Understanding Bitcoin: Risks and Rewards
Bitcoin, the original cryptocurrency invented in 2008, has been one of the market’s best performing assets with a gain of over 300% during 2020 and almost 100% so far during 2021. Bitcoin is also a technology, and it could be an inflation hedge, a tool to guard against political risks, a vehicle to democratize monetary policy, an anonymous method of transacting for unscrupulous players, or an investment. In short, the reasons someone may want to hold Bitcoin are abundant.
A common question we get is whether Bitcoin is a good investment. As with any investment, the answer depends on what it is worth relative to its price. Investments are traditionally valued based on the cash flows they generate. Future cash flows are then discounted back to today’s dollars. If that value is less than the current price, it signals that investors should sell under the assumption that the market price of the asset will move to its fundamental value in time. The issue with Bitcoin is that it does not have cash flows as a business does, making it impossible to value using standard models. Without a value that is anchored in economics, the price of Bitcoin goes up only when people act on their belief it will go up. Investors buy based on the story alone without the benefit of fundamental data. When the story changes, Bitcoin’s price changes. This is true of any cryptocurrency, making them speculative investments. In this context, “speculative” means the basis for the investment decision is based more on assumptions than on hard data, well-established relationships among quantifiable factors, and past experience in similar scenarios.
The long-term price trend for Bitcoin has been generally positive. However, its volatility has been 15 times higher than that of the US dollar in foreign exchange markets which are considered volatile in their own right. Bitcoin has experienced seven drawdowns of 70% or more in the last decade which compares to just one drop of that magnitude for the S&P 500 over almost a century. Bitcoin has experienced three bear markets, defined as price drops of 20% or more, so far this year. It lost 14% during a single hour of trading during April 2021. One Wall Street firm calculates that if you missed the 10 best days for Bitcoin between 2013 and 2019, the return on your investment would be an average annual loss of 44%.
Bitcoin is no longer unique, and the number of risks to its dominant position are growing. Thousands of similar crypto assets exist because barriers to entry are minimal. Although Bitcoin remains the largest cryptocurrency (based on market capitalization), its market share has fluctuated wildly since its launch. Some of Bitcoin’s competitors have arguably superior technology. Central banks are also entering the game with the launch of their own digital currencies that may serve as formidable substitutes for Bitcoin over time. Moreover, tightening regulation, taxation, and counterparty risks (as evidenced by theft directly from exchanges), offset some of the benefits of owning cryptocurrencies.
Some investors argue that Bitcoin’s low correlation with the S&P 500 of just .04 over the last 10 years makes it a welcome diversifier for stock risks. Other institutional analysts have determined that Bitcoin is a “risk-on” asset that does best when the S&P 500 is up more than 15% during a single year implying its price moves more in tandem with equities that it might otherwise seem. Bitcoin is certainly a disruptor and has gained legitimacy as its uses have broadened. Whether Bitcoin will continue its reign as the most widely used cryptocurrency over the long term is less than certain. Neither the risks nor potential returns are easily quantifiable. It is clear that a speculative position in Bitcoin could result in either large gains or losses, for short-term and long-term investors alike. This exemplifies the caution frequently given to investors that past performance is no guarantee of future returns. While we are bullish on the blockchain technology behind Bitcoin, we prefer to obtain exposure to its application to cryptocurrency indirectly via companies that are beginning to use, accept, or trade cryptocurrencies such as PayPal, JPMorgan, and Bank of New York Mellon, to name a few. The crypto market is still in its infancy, therefore we submit that for investors seeking to protect their wealth, calculated investments in companies profiting from increased use of cryptocurrencies is, for now, the more prudent way to gain exposure rather than holding substantial positions in the cryptocurrency itself.
