If you’ve been watching, reading or listening to financial news over the past few months (or any news for that matter), you’ve likely heard quite a bit about the drastic run-up in value that Bitcoin and other cryptocurrencies have enjoyed.
The price of a single Bitcoin 12 months ago on January 30, 2020, was $9,388.88. Fast forward to January 30, 2021, the value of a single Bitcoin has risen to $34,207.29.1
While Bitcoin might have been a successful investment over the past few months for some who were lucky enough to time the volatility correctly, the question inevitably becomes, is Bitcoin a good investment?
To explore this question of whether Bitcoin is a viable long-term investment option that should be part of your portfolio, and relay our thoughts on the topic, we’ll first talk about what Bitcoin is, and then look into what factors you should consider when thinking about investing in Bitcoin and other cryptocurrencies.
What is Bitcoin?
The answer to even this seemingly straightforward question varies depending on who you ask. For some, Bitcoin is similar to gold and acts as a store of value; for others it represents a currency or legal tender like the U.S. dollar. For the sake of this article, we’ll aim to discuss Bitcoin from both perspectives.
By most definitions, Bitcoin is a digital cryptocurrency and runs on a blockchain-based network. Bitcoin was created on January 3, 2009, by a computer programmer under the pseudonym of Satoshi Nakamoto. It was created as a decentralized digital currency that can be used to easily transfer large sums of money between individuals anywhere around the world without the oversight of a centralized authority or governmental entity.
Given this decentralized nature, Bitcoin differs from the more common fiat currencies (a currency established as money by government regulation, like the U.S. dollar) that we use on a daily basis to purchase goods and services. One of the key differences between fiat currencies and cryptocurrencies like Bitcoin is that fiat is issued and regulated by a governmental entity.
When it comes to acquiring Bitcoin, the two most common routes are to either purchase cryptocurrencies on exchanges to buy or sell such as Coinbase or Robinhood, or to open a Bitcoin wallet.
Purchasing Bitcoin through an exchange to buy or sell is relatively straightforward, but there are a few potential areas of concern. Transactional fees for cryptocurrency trading remain very high relative to the cost of trading stocks or bonds.2 Additionally, there can be significant spreads between what individuals are willing to buy/sell cryptocurrencies for due to a lack of liquidity, which can lead to unfavorable and volatile price movements.
For individuals looking to open a Bitcoin wallet, this is essentially as if you opened a separate bank account designed to hold Bitcoin. One of the main benefits of using a wallet is also one of the main downfalls: security. Some digital wallets may require what is known as a private key. This private key acts as a password, and can consist of up to 64 randomized numerical and alphabetical characters, and you need to have this private key in order to access your wallet.
If you forget or misplace your private key, you have a set number of attempts to guess the private key before you become locked out of your wallet and possibly lose your Bitcoin, which in the case of one gentleman from the United Kingdom, meant he lost approximately $280 million worth of Bitcoin.3
What factors should you consider when thinking about investing in Bitcoin?
Cash flows from investment
First and foremost, when it comes to investing, we want to think about what cash is generated from the investment. While stocks can provide dividend income, and bonds can provide coupon and interest payments, cryptocurrencies don’t provide any sort of income. If you purchase one Bitcoin today, three months from now you will still only have one Bitcoin.
While some companies have recently developed interest-earning accounts to hold Bitcoin, as things stand today, Bitcoin does not produce (or ever will produce given the current technology) income as part of the investment.
Investing in Bitcoin or any other cryptocurrency is making a bet that you’ll be able to sell your holding at a higher price in the future. Similar to investing in gold, which I wrote about towards the end of 2020, investing in cryptocurrency is pure speculation. You’re assuming the risk that someone will pay a higher price in the future for your cryptocurrency, and you are also accepting the fact that in the meantime of holding your investment, you will not receive any type of income stream directly from that investment.
Bitcoin scarcity, concentration of ownership and emergence of other cryptocurrencies
An interesting aspect of Bitcoin is thinking about the actual number of Bitcoins in existence. When Bitcoin was originally designed by Satoshi Nakamoto back in late 2008/early 2009, it was created so that there is a limit on the total number of Bitcoins that can be mined, and that cap is 21 million. Some proponents of Bitcoin view this as a positive sign in that with a limited supply, over the long-run prices will continue to ramp up (remember the section on speculative investing a few paragraphs ago?). There is some logic behind this, but the scarcity of Bitcoin also leads to a lack of liquidity and often extremely volatile trading periods.
While there may be a cap on the number of Bitcoins that can be mined, there certainly isn’t a cap on the number of cryptocurrencies that are coming to market. According to CoinMarketCap, as of January 30, 2021, there were 8,363 different cryptocurrencies.4 This sheer number of cryptocurrencies represents a risk for crypto investors because there’s no way to know which currency will be the most prominent or widely used moving forward, and a potential oversupply of cryptocurrencies could outweigh demand and lead to decreasing valuations.
