This isn’t news: the price of bitcoin has gone bonkers. It started 2020 at about USD7,800 per bitcoin and has gone above USD50,000 in February 2021 as Elon Musk makes Tesla buy US$1.5b worth of the stuff.
Over five years to December 2020, bitcoin has risen 6,577% or an average of 132% yearly. To put this in perspective, the much-envied S&P 500 returned 118% over five years including dividends or an average of 17% yearly. In contrast, the local FBMKLCI eked out 19% over the same five years or 3.5% annually. In other words, bitcoin in one year did what the S&P 500 would take five years to do and what the FBMKLCI would maybe take 40 years. (Note: calculations done in US dollars. Stock market returns include dividends.)
So, is this some sort of Ponzi scheme or is bitcoin legit for your portfolio?
Bitcoin isn’t quite money yet, but…
With this meteoric rise, everyone’s asking if bitcoin is money. If bitcoin becomes money, its value will certainly rise way above where it is today because everyone would have to own it and not enough people do. But what is money in the first place? Where did people’s trust in these pieces of paper come from? You could say that the government says they are worth something, but where did the government’s trust in them come from?
In fact, most money doesn’t even exist as paper: in the US, only slightly more than 10% of all money is in paper form. This makes the money idea, like the bitcoin idea, even more like it was plucked out of thin air. Although it may feel like we’re putting our basis of life on something so flimsy, fiat money, as it’s called, has value because people believe (mostly indirectly) it is based on their national economic worth.
For bitcoin to gain acceptance as money, more people must be able to use it to pay for things. There are some sellers who accept payment in bitcoin, Tesla being the latest, but it’s safe to say that this is few and far between. Charlie Munger, Warren Buffett’s nonagenarian sidekick, thinks that bitcoin is not a viable currency alternative because it is too volatile.
But there’s also another very strong reason why bitcoin might not become money: governments will stop it from happening. Because bitcoin seeks decentralisation and can be mined by anybody, it can cut out governments as the middleman in money issuance. Governments, of course, won’t have their money-printing monopoly taken away because money is a means to manage society. However, Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, thinks it’s possible people may buy bitcoin as an “insurance” against money, like what gold is used for to a large extent.
Is bitcoin the new gold?
What is more intriguing is gold. Gold doesn’t pay dividends, doesn’t produce anything, is inedible, and can’t fuel your car. Gold has almost no industrial usage, which is why Warren Buffet doesn’t like it. Nobody I know uses gold to pay for things. And yet, people have bought it for thousands of years and still do.
Like gold, bitcoin is scarce: its total supply is fixed, which proponents argue gives it good inflation protection. However, unlike gold, blockchain gives bitcoin a technological twist. Blockchain is what allows bitcoin and other cryptocurrencies to be built and is what techies believe is The Future. This would be the most solid basis for bitcoin’s fundamental value. This is beyond our ability to discuss it here, but there is a ton of material and research out there on blockchain.
The value of gold is just based on the acceptance of central banks and people around the world. The value of money is based on people’s acceptance and belief. Bitcoin seems to be an idea that is gaining value also because of a growing number of people’s belief.
The sum of the parts is greater than the whole
Bitcoin is also currently experiencing the benefits of “network effects”: the greater the number of users there are, the higher the value each connected user gets from the platform. A classic example of this would be the social media platforms: Facebook gets more value from you, me and 3 billion other people using the platform together instead of separately.
A number of investors have warmed up to network effects. Paul Tudor Jones, founder of Tudor Investment, said, “Every day that goes by that bitcoin survives, the trust in it will go up”. A JP Morgan note published in early January revealed that more and more professional money managers are investing in bitcoin today than in the past. Stanley Druckenmiller (famed for betting correctly, along with George Soros, that the pound sterling would crash in 1992) thinks that, “If the gold bet works, the bitcoin bet will probably work better because it’s thinner [and] more illiquid.” These investment hypotheses point to the possibility of momentum coming directly from the sheer number of people getting into the bitcoin game than it seems from anything else.
The principle of negative correlation also comes into play. This simply means that it’s good if the prices of assets in your portfolio don’t move together because, crudely speaking, when the prices of risky assets fall, the other assets that retained value (whose prices either stayed the same or went up) could be sold to buy more of the fallen asset. When baked into investment policy, this rebalancing process boosts returns over the long term.
Gold has historically been known for not moving together with equities. Some studies have also shown that the price movement of bitcoin doesn’t really mirror that of the S&P 500. This suggests that bitcoin could be beneficially added to portfolios, especially higher risk-return ones.
Catalytic converter
The barbell strategy, famously advocated by The Black Swan author, Nicholas Nassim Taleb, could also be used for investing in bitcoin. Because we almost never see black swans, the term refers to rare events such as earthquakes, a meteor strike, a global stock market crash, or a crazy rise in cryptocurrencies.
This investment approach would be a high allocation to the low-risk pool (e.g. cash and gold) of say 95%, while a tiny allocation goes to the ultra high-risk pool (e.g. bitcoin or other cryptocurrencies). The juxtaposition of ultra-safe vs ultra high-risk investments protects your downside while also opens up the possibility for the $100k or million dollar bitcoin lottery. It is possible to have a version of the barbell by adding a small but catalytic crypto allocation to traditional portfolios.
In fact, some people actually believe that bitcoin will go to US$1 million! Regardless of whether you believe that, a barbell strategy is like an insurance policy taken out on the portfolio just in case that happens. This is very different from betting that it would definitely happen.
To bitcoin or not to bitcoin?
The case for adding bitcoin or cryptocurrencies in general to an efficient portfolio is growing stronger. The idea here is to add returns to investors who can take the extra risks. It probably would make sense to limit a cryptocurrency allocation to no more than 5% for the riskiest portfolios, while ensuring that the majority of the portfolio is properly diversified through traditional asset classes such as equity and bonds. In that way, the bitcoin exposure could enhance a portfolio’s growth, while the rest of the allocation would offer proper diversification to give overall protective management to the portfolio.
