Bitcoin has long been treated as a disdained upstart by the mainstream investing world.
But in the last year or two it has started to gain a foothold of acceptance as a legitimate investment from established advisers and organizations.
A growing number of advisers and a few major financial firms like Fidelity Investments have begun to include bitcoin as a recognized asset class in mainstream portfolios. Typically, they only allocate it one to five per cent of total portfolio value, but that still represents a huge turnaround in recognition.
Yet, despite growing acceptance of bitcoin, it makes sense to stay skeptical.
Bitcoin is still highly volatile and speculative and on that basis, I don’t see it as belonging in the portfolios of most average investors — not even for one to five per cent.
The most that can be said is that buying bitcoin can make sense in certain situations provided you accept the risks and don’t invest too much. That includes if you’re buying bitcoin (and other cryptocurrencies) for its own sake as part of being involved in new technologies, where investing is at most a secondary goal.
A key investment shortcoming is that bitcoin, and other cryptocurrencies, lack investment fundamentals. Unlike bonds, bitcoin generates no interest yield. Unlike stocks, you don’t own shares in company profits, cash flows and dividends. So bitcoin doesn’t have a tangible basis for determining its value.
“The reason I don’t think there is a place for it (in average investor portfolios) is that I still don’t see the fundamental case for it,” says Dan Hallett, vice-president of research at HighView Financial Group, an investment counsel firm. “If you don’t have a real way of determining a value today, you can’t know if you’re getting a good price for it.”
Instead, earning a return on bitcoin is dependent on what future purchasers are willing to pay for it. With nothing tangible to rely on, the market for bitcoin is heavily impacted by swings in sentiment, resulting in huge price oscillations.
Bitcoin’s price Friday morning was close to $50,000, down about 17 per cent year-to-date. In 2021, its price reached over $75,000 in the spring and fall, but sunk to around $40,000 in July.
Bitcoin proponents view it as a good diversifier for their portfolios. But it has a limited track record and its role as a diversifier hasn’t been tested that much during periods of economic adversity, when the benefits of diversification tend to be most important.
Many investors thought bitcoin would help protect portfolios from events like rampaging inflation and geopolitical instability that we’re seeing now. But its prices have instead suffered a double-digit year-to-date decline similar to the overall drop in technology stock prices.
There are, however, two special situations where investing in bitcoin might make sense:
The first niche reason for buying bitcoin is to be involved in the digital revolution that is remaking the financial industry based on innovative technologies like blockchain, which provides the secure, distributed database record for bitcoin transactions. Trying to earn an investment return isn’t the main 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 scarce thing and it never gets used up,” writes Hunt. In that case, bitcoin’s inherent value is in the eye of the beholder. The lack of investment fundamentals isn’t relevant.
Surveys show this is a common motivation. A Bank of Canada study released in April found that only about 40 per cent of bitcoin owners surveyed in 2018 and 2019 owned it primarily for investment purposes. Instead, most bitcoin owners said they were primarily motivated for reasons ranging from involvement with technology (about 26 per cent), to transactional purposes (17 per cent) to distrust of the established financial system or the desire to make anonymous payments (17 per cent).
Another justification for buying bitcoin applies to people who have chosen to embrace speculative investing. Of course, making money from speculation is harder than making money from fundamental investing. You need to delve deeply to try to understand the factors that might affect the value of your investment and you generally need to take on a lot of risk. It’s not a suitable approach for most investors, but it’s possible to make speculation pay off in the right circumstances.
A key insight is that valuation based on speculation without fundamental underpinnings can cut two ways. As prominent technology analyst Henry Blodget famously said, the value of one bitcoin could go to $1 million or it could go to $1.
“There’s nothing fundamental to support it,” Hallett says “but there’s nothing fundamental to hold it back from potentially going to the moon.”
To stand a chance of speculative gains, you have to thoroughly understand bitcoin’s market dynamics, which isn’t easy. But there are thoughtful bitcoin advocates like Jurrien Timmer, director of global macro at Fidelity Investments, who have done a careful analysis of bitcoin and concluded that the upside potential justifies the risks.
Timmer, in a 2021 Fidelity white paper, points to the fact that bitcoin is restricted in supply with an ultimate cap of 21 million bitcoins. On the demand side, growing adoption of bitcoin benefits from a network effect similar to many technology stocks. As more people use it, it becomes much more valuable to each user, potentially providing an exponential boost to demand.
In his view, bitcoin can play a role as an alternative store of value similar to gold, except that it is scarcer, and the network effect adds a “potentially exponential demand dynamic.” So he thinks bitcoin has the potential to encroach on gold for inclusion in portfolios “at some prudent level” alongside conventional assets like stocks and bonds.
While there is some logic to his views, demand trends for new technologies are hard to predict. History has shown that user growth and the associated network effects for a new technology often unravel at some point. As Hallett points out, “you can look at technology investments like Myspace, like Vine, things that had very strong networks but lost them because something better came along. So that’s the big risk in technology.”