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Sensibilities About Bitcoin / Investing at All Time Highs

January 15, 2021
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Recently I saw a Twitter post from a financial advisor that said "If your financial advisor isn't recommending a 1-5% allocation to Bitcoin, why haven't you fired them?"... When this kind of sensationalism starts becoming more mainstream, it warrants being addressed. That's what this email is: me addressing this phenomenon... and then, for good measure, I also threw in a section about investing in stocks at all time highs. 

Enjoy. 

Adam Harding, CFP

Owner/Advisor @ Harding Investments & Planning | Dave Ramsey Smartvestor Pro

Thing #1: Some details about Bitcoin

For the better part of a decade, "Bitcoin Bulls" have been pushing narratives of Cryptocurrency is the wave of the future and You should be buying it or risk missing out on a generational opportunity for massive wealth. 

For the record, these bulls already own Bitcoin, so of course they have incentives to create new buyer demand and the accompanying rise in price of the stuff they already own. 

Nobody likes to miss out, so it's understandable if that's how you're feeling right now... Hopefully this quick write-up helps numb the pain of FOMO (fear of missing out). 

For reference, here's the 10 year chart for the price of Bitcoin (source: Coindesk):

I last covered Bitcoin in my blog back when it was spiking in 2017, and the media/social media influence became impossible to ignore. The same thing seems to be happening right now (hence this blog). 

.... The next section dives into Bitcoin. If you want to save your eyeballs from reading, just skip to "Thing #2" where I succinctly give my opinion on it. 

If you're in the dark on what Bitcoin or cryptocurrency actually IS, here's a quick overview: 

Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it.

Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million,1 of which more than 16 million are in circulation.2 Transactions are recorded on a public ledger called blockchain.

People can earn bitcoins in several ways, including buying them using traditional fiat currencies3 or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.

For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $16,000 per bitcoin,4 the total value of bitcoin in circulation is less than one tenth of 1% of the aggregate value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months have contributed to intense media attention.

What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value?

You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.

Expected Returns

Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.

Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Thus, besides the potential for providing positive expected returns, another reason to hold government bonds is to reduce the uncertainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.

Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.

The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies.

With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins.

A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.

If bitcoin is not currently practical as a substitute for cash, should we expect its value to appreciate?

Supply and Demand

The price of a bitcoin is tied to supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit, which might imply limited future supply. The future supply of cryptocurrencies, however, may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another, implying the quantity of future supply might be unlimited.

Regarding future demand for bitcoins, there is a non‑zero probability5 that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand).

Future regulation adds to this uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns.6 Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.

All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today.

What to Expect

So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.

None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.

When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.

Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more of such goals.

If, however, one has a goal not contemplated herein, and you believe bitcoin is well suited to meet that goal, keep in mind the final piece of our asset allocation framework: What percentage of all eligible investments do the value of all bitcoins represent? When compared to global stocks, bonds, and traditional currency, their market value is tiny. So, if for some reason an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny.7

Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust dimensions of expected returns, has been helping investors effectively pursue their goals for decades.

Thing #2: Bitcoin, Succinctly

The section above is a lot of information, so I felt like parcelling off this succinct opinion to stand on its own. 

Here's where I officially stand on the subject: 

I originally thought Bitcoin would eventually be deemed worthless -- I no longer think that now, but it has nothing to do with the case made for Bitcoin's viability as an alternative currency or blockchain's potential to change the world we live in.

Instead, here are two images related to why I believe it won't be deemed worthless:  

Of course, the images above show Las Vegas, a city built on gambling revenues, and a Mega Millions lottery ticket. 

In the cases of casino gambling and the lottery, the participants know their strategies aren't viable and the odds are stacked against them --but they still play. 

In much the same way, Bitcoin (and other cryptocurrencies) is not about an investment into a future utility, but instead it's about speculation for the sake of speculation. 

Humans love to gamble -- and the nature of the massive gains or total loss in most casino games is enough to make the speculation worthwhile. Very few blackjack players would be excited to win a 12% rate of return even if the odds of doing so were much higher than the odds of winning a 100% rate of return less frequently. 

As I write this, Bitcoin has exploded upward in recent months. However, it's also fallen as much as 10% just in the midst of trading today (I originally started writing this on January 4, 2020, which is the day it fell 10%). 

The potential for great short term gains is much more appealing to our modern impatient society which has been ingrained with on-demand TV (Netflix, etc.), same-day delivery of things we need (Amazon, etc.), fast-casual restaurants, and many other things (like vaccines developed in record time).

But immediate gratification is not how wealth-building works -- Wealth is built by doing the same thing over and over again, compounding each action on top of the prior ones, and reaping the benefits of compound interest. 

In short, do I think Bitcoin is going anywhere anytime soon?

No, I do not. It will boom and bust and boom and bust and when it's booming people will be really loud about how the boom has helped them build wealth and when it busts they will be really quiet about it. 

And finally, I'd encourage you to remember this:

When you're investing, you have to have a set of beliefs to guide your approach. Relying on your beliefs when 'new things' come along (like cryptocurrency) can help you see through the noise. 

