Bitcoin has long been treated as an upstart scorned by the mainstream investor world.
But over the past couple of years it has started to gain acceptance as a legitimate investment by established advisors and organizations.
A growing number of advisors and some large financial firms like Fidelity Investments have started to include bitcoin as a recognized asset class in traditional portfolios. Typically, they only award it one to five percent of the total portfolio value, but that’s still a huge turnaround in recognition.
Yet, despite bitcoin’s growing acceptance, it makes sense to remain skeptical.
Bitcoin is still very volatile and speculative and on that basis, I don’t consider it part of most average investors’ portfolios – not even for one to five percent.
The most that can be said is that buying bitcoins can make sense in certain situations provided you accept the risks and do not invest too much. This includes if you buy bitcoin (and other cryptocurrencies) for itself as part of your involvement in new technologies, where the investment is at most a secondary goal.
One of the major investment shortcomings is that bitcoin and other cryptocurrencies lack investment fundamentals. Unlike bonds, bitcoin does not generate any interest yield. Unlike stocks, you don’t own shares in the company’s earnings, cash flow, and dividends. Bitcoin therefore has no tangible basis for determining its value.
“The reason I don’t think there’s a place for it (in the portfolios of average investors) is that I still don’t see the fundamental case for it,” says Dan Hallett, vice president of the research at HighView Financial Group, an investment advisory firm. “If you don’t have a real way to determine a value today, you can’t know if you’re getting a good price for it.”
Instead, earning a return on bitcoin depends on what future buyers are willing to pay for it. With nothing tangible to rely on, the bitcoin market is heavily impacted by swings in sentiment, leading to huge swings in price.
The price of Bitcoin on Friday morning was near $50,000, down about 17% year-to-date. In 2021, its price reached over $75,000 in the spring and fall, but dropped to around $40,000 in July.
Bitcoin proponents consider it a good way to diversify their portfolios. But it has a limited balance sheet, and its role as a diversifier has not been tested during times of economic adversity, when the benefits of diversification tend to be greatest.
Many investors believed that bitcoin would help protect portfolios against events such as runaway inflation and geopolitical instability that we are currently seeing. But its prices have instead suffered a double-digit decline since the start of the year, similar to the overall decline in tech stock prices.
There are, however, two particular situations where investing in bitcoin can make sense:
The first niche reason to buy bitcoin is to be involved in the digital revolution that is reshaping the financial industry based on innovative technologies like blockchain, which provides secure and distributed database record for bitcoin transactions . Trying to earn a return on investment is not the primary motivation for owning bitcoin in this case.
Rather, owning it is an expression of identity and lifestyle — like buying art, says Hallett, citing the writings of portfolio manager and blogger Ben Hunt. “There is lasting value in good art, because it is a very rare thing and it never runs out,” Hunt writes. In this case, the inherent value of bitcoin is in the eye of the beholder. The lack of investment fundamentals is irrelevant.
Surveys show this to be a common motivation. A Bank of Canada study released in April found that only around 40% of bitcoin owners surveyed in 2018 and 2019 owned it primarily for investment purposes. Instead, most bitcoin owners said they were primarily motivated by reasons ranging from involvement in technology (around 26%), transactional purposes (17%) to mistrust to respect to the established financial system or the desire to make anonymous payments (17%). ).
Another rationale for buying bitcoin applies to people who have chosen to embrace speculative investing. Of course, making money through speculation is more difficult than making money through fundamental investing. You have to do some digging to try to understand the factors that could affect the value of your investment and you usually have to take a lot of risk. This is not an appropriate approach for most investors, but it is possible to profit from speculation under the right circumstances.
A key idea is that valuation based on speculation without fundamentals can be a double-edged sword. As noted technology analyst Henry Blodget said, the value of one bitcoin could be as high as $1 million or $1.
“There’s nothing fundamental to back it up,” Hallett says, “but there’s nothing fundamental to stop it potentially going to the moon.”
To stand a chance of speculative gains, you need to fully understand the dynamics of the bitcoin market, which is not easy. But there are thoughtful bitcoin advocates like Jurrien Timmer, director of global macroeconomics at Fidelity Investments, who have done careful analysis of bitcoin and concluded that the upside potential justifies the risks.
Timmer, in a 2021 Fidelity white paper, highlights the fact that bitcoin supply is limited with an ultimate cap of 21 million bitcoins. On the demand side, the growing adoption of bitcoin benefits from a network effect similar to that of many technology stocks. As more and more people use it, it becomes much more valuable to each user, potentially providing an exponential increase in demand.
According to him, bitcoin can act as an alternative store of value similar to gold, except that it is more scarce and the network effect adds “potentially exponential demand dynamics”. He therefore believes that bitcoin has the potential to encroach on gold to include it in portfolios “at some conservative level” alongside conventional assets like stocks and bonds.
Although there is some logic in his views, demand trends for new technologies are difficult to predict. History has shown that user growth and associated network effects for a new technology often collapse at some point. As Hallett points out, “You can look at tech investments like Myspace, like Vine, things that had very strong networks but lost them because something better happened. So that’s the big risk of tech .