Rising Out of the Crypto
Everything you don’t understand about money combined with everything you don’t understand about computers.
— HBO’s Last Week Tonight with John Oliver, March 11, 2018
The tremendous surge in the price of cryptocurrencies has attracted the attention of many investors, who may be considering digital currencies as potential substitutes or even replacements for traditional asset classes. Given the dramatic price movements of Bitcoin and some other cryptocurrencies (now numbering in the thousands), it has been the subject of debate and fascination.
The chart below shows the price of Bitcoin over the past 10 years:
In its relatively short existence, bitcoin has proved to be extraordinarily volatile, sometimes gaining or losing more than 40% in price in a month or two. Any asset subject to such sharp swings may be great for people looking for short term trades. At the moment, cryptocurrency prices depend mostly on speculation about their adoption and use. The pool of currency is also controlled by a few individuals which makes its price discovery much less transparent. The volatility of its price ironically undermines the use of these currencies as a replacement for cash or as an asset class in an investment strategy.
Assessing the merits of cryptocurrencies as an investment is also problematic. Adding it to a portfolio could mean reducing the allocation to existing investments such as stocks, property, or fixed income. However, unlike traditional asset classes, cryptocurrencies lack intrinsic economic value and generate no cash flows, such as interest payments or dividends. As such, an investor in cryptocurrencies will not receive more of the currency in the future and can only hope for sustained price increases based on assumptions that demand will always outpace supply.
With cryptocurrencies and spot commodities, such as gold, there is no expected premium (or return) from holding such assets as compensation for bearing the risk of their price movements. These assets represent uncompensated risk to anyone’s portfolio and as such, are not a good substitute for stocks and bonds.
There are other issues that investors or potential investors in cryptocurrencies should also consider:
Being stranded without service
Bitcoin is not backed by an issuing authority and exists only as computer code, generally kept in a “digital wallet,” which is accessible through a password chosen by the user. Many of us have forgotten or misplaced computer passwords from time to time and have had to contact the sponsor to restore access. No such avenue is available to holders of bitcoin. After a limited number of password attempts, a user can permanently lose access. Since there is no central authority responsible for bitcoin, there is no recourse for the forgetful owner: a recent New York Times article profiled the holder of more than $200 million worth of bitcoin that he can’t retrieve. He is not alone in his plight —a prominent cryptocurrency consulting firm estimates that 20% of all outstanding bitcoin represents stranded assets unavailable to their rightful owners.
Reliability of brokerage platforms
Mt. Gox, a Tokyo-based bitcoin exchange launched in 2010, was at one time the world’s largest bitcoin intermediary, handling over one million accounts in 239 countries and more than 90% of global bitcoin transactions in 2013. It suspended trading and filed for bankruptcy in February 2014, announcing that hundreds of thousands of bitcoins had been lost and likely stolen. Closer to home, investors who traded on Torque, a local crypto-trading platform recently lost all their money and in some cases their life savings after having their accounts suspended by the platform as it underwent bankruptcy.
Innovation is a part of every industry; cryptocurrency and the technology surrounding it may someday prove to be a historic breakthrough. For those who enjoy the thrill of speculation, trading such assets will give them the excitement they crave. However, there is no enduring economic or investment rationale to expect cryptocurrencies to generate positive real returns. Allocating a large chunk of your investment portfolio towards it means reducing allocations to traditional asset classes such as stocks, bonds and cash — the fundamental building blocks of a good investment portfolio.
