The investment world today appears split down the middle about why we should invest in bitcoin.
While many investors have been pulled into bitcoin because of the extreme returns that some have made (and some returns have been wild!), many others still hold back because they are convinced bitcoin has no intrinsic value and because it is only a speculative asset.
Due to popular demand from our investor community, Sarwa has decided to start offering bitcoin, and Jiro Kondo, Sarwa’s Portfolio Advisor, looked at the facts about bitcoin as an investment asset. This article intends to thoroughly review his preliminary assessments on bitcoin alongside the professional insights of other financial experts.
Overall, there are three values that enthusiasts believe bitcoin adds as an investment asset due to what some believe is a gold-like status:
First, it can help further diversify a portfolio due to its near zero correlation to stocks and bonds (meaning reduced portfolio risk). Second, it can be a hedge against inflation due to its fixed supply. Third, it has the potential to provide a higher risk-adjusted returns than other assets, including gold.
In this article, we consider whether these three advantages hold true at the moment and if they will do so in the future.
We do this by considering:
- The major uses of bitcoin
- Why invest in bitcoin: Understanding the investment value of bitcoin
- Bitcoin as a gold-like asset: The diversification benefit
- Bitcoin as a gold-like asset: The inflation benefit
- Bitcoin and its speculative value: Outsized returns at high risk
- The future of bitcoin: Will the investment value of bitcoin survive?
- How to invest in bitcoin
Let’s get started.
1. The major uses of bitcoin
The first mistake most people make when thinking about bitcoin is to view it simply as an investment asset like stocks, bonds, and real estate.
However, if the origin of bitcoin tells us anything, it is far more than an investment asset.
Bitcoin was created due to frustrations with the fiat currency system — especially the lack of anonymity and the ability of the government to print money as they wish.
As a result of these frustrations, bitcoin was brought into existence acting as a digital currency — essentially an alternative currency to government-backed and government-controlled fiat money. Many participating in the crypto world believe they are building a decentralized Wall Street, calling it DeFi, or D-E-F-I, which is short for decentralized finance.
Consequently, there are two ‘uses’ of bitcoin besides its popularity as an investment asset:
Payment system
Users in some limited places can currently use bitcoin as a payment method to facilitate transactions.
Why is it believed that bitcoin is different in this regard?
First, it provides anonymity. Buyers and sellers can transact without any government agency facilitating or monitoring their transactions.
Secondly, bitcoin is free from some of the regulations that restrict or delay other currencies from being sent across national borders. This is because bitcoin is not governed by any body of international regulators.
Finally, because bitcoin uses a decentralised blockchain system, it’s very difficult for fraudulent transactions to take place. Bitcoin transactions can be verified and ownership of bitcoin can be confirmed at any time because the transaction takes place on a public ledger.
That being said, one of the top criticisms of bitcoin is also directly linked to its decentralised system: bitcoin is open to money laundering abuse because of the blockchain system.
[To learn more about the origin of cryptocurrencies, read, “What is Cryptocurrency: A Beginner’s Complete Guide”]
Store of value
An asset becomes a good store of value if you can hold it for a long period of time without deterioration in its value. The more an asset can keep or grow its value over time, the better it acts as a store of value.
Fiat money is not a perfect store of value because governments can print more money at any time. When governments print more money (increasing supply) relative to demand, inflation sets in (too much money in circulation) and reduces the value of the currency.
For example, what $1 would have purchased in 1913 required $26.15 in 2020.
Consequently, the less changeable the supply of an asset, the better it is as a store of value.
This is why some consider bitcoin as a good store of value. The supply of bitcoin is limited to 21 million – it can never be more than 21 million.
This means that the value of bitcoin cannot be eroded through an increase in supply. Rather, as demand increases relative to the given supply, the price increases.
The big risk, however, lies in the overall future of bitcoin. Bitcoin was only launched in 2009 — that is very young as far as a qualified store of value goes.
