Bitcoin:  Wave of the future, or bubble in the making?

No matter where I went over the holidays it seems there were three subjects everyone wanted to discuss.  Whether it was a formal holiday party, or an informal gathering of old friends, discussions centered around 1) The new tax plan and what it would or wouldn’t do for the economy, 2) The job Donald Trump has done as President in his first year, or 3) What was my take on Bitcoin?

After a dozen or so discussions on the risks and merits of Bitcoin, it seems that this is an important  question on many investors’ minds.   Enlisting some assistance from Dimensional Fund Advisors, here are some thoughts and advice on the cryptocurrency known as Bitcoin.

What exactly is Bitcoin?

Bitcoin is the first implementation of cryptocurrency, a concept first described in 1998.  Cryptocurrencies are new forms of money that use cryptography (secure third party communication techniques) to control its creation and transactions.   It is a form of computer code and it is stored in a digital wallet.

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.  In the specific case of bitcoin, there is a finite supply of 21 million bitcoins.  More than 16 million bitcoins are currently in circulation.  Bitcoin transactions are recorded on a public ledger called blockchain.

Bitcoin can be obtained in several ways, but two methods are more common than others.  First, bitcoin can be “earned” by “mining” them through the use of powerful computers to compile recent transactions into new blocks of the transaction chain by solving complex mathematical puzzles.  This has been occurring for about a decade with the first release of bitcoin in January of 2009 and the last release in November of 2017.

The other common method for obtaining bitcoins is purchasing them using traditional fiat currencies.  This method has attracted a great deal of media attention the past year, with the price of bitcoin fluctuating widely throughout 2017.  Bitcoin began 2017 trading at a price of $968.23 and reached a peak of $19,343.04 in mid December.  Bitcoin ended the year at a price of $13,860.14.

Obviously, the wild price swings and fluctuations of bitcoin have attracted the attention of the media and investors alike.  And many investors wonder what place bitcoin should have in their investment portfolio, if any.  Let us consider bitcoin through a couple of different paradigms to help us ascertain how attractive it might be to investors.

Expected Returns of Asset Classes

Investors basically hold three basic types of financial instruments: cash, stocks (equity) and bonds (fixed income).  Each of these classes of financial instrument has a specific risk and return profile.  Stocks or equities represent an ownership share in a company and offers investors a claim on the company’s future profits.  Bonds, on the other hand, represent a promised stream of future cash flows and the repayment of the principal amount borrowed when the bond reaches maturity.

The price of a stock or bond reflects the investment return investors demand to exchange their cash today for an uncertain, but certainly greater amount of expected cash in the future.  Bonds are considered safer than stocks because of the promised stream of payments and the return of principal.  Stocks have no such guarantees of a share of future profits, and therefore are a riskier investment than bonds.  Because of the risk involved, investors in stocks will require a higher expected rate of return than investors in bonds will require.

An investor who purchases a portfolio of stocks and/or bonds, or any combination thereof, expects to grow his or her wealth by taking on additional risk today to enjoy greater consumption in the future.

Cash offers no such expected return on investment.  It would be nice if holding fifty dollars in your wallet or purse entitled you to additional dollars in the future, but that is not the way it works.  Currencies, as an asset class, have no positive expected return or future income stream. We should not expect a positive return from holding cash in one or more currencies unless we can predict when a currency will appreciate or depreciate relative to another currency.  Since bitcoin is a type of currency, just like any other fiat currency, it has no expected positive return.

Academic studies strongly suggest that short-term price movements in currencies are unpredictable.  The implication is that there is no reliable or systematic way to profit by just holding cash, regardless of the form it is held in.

Supply and Demand

Economic principles provide us with another lens through which to view bitcoin.  Bitcoin’s price, like other goods, is a function of supply and demand.  The supply of bitcoins is slowly increasing with the periodic release of bitcoins.   But we also know that there is a limited future supply of bitcoin as there is an indicated limit of 21 million bitcoins to be mined.  The economic principle of scarcity might suggest that a limited supply of bitcoin, coupled with a high demand for bitcoin, might result in a mismatch in equilibrium and justify the high current price.

The future supply of cryptocurrencies may be much less limited however.  If current and future cryptocurrencies function as close substitutes of each other, then the current price for bitcoin, viewed as a scarce and limited resource, may be largely overvalued.

Some Final Thoughts           

While bitcoin is the best-known cryptocurrency currency that exists today, it is not yet a practical substitute for fiat currencies.  Few businesses accept bitcoin as payment, although there are some notable businesses that do like Subway, Microsoft and Overstock.com.  It is not known if bitcoin, or any other cryptocurrency for that matter, will ever be a viable mainstream substitute for cash.

But let us suppose that bitcoin does become a popular form of currency and becomes a widely accepted form of payment.  Does this make bitcoin, or any other cryptocurrency an attractive investment?  And if bitcoin is an attractive investment, what role should it have in an investor’s portfolio?

To answer that question let us recall what we discussed earlier about cash.  Fiat currency, a dollar or euro for example, has no positive expected return associated with it.  A piggybank full of fifty one dollar bills will still have fifty one dollar bills in it in one day, one week, one month or one year’s time.  The only way to profit from holding a currency is by successfully anticipating how it will appreciate or depreciate     relative to another currency.  And we know these movements are unpredictable, so any potential gain is highly speculative.

Let us suppose you are an investor with an appetite for risk, then where does bitcoin fit in your portfolio?  While bitcoin may be trading with a lot more volatility and speculation than most currencies, it still remains a cash substitute and should be positioned in any portfolio accordingly.

The meteoric rise in the price of bitcoin in 2017 has all of the aspects of a bubble.  Investors are advised to be cautious in adding bitcoin to their investment portfolios.

Sources:  Dimensional Fund Advisors, www.bitcoing.org