Has all the attention to “Bitcoin” and “cryptocurrency” got you wondering what all the fuss is about? The news around this is hard to ignore, so we thought we’d take a closer look. Although this will be a bit more technical, I hope it’s helpful as you continue to hear about this topic.
Our quick take? Cryptocurrency is an interesting development with a number of promising possibilities. Human ingenuity is always a marvel to behold. But like any relatively new, highly volatile pursuit, it entails considerable risk. If by chance you’ve thought of trading in it for fun or profit, we advise against putting in any more than you could afford to lose entirely. In our estimation, cryptocurrency remains more of a speculative venture than a disciplined investment.
With that, let’s take a look.
Beginning with Bitcoin
Cryptocurrency was introduced in 2009 by a pseudonymous Satoshi Nakamoto. Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption.
Bitcoin became the first cryptocurrency, and is still the most familiar kind. According to CoinMarketCap, Bitcoin had a market cap of nearly $600 billion as of January 22, 2021, with its closest competitor Ethereum at $140 billion. Market caps drop considerably after that, but there are plenty of others. As of September 30, 2020, a CFA Institute Cryptoassets Guide reported: “More than 6,000 different cryptoassets exist, and many new ones are created each month.”
Unlike a dollar bill, cryptocurrency only exists as computer code. You can’t touch it or feel it. You can’t flip it, heads or tails. But increasingly, holders are spending cryptocurrency in ways that emulate “regular” money (although limitations remain) – and potentially even adding to its uses. There’s also growing interest in trying to build or at least preserve wealth by trading in cryptocurrency, which some describe as being like “digital gold.”
Cryptocurrency vs. “Regular” Money
In comparing cryptocurrency to regulated fiat currency – or most countries’ legal tender – there are at least two components to consider: limiting supply and maintaining spending power.
- Limiting Supply: Obviously, if a currency “grew on trees” it would cease to have any value to anyone. That’s why central banks like the U.S. Federal Reserve, Bank of Canada, and Bank of England are tasked with limiting their currency’s supply, without strangling its demand. For Bitcoin, supply is limited to a maximum of 21 million coins. While cryptocurrency proponents offer explanations for how supply and demand will be managed, some systems will undoubtedly be more effective than others at sustaining this delicate balance, especially when exuberance- or panic-driven runs might outpace reason.
- Maintaining Spending Power: Neither fiat currency nor cryptocurrency are still directly connected to the value of an underlying commodity like gold or silver. Thus, both must have another way to maintain their value, or spending power, in the face of inflation. In most countries, the nation’s central bank is in charge of keeping its fiat currency’s spending power relatively stable; only the government can add or subtract from its supply of legal tender. For cryptocurrency, there is no central bank, or any other centralized repository or regulator. Stability is instead backed by its underlying blockchain.
What’s a Blockchain?
Using bitcoin to illustrate, a block is essentially a bitcoin transaction waiting to be settled. Think of it as being like a written, but uncashed check; it’s not real money until the transaction is verified and added to a permanent ledger.
Except there is no bank to complete the transaction. Instead, bitcoin “miners” compete against one another for the role. Each block is secured with a complex mathematical equation. The first miner to solve the equation gets to add the new block to a blockchain. The winning miner is then rewarded handsomely for their effort. They are paid with bitcoin, which can currently be valued at tens of thousands of dollars for settling a single block. [Source]
In other words, blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest, as any attempted “cheating” by cryptocurrency holders or miners should be promptly detected.
What About Trading Bitcoin?
How about trading in it, directly or in fund form? If you’re considering that possibility, know that, at this point:
- Cryptocurrency is a highly risky holding: For every cryptocurrency success story you read, there are plenty of other tales of woe.
- Cryptocurrency is not an investment; it’s a speculative venture: Bottom line, cryptocurrency doesn’t fit into our principles of evidence-based investing … at least not yet.
There are also transactional risks that can heavily impact cryptocurrency traders, such as:
- Potential loss or theft of an underlying cryptocurrency you’re holding
- Loss of equilibrium between a cryptocurrency’s supply and demand
- Governmental regulation hobbling a cryptocurrency’s growth potential
- The massive energy consumption required to mine cryptocurrency
If you’re saying to yourself “that’s a lot of risk,” you’re right. These and other risks have translated into an extremely volatile ride for cryptocurrency traders, and one reason you might want to think twice before piling your life’s savings into them.
Then again, every investment carries some risk. Without risk, there’d be no expected return. That’s why we also need to address an important difference between evidence-based investing vs. speculative ventures. It has to do with how we evaluate future expected returns.
What’s a bitcoin worth? A dollar? $100? $1 million? The answer to that has been one of the most volatile topics the market has seen since tulip mania in the 1600s. As described in this Wall Street Journal piece, bitcoin was trading for around $7,000 per coin in early 2020; as of this writing, the price topped $60,000. As time goes on there’s not much stopping it from being worth far more than that … or far less.
Here are a few financial educators/professionals weighing in on the matter:
“Bitcoin’s fundamental value is zero. … It’s almost all speculative.”
- Steve Hanke, Professor of Applied Economics, Johns Hopkins University
“[Bitcoin] is not a vehicle for investment, not a store of value, and not an inflation hedge. BTC is not a capital asset: it does not generate cash flows derived from economic returns on capital. Its extreme volatility invalidates claims of a reliable store of value and calls into question any inflation-hedging properties.”
— Alex Pickard, Vice President of Research, Research Affiliates
“Bitcoin depends on the faith of investors and nothing more. It could equally well go to zero tomorrow if 10% of investors sold.”
— Eswar Prasad, Trade Policy Professor, Cornell University
“You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”
— Alan Greenspan, former Federal Reserve Chair
Investing vs. Speculating
In other words, we’re not saying it’s impossible to profit from trading in cryptocurrencies. But the attempt more closely resembles a game of chance than an investment. In contrast, evidence-based investing enables us to create a unified portfolio we can manage according to YOUR individual goals and risk tolerances. Evidence-based investing calls for the ability to:
- Estimate an asset’s expected return, based on relatively well-established fundamentals
- Factor in how different asset classes interact with one another within your total portfolio
- Provide a sensible structure for embracing a long-term, buy, hold, and rebalance strategy
Cryptocurrency simply doesn’t yet synch well with these parameters. It does have a price, but it can’t be effectively valued for planning purposes.
Making Sense of Cryptocurrency
We hope this has helped you put this headline-grabbing subject in the proper context. Whether cryptocurrencies mature into mainstream transactional tools or they eventually wither on the vine, we remain available to assist you in managing your total wealth, in whatever form it takes.