Yet, every year bitcoin survives, it becomes more trusted. If the digital currency remains relevant years from now, then it can be deemed a truly tried and tested storage of value. If it proves to be only a fad, then it will have failed in this mission. As of today, bitcoin remains very volatile and leaves more questions than answers concerning its future.
2. Why invest in bitcoin?
The third use of bitcoin is as an investment asset. This is perhaps the most popular use today because of bitcoin’s rapid increase in value.
For example, one bitcoin that was worth $1 in April 2011 is now worth $36,445 (at the time of writing).
In fact, with bitcoin, there has been outrageous growth in value, with many people becoming millionaires because of it. But the reality is, when you buy bitcoin you’re buying a very speculative asset. You’re speculating that it will become ‘digital gold’ or possibly one day a proven store of value.
But this road is a guaranteed rollercoaster ride.
If bitcoin is not the only store of value and investment asset (stocks, bonds, REITs are others) and it is much more volatile than the others, why are people interested in it and enthusiasts promoting it?
Said simply, why even invest in bitcoin?
Below, we’ll review 3 core benefits that bitcoin investors and enthusiasts have argued for it.
1. Bitcoin as a gold-like asset: The diversification benefit
One of the most popular investment theories today is the Modern Portfolio Theory, a Nobel prize-winning theory propounded by Harry Markowitz in 1952.
Among the basic tenets of this theory is that an investor can minimise risk and maximise returns by investing in a portfolio of uncorrelated and/or negatively correlated assets.
Essentially, two assets are said to be uncorrelated when a change in one does not result in a change in the other. In this case, the correlation coefficient is zero. For example, they are said to be negatively correlated when a change in Asset A in one direction results in a change in Asset B in the opposite direction.
Harry Markowitz recommended uncorrelated and/or negatively correlated assets because when Asset A is falling in value and losing money, B stays the same (if they are uncorrelated) or grows in value and makes money (if they are negatively correlated).
These two options are preferable to positive correlation because in this case, Asset A and B would move in the same direction — when A loses money, B also loses money (double trouble) — creating high risk for your portfolio.
Following this theory, the best way to minimise risk and maximise return is to have a portfolio of uncorrelated and/or negatively correlated assets. The more uncorrelated or negatively correlated, the better.
So why is any of this important for investing in bitcoin?
Like gold, like bitcoin
While the negative correlation between stocks and bonds still holds most of the time, some analysts believe it is eroding as the positive correlation between stocks and bonds begins to increase.
(To learn more about the relationship between stocks and bonds, read “What are Stocks and Bonds: A Beginner’s Guide”)
Traditionally, some investors have depended on gold for achieving this broader diversification. It has been common thought for many years to use gold as a hedge against inflation, for example.
However, bitcoin has emerged as an alternative to gold that can also provide this same diversification benefit. Recently, new studies have emerged to support this thus far.
According to data from Morning Star (2012-2020), the correlation coefficient of bitcoin to the stock market was 0.01 — that’s almost zero correlation. For further comparison, gold had a 0.02 correlation to the stock market within the same period.
Bitcoin was even closer to zero correlation with the stock market than gold, giving rise to why financial analysts have increasingly compared bitcoin to gold.
At the same time, when it comes to bonds, the difference is even starker. So far, bitcoin has a proven correlation of 0.02 to the bond market, while it was 0.28 for gold.
To take the two data points together, between 2012 and 2020, bitcoin was closer to zero correlation with both stocks and bonds than gold.
This is why analysts have called bitcoin “digital gold.”
“Statistically, we’ve found that over the last 6 years, bitcoin has – in some notable ways – been trending towards an asset with “gold-like” investment properties,” said Jiro Kondo, Associate Professor of Finance at McGill University and Head of Portfolio Construction at Sarwa.
“This is important because gold is often seen as a particularly useful diversification tool.”
Consequently, investing in bitcoin is now considered a good way to diversify your portfolio.