Additionally, while the amount of news coverage surrounding Bitcoin may lead investors to think it makes up a significant piece of the overall investment landscape, as of January 31, the market cap of Bitcoin was $617 billion, and the market cap of all cryptocurrencies was $990.4 billion.5 To put that in perspective, there are five different individual stocks (Apple, Microsoft, Amazon, Google Class C and Class A) that each have a larger market cap than the entire cryptocurrency asset class.6
When individuals are constantly listening to or watching news about Bitcoin and hearing about how it’s a decentralized currency that anybody can hold or access, it’s reasonable for them to then assume that Bitcoin has a relatively widespread ownership.
In reality, that’s about as far from the truth as it could possibly be. According to recent Bloomberg reports and the research firm Flipside Crypto, “about 2% of the anonymous ownership accounts that can be tracked on the cryptocurrency’s blockchain control 95% of the digital asset”.7 The fact that nearly 95% of all Bitcoin is held by roughly 2% of the largest Bitcoin investors, commonly referred to as “whales,” provides a stark rebuttal to the notion that Bitcoin is a “currency or asset for the people.” This extreme concentration of ownership is another factor behind the lack of liquidity and extreme volatility that we commonly see with Bitcoin. If a “whale” investor decides to liquidate a significant portion of their holdings, that could cause a drastic movement in the value of Bitcoin.
As alluded to above in the whale investor example, and as you’ve likely seen in the news, Bitcoin has experienced quite a few bouts of volatility recently. Whether we look at when Bitcoin dropped more than 70% in 2018,8 lost roughly $150 billion of market cap (10% drop) in the beginning of January 2021 on a single day9 or jumped roughly 14% in a day largely due to a single tweet,10 it’s undeniable that Bitcoin and volatility are intertwined.
While this extreme volatility can be profitable for those lucky enough to time their investment correctly, it also presents an immense amount of risk. In order to try and time a Bitcoin investment, or time the markets in general, you need to be right twice. You need to get invested at the right time (preferably at a low) and sell at the right time (at a high).
This volatility also presents a significant near-term hurdle to Bitcoin and other cryptocurrencies becoming widely accepted as a means of currency, which is what Bitcoin is often pioneered to be. One of the key tenets of being a widely accepted currency is that a currency represents a stable form of value. If we think about the U.S. dollar as an example, yes, there are some fluctuations in the dollar’s value, but at the end of the day, it’s negligible relative to the fluctuations we see for the most prevalent cryptocurrencies. If an employer offered to pay an employee two Bitcoins per year as their salary, the value of that annualized salary would likely fluctuate drastically on a daily basis.
To put this in perspective, let’s look at some data we pulled from Morningstar. Volatility can be defined as a statistical measure of the variation of returns for a given investment and is often measured by standard deviation. The higher the standard deviation, the higher the volatility, and zero represents no variation.
Below is a chart detailing the standard deviation of the U.S. dollar relative to a basket of foreign currencies, compared to Bitcoin represented by the CMBI Bitcoin Index over various timeframes.
As we can see, regardless of what timeframe we look at, Bitcoin’s standard deviation is more than twelve-fold that of the U.S. dollar. This tells us that there are quite some ways to go before Bitcoin can achieve that stable form of value needed to be a widely accepted currency.
Regulatory concerns and potential fraud from ICOs (initial coin offerings)
At its core, Bitcoin is a decentralized asset that is not governed by a single regulatory entity. However, many governments around the world are uncomfortable with the notion of an asset class that isn’t governed or regulated.
Whether we’re thinking about the taxation of investing in Bitcoin, the fact that only a handful of countries recognize it as a legal tender or how Bitcoin has historically been known to finance deals on the black market, there is a significant gray area of regulatory guidance around Bitcoin, and governments around the world will try to shed light upon that murky “freedom” Bitcoin currently enjoys. This likely growth of regulatory oversight could have a negative impact on the future valuations of Bitcoin and similar cryptocurrencies.
If we take a step back from Bitcoin and look at the broader cryptocurrency space, we can see a number of red flags within the asset class from a regulatory standpoint. Between exchanges and finance platforms taking relatively prominent cryptos like XRP off the market due to SEC complaints,11 investors losing hundreds of thousands of dollars by investing in fraudulent Initial Coin Offerings (ICOs)12 or scammers sending out phishing emails to get their hands on an individual’s Bitcoin wallet private key, it could be argued that the lack of regulation in the crypto space has led to an abundance of fraudulent activities.
Taking the right approach to investing for you
While investing in Bitcoin may seem enticing given all of the press coverage it’s received over the past few years, it’s important to consider the above factors when debating whether to add Bitcoin to your portfolio. The temptation of investing in the next bright, shiny asset will always be present as part of human nature, but at Wipfli Financial Advisors, we remain convicted in our philosophy of taking a long-term approach to investing and focusing on the aspects of investing that we can actually control: allocation, diversification, expenses and tax-efficiency.