One of my primary investing beliefs is that we, as investors, are taking our accumulated capital, held in cash, and using it to buy something that produces value in the future. That value is typically a cash flow of some sort: dividends (from stocks), rent (from real estate), or income (from bonds). Owning those cash flows is valuable to different people at different times with different circumstances, which is why the value of stocks/real estate/bonds go up and down. The owner of one of these assets can simply collect dividends/rent/income while they wait for a good time to sell the asset to someone else who is willing to give up their capital to the future stream of cash flows. 

In the case of currencies (Bitcoin), there is no value production when you hold it. Here's the method to make money in Bitcoin: 

Step 1: Exchange dollars for Bitcoin by buying it from someone who would rather have dollars than Bitcoin. 

Step 2: Hope the Bitcoin goes up in value. If it does, think to yourself "that person who sold the Bitcoin to me must be kicking themselves."

Step 3: Sell the Bitcoin to someone for dollars before it plummets. If it does plummet, then think to yourself "that person who bought the bitcoin from me must be kicking themselves."

In each of these cases, you are just as likely to be the person kicking yourself as you are the lucky one. However, the total amount of wins and losses balances out (i.e. a zero-sum game). 

The beauty of capitalism is that it grows the size of the pie so that people can benefit from different things at different times (like the person who wants the future cash flows vs. the person who wants access to their current lump sum of cash). I prefer to pursue this theme when investing. 

All of the trading and speculation that goes with Bitcoin "investing" is an unproductive endeavor for society. But then again, so is gambling and buying lottery tickets.

In this case, you have to consider who is The Casino and who is The Gambler. In my opinion, The Casino are the wealthiest owners of the commodity, who plan to loudly proclaim the merit of the asset, experience growth, and then dump it on to everyday individuals (The Gambler) before the crash.

For now, I don't want any part of either side.

#3: Investing at All Time Highs

No one in the History of Investing has dealt with more noise than you.

Here are some examples of "Noise":

A CNBC program with commentators making market predictions about The Second Coming of the Great Depression.  

A Forbes article written by a guy who exclusively sells life insurance, claiming that "Traditional Investing is BROKEN!"

Your Aunt Carol on Facebook who shares a conspiracy theory about the dollar and insists on owning nothing but gold coins.

A family member who owns Tesla stock and loudly proclaims his success. 

... and, yes, this newsletter is also part of that noise. 

Around every corner is another doomsday approach to fend off. Congratulations on your resilience thus far. 

That said, 2020 was a year which tested all of our collective resolve -- when trying times occur, we have to learn from them.

As investors, we believe in compounding, which is the process of building on top of past events to establish a greater future. In that spirit, I suggest you go through 2020 and determine the good, the bad, the room for improvement, and the "wins" you picked up. We have a tendency to focus on the actions we didn't  take and the regrets we have, but I think our time is better spent focusing on the things we did... Pat yourself on the back.

However, with last year's crash freshly implanted in our memories, it can be tempting to want to protect yourself from the next crash.

Specifically, I know there's a lot of hesitance about stocks being at all time highs and the feeling that they could crash any minute. While there are sound investment decisions you can make if you're feeling like your portfolio is too risky, it's also worth noting that all-time-highs aren't necessarily a cause for concern. In fact, historically speaking, all-time-highs are a better predictor of new impending highs than they are of a future market crash. The graphic below highlights this observation: 

Of course, past performance is not an indicator of future performance, but hopefully this data gives you a bit more comfort about the market hitting new all time highs. 

I know it's scary to buy (or hold) stocks just after the big rebound we've seen, so I'd like to recommend you go through the following exercise: 

Step 1: Find some money ... You know, the paper stuff that you hand to someone when you're buying something. Hold that money in your hand for a minute. 

Step 2: Think about the value of that money. What's its purpose? For one, that physical papermoney is really good at being exchanged for the stuff you need today or tomorrow or maybe a few weeks from now. But is it good for buying the stuff you may need two years from now? What about two years ago? What if you wanted to buy real estate in 2021 and had been saving up paper dollars to buy something in 2018, 2019, and 2020 --the inflating price of real estate would have turned your savings goal into an uphill battle. 

Step 3: Really look at that money and think about the purpose it serves if you don't need to spend it in the short term. If you don't have a purpose for it in the short term, then you'd almost rather own something else with those dollars, right? Perhaps you'd rather own stock in a company that is selling you (and a bunch of other people) that same stuff you'd like to buy with those short term dollars. 

Step 4: Realize that holding more of your net worth in dollars will keep your net worth more stable, but is a "stable" net worth important if you have the cash and income to meet all of your short term goals? Perhaps it is or perhaps it isn't --that's up to you-- but I'd like you to think of your net worth as a collection of assets, then consider the actual cash you own as a conscious decision to hold US Dollars. 

History is on the side of sticking to your investment strategy regardless of all-time-highs, market corrections, etc..But if you're nervous, start thinking about the purpose of money, and if there's not an immediate short term need for those dollars, then you might start scrutinizing the actual value of those dollars.

Of course, every person has unique feelings about risks and objectives to consider.

There are no "wrong" or "irrational" investment decisions -- there are only "best guesses" within the risk and return objectives we set for ourselves. 

That's all for now.

Onward,

AH

 

PS... Here's a picture of my kid 'flying into 2021'...