't embrace digital media and Blackberry didn't believe in smartphones. But look at Netflix and Apple now.