At some point in most conversations lately, we have been getting the question: “What do you think about Bitcoin?” Which totally makes sense. Bitcoin has surged almost 280% in one year as of the date that I am writing this[1], and it is difficult to ignore an investment that gets notable commentary from investment powerhouses like Elon Musk and Warren Buffet. (Musk is notoriously bullish on crypto and Buffett is notoriously a critic.) In this post, we will discuss some key items to understand about cryptocurrency and specifically Bitcoin, along with some considerations about how these types of investments may fit into your overall financial plan.
Some basics of cryptocurrency
Cryptocurrency refers to digital currencies that are created and held electronically using blockchain technology. As a completely new form of currency, crypto provides fast, anonymous, low-cost transactions with other individuals and businesses who accept payment with this type of currency. There are hundreds of cryptocurrencies and Bitcoin is the most popular as it was the first and is the largest. Others you may have heard of include Ethereum, Litecoin, Dogecoin, etc.
What is a blockchain?
Essentially, a blockchain records details in a general ledger much like a database. However, the database is not stored in a single central location. Instead, a blockchain spreads the information over a large network. This creates transparency of transactions without access to personally identifiable information. It also allows de-centralization of control. Blockchain has been an exciting and disruptive technology that has many applications in the way we conduct business in the future.
Positive impact of cryptocurrency
There are some intriguing upsides of crypto. Here are some of the key
positives that investors should consider:
Decentralized control: Crypto is not controlled by a government or financial institution. This can be appealing for many who are seeking privacy.
No exchange rates: When you own crypto, you have a global currency. Once you convert your US dollars or other currencies to a cryptocurrency, that money leaves our current fiat money system, and your transactions will be based on the value of the cryptocurrency going forward.
Eliminating the middleman: With cryptocurrency, transactions can be made directly between individuals or businesses without an intermediary. This feature speeds up transfers, reduces transaction costs, and enhances privacy. However, keep in mind that there are costs for transacting on a cryptocurrency exchange.
Digital gold: Some investors have compared cryptocurrency to gold and other precious metals in that it acts as an alternative to our current money system. Skeptics of our current system feel that since we are not on a gold standard and monetary policy continues to print more money, our currency is not sustainable.
Opportunities for emerging markets: Cryptocurrency creates an opportunity in parts of the world that have less stable currencies to raise money and create wealth. Companies can raise money through new channels that haven’t been available in the past.
Challenges to crypto as a currency
If the positives above sound too good to be true, you may be on to something…
Government regulations: As the popularity of cryptocurrency escalates, so will the actions of governments to impose regulations. Governments are conscious of the threat of cryptocurrency to their ability to set monetary policy and tax earnings. In fact, South Korea has recently passed regulations to reduce money laundering and last week China banned financial institutions and payment platforms from offering services related to cryptocurrency.[2]
Lack of protections: Cryptocurrency is not legal tender. This means that it is limited to whoever will decide to accept it as payment. There are also no safeguards in place regarding transactions. For example, payments are irreversible and solely dependent on the agreement between the parties of the transaction. Crypto platforms are unregulated. They can be hacked or simply fail and there are no protections (No FDIC insurance).
Corruption: Cryptocurrency has become a way for corrupt organizations to raise money circumventing sanctions and other controls. This will likely spur oversight in the future.[3]
Taxes: If cryptocurrency is exchanged as a currency there is no taxation. However, the IRS provided guidance this year that cryptocurrency is considered an asset. This means that if you sell your cryptocurrency, you are required to report your profits just like any other investment.
Non-traditional currency produces negative carry: Currencies are different from investments in that we are paid interest to hold stable currencies like the dollar. However, with assets like crypto and gold, we can lose money by simply holding the asset (we can also make money through appreciation).
So…Should I invest in Bitcoin?
