It’s hard to scan the financial headlines these days and not spot at least one call to action related to Bitcoin’s latest moves. Some of you have asked us whether you should be considering it as an investment, and Dimensional Fund Advisors even addressed it briefly in its recent Investor Symposium. Has all the attention given you cryptocurrency fever, or are you at least wondering what it’s all about? Before you start loading up on bitcoin or any other form of cryptocurrency, let’s take a closer look.
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. In our estimation, cryptocurrency remains more of a speculative venture than a disciplined investment.
Beginning with Bitcoin
Cryptocurrency first hit the scene in 2009, launched by a pseudonymous Satoshi Nakamoto. Nakamoto described a new kind of money, or currency, meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption. Pair “encryption” with “currency,” and you’ve got cryptocurrency.
Bitcoin became the first cryptocurrency and is still the most familiar kind.1 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. But increasingly, holders are spending cryptocurrency in ways that mimic “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 – you should consider at least two components: 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 keeps 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]
The CFA Institute’s Cryptoassets Guide describes cryptocurrency security as follows:
“This is the real breakthrough of blockchains: creating timely, bad-actor-proof consensus across all copies of a decentralized and distributed database. … Today, more than 40,000 computers are independently verifying every single bitcoin transaction.”
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.
Cryptocurrency flows in peer-to-peer exchanges, which, at least in theory, enables it to be exchanged with fewer fees and administrative hurdles. Potential benefits include a faster and cheaper (or at least additional) way to conduct domestic and international commerce; a way to democratize currency exchange, particularly for those who live in places that lack dependable currency; and a way to make money more “programmable” by adding rules or conditions during an exchange. For example, this in-depth report describes how a cryptocurrency could potentially be programmed to act as a digital trust, contract, or escrow reserve, which could only be unlocked when certain conditions were met.
But even as the benefits make cryptocurrency attractive, certain challenges exist. Bitcoin can be stolen or lost, and with no central authority in charge of safeguarding your ownership or preserving your cryptocurrency’s worth, its purchasing power may or may not endure. In addition, we’re facing a bit of the “wild West” when it comes to oversight — because of its newness, cryptocurrency regulation is still in its infancy.
The Bottom Line
In short, cryptocurrency is a risky holding. For every success story you read, you’ll also find tales of woe. Also, cryptocurrency is not — in our opinion — an investment. It’s a speculative venture that doesn’t fit into our principles of evidence-based investing…at least not now.
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 AMDG Financial 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 sync well with these parameters. It does have a price, but it can’t be effectively valued for planning purposes.
1 You may notice, we sometimes capitalize Bitcoin as a proper noun, and we sometimes leave it as lower case. General practice is to capitalize the entity, “Bitcoin,” but to use lower case for the coins themselves. Think of it like the difference between “the U.S. Dollar,” vs. “a dollar bill.”