However, Jiro Kondo warns that there is no guarantee that this trend will continue:
“With that said, bitcoin still has a very long way to go to reach true “gold-like” status and there’s no guarantee that the recent convergence trend will continue.”
Therefore, while it seems that bitcoin is indeed a good asset for portfolio diversification at the moment, there is a need to see it do this consistently for a long period to consider bitcoin as a true “digital gold.”
(To learn more about the Modern Portfolio Theory, read “The Brilliance of The Modern Portfolio Theory: A Nobel Prize-Winning Formula To Cut Investment Risk“)
2. Bitcoin as a gold-like asset: The inflation benefit
When an asset is a store of value, its value cannot be eroded like fiat money.
One benefit of this is that such assets protect investors during inflationary periods.
This has been one of the principal appeals of gold.
While the supply of gold can be increased, it’s very difficult and expensive to mine new gold. So it’s impossible to just flood the market with new gold, thereby causing inflationary pressure.
Consequently, in an inflationary period (when the government prints more fiat money and the value of fiat money is decreasing), investments in gold provide a hedge against inflation as they retain their value, which is not eroded by rising supply.
Because bitcoin also has a limited supply, it is seen by some as a good hedge against inflation. In fact, while the supply of gold can be increased (though it’s difficult and expensive to do), the supply of bitcoin is capped at the finite limit of 21 million coins.
While new technology could make gold cheaper and easier to produce, no new technology can increase the supply of bitcoin beyond 21 million. It is simply against the rules originally programmed into bitcoin.
Given the above, it seems, then, that bitcoin can be seen as a hedge against inflation like gold.
There is only one problem.
Jiro Kondo summarises it well:
“The link between bitcoin’s finite supply and its effectiveness as an inflation-hedge is still theoretical. We don’t have historical evidence to back up this hypothesis because inflation expectations have been fairly low and stable during the period that bitcoin has been meaningfully traded [e.g., 2015 and beyond],” observes Kondo.
“Inflation fears have only spiked recently and this one episode is insufficient to statistically gauge bitcoin’s usefulness as an inflation hedge.”
So while bitcoin should be a hedge against inflation (a better hedge than gold given its fixed supply), the low-inflation environment of the past 6 years has made it difficult to prove this thus far.
3. Bitcoin and its speculative value: Outsized returns at high risk
If you didn’t already know that some investors see bitcoin as a great investment asset for diversification and inflation protection, you surely know that it has produced outsized returns that have made many millionaires.
The chart below shows how bitcoin has outperformed stocks and gold between 2016 and 2021.
Just $100 invested in bitcoin in February 2016 was worth more than $10,000 five years later while the same amount invested in stocks and gold was less than $500 over the same period.
However, it should also be evident that bitcoin is a very volatile asset (more volatile than stocks, bonds, and gold). The chart above shows the speed and extent with which bitcoin moves upward or downward. Therefore, the same asset that has made many millionaires has led many to lose millions.
So is this a good reason to shun bitcoin?
Below are three important considerations:
Decreasing volatility
The volatility of bitcoin has been steadily lowering as it nears its supply limit (the 21 million coin mark).
Over the past five years, bitcoin has experienced much more volatility than gold because gold is well established with a market cap of $12.02 trillion.
However, as bitcoin’s market cap has grown, its volatility has been reduced. In fact, except in 2012, the lowest price of a bitcoin in a year has been higher than the previous year.
No one can be sure how it will behave in the future and despite the reducing volatility, it is still more volatile than stocks, bonds, and gold.
It’s the long term that matters
We know that any investment experience can include volatility. It’s the market’s nature.
Even Amazon’s stock (AMZN) experiences a double digit drop in value once every year. But over the long term, your money grows.
One could argue it’s the same with bitcoin.
As of December 22, 2020, no matter when you bought bitcoin in the past 11 years, the price was always higher three years after or more.
In this way, bitcoin has so far followed the same rule as other investment assets: the longer you stay in the market, the harder it is for you to lose money.
