Why Bitcoin has a place in my diversified portfolio

I know what many readers are probably thinking. Financial Horse has finally gone off the rafters. Bitcoin in his diversified portfolio alongside stocks, REITs, and bonds? What is this guy smoking?

Trust me, when I first heard about cryptocurrency, I thought it was absolutely ridiculous as well. A virtual currency administered via distributed ledger and not backed by any income stream, government or commodity? Why would anyone want that?

A lot of really important people, including Warren Buffet, JP Morgan’s Jamie Dimon (although he did regret making this statement later) and Bill Gates have all come out to state their belief that Bitcoin is a bubble. But there is an important disctinction between bitcoin and cryptocurrencies generally. Even if you think Amazon stock may be in a bubble, that does not necessarily mean that the stock market is overvalued.

The more I read about cryptocurrency, the more I came to question my initial beliefs. There is a lot of appeal behind a decentralized currency that cannot be manipulated or controlled by any one government. The blockchain technology behind cryptocurrency has huge potential, and has been likened to the internet in its early dayss. Despite multiple bear markets (85% pullback from January 2014 through January 2015, and the 64% decline from December 2017 through March 2018), bitcoin, and cryptocurrencies, have demonstrated remarkably resilient price action.

A lot of people though fiat currency (currency backed by the government and not the gold standard) was crazy when it was first introduced after Bretton Woods. Look where we are today. I encourage all readers to read this article with an open mind. At the end of the article, you can make your own conclusion whether crypto is for you.

Basics: What is Cryptocurrency

The google definition is surprisingly good:

A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.

Basically, it is a digital currency that makes use of encryption and blockchain technology to verify a transaction, without having to go through a central intermediary like a central bank.

There is a great article here that really sets out all you need to know about crypto, but broadly, the key characteristics of crypto for investing purposes are the fact that (1) its supply is fixed, and (2) it is not backed by any one government (unlike fiat currency):

1) Controlled supply: Most cryptocurrencies limit the supply of the tokens. In Bitcoin, the supply decreases in time and will reach its final number somewhere in around 2140. All cryptocurrencies control the supply of the token by a schedule written in the code. This means the monetary supply of a cryptocurrency in every given moment in the future can roughly be calculated today. There is no surprise.

2) No debt but bearer: The Fiat-money on your bank account is created by debt, and the numbers, you see on your ledger represent nothing but debts. It‘s a system of IOU. Cryptocurrencies don‘t represent debts. They just represent themselves. They are money as hard as coins of gold.

To understand the revolutionary impact of cryptocurrencies you need to consider both properties. Bitcoin as a permissionless, irreversible and pseudonymous means of payment is an attack on the control of banks and governments over the monetary transactions of their citizens. You can‘t hinder someone to use Bitcoin, you can‘t prohibit someone to accept a payment, you can‘t undo a transaction.

As money with a limited, controlled supply that is not changeable by a government, a bank or any other central institution, cryptocurrencies attack the scope of the monetary policy. They take away the control central banks take on inflation or deflation by manipulating the monetary supply.

What happens if you include 1% of cryptocurrency in your portfolio in 2014

The article here does a lot of the groundwork, so I’m going to take extracts from this report (Credit: Matt Hougan):

Cryptoassets exploded onto the national scene in 2017, as the price of Bitcoin rose from just over $1,000 to a peak of $19,783 on Dec. 17. Prices then fell sharply, with Bitcoin trading down 64% from its peak to end March 2018 just a shade above $7,000. This whipsaw volatility left many investors wondering what role—if any—cryptoassets like Bitcoin might have in an institutional-caliber, diversified portfolio.

To answer this question, this study examined the performance of a traditional 60% equity/40% bond portfolio with and without an allocation to Bitcoin. Bitcoin was used as a proxy for the broader cryptomarket, because it is the largest cryptoasset and the one with the longest track record.

The study looked at the period Jan. 1, 2014 through March 31, 2018. This period was chosen because it captures two of the worst bear markets in Bitcoin history: The 85% pullback from January 2014 through January 2015, and the 64% decline from December 2017 through the conclusion of the study in March 2018. The study considered looking at returns since Bitcoin’s inception on publicly available exchanges in 2010, but the early returns of Bitcoin were so high that they skew the analysis. In 2013, for example, Bitcoin’s price rose 5,507% (see table). The chosen start date captures what amounts to the worst historical scenario for adding Bitcoin to a portfolio.