If we look at crypto as an investment, it has been hard to ignore. The chart below shows Bitcoin’s spectacular price performance over the last few years along with its spike in interest over this last year. However, along with spectacular price performance has come spectacular volatility. For example, the chart shows bitcoin’s price on 5/6/21 near its peak at $56,447 per share. As I write this, it is trading at about $37,000 per share.
What is Bitcoin?
Adding to the discussion of crypto above, Bitcoin has been gaining traction since about 2008. It is an interesting investment in that it is limited with only 21 million Bitcoins available to be mined (Currently there are approximately $18.7 million in circulation). The process of mining bitcoin involves complex algorithms that solve a series of calculations.
There is more opportunity than ever to use Bitcoin as currency since it has gained popularity. Mainstream exchanges like Coinbase, Gemini and Paypal are making it easier to store Bitcoin in online wallets and we see headlines everyday about large companies that are willing to accept Bitcoin as payment.[6] However, most of the popularity around Bitcoin is as an investment.
Where does it fit in the plan?
Diversification is an important part of the investing process and Bitcoin may be an acceptable asset to add diversification. It should be treated as a separate asset class from your stocks, bonds, cash, and real estate. As a piece of an overall portfolio, here are a few items to consider:
It is difficult to know how correlated Bitcoin is to the stock market. Some investors feel that crypto could act as a hedge against stock volatility. However, there is not a clear pattern of this being true and especially recently, Bitcoin has been highly correlated with moves in stocks.
Bitcoin isn’t widely available in mainstream brokerage platforms yet and primarily is bought on specific crypto exchanges. Legally, Bitcoin can be held in an IRA, however there are very few platforms that allow cryptocurrency in IRA accounts, so investors would have to find a platform that allows this type of direction of IRA money.
There are significant risks and headwinds that must be considered for Bitcoin to be a store of long-term value. We mentioned several challenges to crypto, in general, above. In addition, the process for mining Bitcoin is extensive and involves a large amount of energy. In fact: “cryptocurrency mining consumes roughly 0.6% of the world’s electricity — more than that used by the entire nation of Argentina, according to the Bitcoin Electricity Consumption Index maintained by Cambridge University’s Centre for Alternative Finance.”[7]
It is important to approach Bitcoin as we would any other investment when considering it as part of our portfolio. From a financial planning perspective our investments should serve a purpose in helping us reach our financial goals and should optimize returns while keeping our risk parameters in mind.
Whenever we build an investment portfolio, we always ask the following question: If you unexpectedly received $25,000 to invest and you had to pick one of the following, what would you pick?
A. A bank savings account, money market or CD
B. High quality bonds, or bond mutual funds
C. Large well-known stocks or stock funds
D. Speculative stocks that could be “home-runs”
Bitcoin would fall into category D or higher. We recommend treating
Bitcoin as a speculative piece of any portfolio and only allocating an amount of money to it that an investor is willing to lose. This means it should typically represent a small percentage of an investor’s overall portfolio.
Looking ahead
That ability to invest and transact with crypto is evolving almost as fast as the prices move. Keep in mind that while crypto has been around for over 10 years, it is still considered very new, and we don’t have a lot of data to evaluate. For investors, this creates opportunity and risk. We will be continually watching this new asset class and we will be available as a resource to discuss how it may fit into your overall financial plan.
[1] 1 yr return 280.39% as of June 3, 2021 https://www.marketwatch.com/investing/cryptocurrency/btcusd [2] https://www.reuters.com/technology/chinese-financial-payment-bodies-barred-cryptocurrency-business-2021-05-18/; https://www.coindesk.com/korea-crypto-anti-money-laundering-law [3] https://www.wsj.com/articles/israel-gaza-conflict-spurs-bitcoin-donations-to-hamas-11622633400 [4] Capital Group [5] Capital Group [6] https://www.forbes.com/sites/doylerader/2019/08/23/the-dallas-mavericks-are-now-accepting-bitcoin/?sh=581308c534b5 [7] Capital Group
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