So, it’s possible to minimize the effects of bitcoin volatility by investing in it for the long term. Otherwise, it is a very volatile asset that is difficult to trade.
3. The future of bitcoin: Will the investment value of bitcoin survive?
What does the future hold for bitcoin?
Will it keep showing zero correlation with stocks and bonds, thereby providing a strong diversification benefit?
Will future data show that bitcoin offers a true hedge against inflation?
Jiro Kondo is optimistic about gold-like assets in general: “given aforementioned concerns about inflation and the decrease in yield of other safe assets like bonds, we might also expect the total demand and thus value for gold-like assets to increase.”
But the important question is if bitcoin will continue to be a gold-like asset and enjoy this increasing demand? Jiro adds: “When looking at bitcoin as an insurance-like asset, the evidence is mixed but, in some cases, trending in a promising direction.”
Moreover, some data has shown that bitcoin is already eating into the market share of gold as investors sell gold for bitcoin. But it remains to be seen if this trend will continue — that is, if bitcoin will become more gold-like.
How will the presence of other cryptocurrencies affect bitcoin in this regard?
Here, Jiro raises another crucial point that we need to consider: “While bitcoin itself has finite supply, can’t new crypto currencies be created? Does this produce the potential for an unlimited supply of bitcoin-like assets? Could new entrants even displace bitcoin?”
Since the creation of bitcoin, thousands of coins have been created. About 60% of them didn’t go past ICO (initial coin offering).
While many have indeed gone past ICO (there are now 10,304 of them), bitcoin has continued to dominate. It was the first cryptocurrency and has the highest market cap ($676.17 billion as at the time of writing), which is 40.79% of the total crypto market.
So while new cryptocurrencies with unlimited supply have arisen (e.g. ethereum), bitcoin is still strong and dominant. But it remains to be seen if this dominance will continue or if a crypt with unlimited supply like ETH can eat deep into bitcoin’s market share.
Moreover, rather than displacing bitcoin, the existence of new cryptocurrencies can instead lead to the creation of Cryptocurrencies ETFs that provide investors with reduced risk and a better chance of returns.
(To learn more about ETFs and why they are very efficient in minimising risk and maximising returns, read “What are ETFs: Explaining The Popularity Of the Go-To Fund“)
Ray Dalio, the founder of Bridgewater Associates, the largest hedge fund in the world, was a bitcoin sceptic for a long time.
He was concerned that the lack of full scale adoption as a medium of exchange, volatility, and lack of government control would eventually bring the downfall of bitcoin.
Today, Ray says he now holds bitcoin as part of his investments. He believes that the US dollar is on the road to experiencing 1971-esque devaluation and in such an inflationary scenario, bitcoin could be a good savings vehicle (store of value).
However, he clearly admits there are some strong underlying risks with bitcoin still.
“That is why to me bitcoin looks like a long-duration option on a highly unknown future that I could put an amount of money in that I wouldn’t mind losing about 80% of,” says Dalio.
How to invest in bitcoin
Now that you know the standard reasons given for investing in bitcoin, it’s time to start thinking about how to invest in it, if you choose to do so.
One way to invest smartly is by adding a small allocation of 5% to your diversified portfolio. By using Grayscale’s GBTC, investors can add bitcoin to their portfolio in the same way that we trade gold ETFs.
Now you can invest in bitcoin by including GBTC as part of your Sarwa Portfolio.
If you have any questions, schedule a free call with a Sarwa Wealth Advisor to continue learning about how bitcoin can be smartly included in your investments.
Takeaways
- Bitcoin today is too omnipresent to ignore, and smart investors should thoroughly study why financial analysts increasingly consider it a good hedge for investment portfolios.
- It’s important that you are able to handle the scenario if you’re “wrong” because this outcome is also plausible.
- You must also have the stomach to weather the ups and downs of bitcoin prices because, even if you’re right, bitcoin values are likely to experience meaningful drops on the way to the “upside” scenario.