Despite this (intentionally) adverse timing, the study found that a systematic allocation to Bitcoin significantly increased the portfolio’s risk-adjusted returns, assuming a diligent rebalancing strategy was in place. In fact, a small allocation to Bitcoin achieved this result without increasing the risk profile of the portfolio in any meaningful way.

By allocating 5% of your portfolio to bitcoin, you would have massively outperformed a traditional 60:40 equity portfolio. However, after a few years, the large returns from bitcoin would have resulted in your portfolio being dominated by one asset class, which is not wise from a diversification perspective. The solution of course, is rebalancing.

With quarterly rebalancing, the volatility, and consequently the risk adjust returns, improve massively. In fact the best risk adjusted returns were achieved with a tolerance based readjusted, using a 50% tolerance (readjusting when it hit 50% more than its original weightage).

The results are clear. By including a miniscule 1% of your portfolio in bitcoin, you would have outperformed a traditional 60:40 portfolio by a massive 4.5% total return.

Past returns are not an indicator of future performance

Like any good financial disclaimer would say, past returns are not an indicator of future performance. Just because an asset class has outperformed the past 5 years does not mean it will continue to outperform in the next 5 years.

With a stock, there are income flows and balance sheets to look at, and you can value a stock off its fundamentals and future prospects. With a bond, you can value its future income streams. With a commodity, there is inherent value given its usage in industrial processes.

With cyptocurrency however, no one knows how to value it with any degree of certainty. In the short run, price performance will depend entirely on market sentiment. In the long run however, crypto may or may not mature into a new asset class. Let’s look at where potential price drivers may come from.

Where does Crypto’s value come from

Artificial Scarcity

All cryptocurrencies have a predetermined supply, whether determined by an inbuilt algorithm or otherwise. This controls the supply of currency (something I cannot say of the USD).

This means that if demand for a cryptocurrency continues to grow, its price should theoretically increase.

One potential problem however, is that anyone with a laptop can create a new cryptocurrency. This will result in an endless supply of new currencies. My analogy is this, think of cryptocurrencies like WhatsApp, before it became popular. It was competing with a number of other messaging apps, be it Kakao talk, Kik, Telegram, because anyone could copy the idea and write an alternative messaging service. However, once WhatsApp because more popular, it fed on its own success, because existing users started referring their  friends and resulting in exponential growth, drawing more and more users to it.

I see crypto in the same way. There any many different coins out there today, but once one starts to dominate, be it Bitcoin, Ether or any other coin, it will eventually grow to become the dominant currency. Unfortunately, I don’t know which coin this would be.

Blockchain technology has vast potential

There is a famous quote from Jack Ma where he says that Bitcoin is a bubble, but the blockchain technology behind Bitcoin, is incredibly powerful. I’ve been talking to a lot of people involved in the crypto world recently, and the excitement in this space in unparalleled. There is genuine belief among the people on the ground on the ground that blockchain technology is in its infancy, and that it has the potential to revolutionise the world, much in the same way the internet did. Blockchain, simply put, is:

“The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”

Don & Alex Tapscott, authors Blockchain Revolution (2016)

If you think about it, an incorruptible digital ledger can truly revolutionise the world. A lot of legacy systems, the land title registry, supply chains, bill of ladings, all rely on archaic paper records that have to be manually verified and rely ultimately on an implicit trust of the counterparty. A true implementation of the blockchain technology will change all that, and revolutionise the backbone of the global economy.

Of course, this will take time. The internet first appeared around the 1990s, and a mere 20 years later, the internet now permeates every aspect of our life. Using a similar timescale and accounting for the exponential growth of technology, we may be seeing massive impact from blockchain technology in the next 10 to 15 years.

Not controlled by any central government

Cryptocurrencies are decentralized. No one government has control over the currency. This has led to powerful uses of cryptocurrency in everything from money laundering to evading capital controls. I see recent moves by the Iranian government in banning cryptocurrencies to prevent capital outflow as a powerful recognisation of this trend.

If I were living in a developing nation at high risk of currency depreciation or hyperinflation (Venuzuela comes to mind), I would seriously consider moving some of my money into crypto. The problem with holding USD or gold is storage. A government official can bust your door and raid your stash of USD or gold, but with crypto, the only thing required to unlock this money is the private key. This is a long string of numbers and letters that can simply be saved in an email, or in a thumbdrive. It’s a lot more robust than trying to store or hide money in any other asset class.

The flipside of this, is that governments have recognized this, and are imposing greater controls. This can range from banning cryptocurencies outright, or imposing more stringent know your client checks on cryptocurrency exchanges. I don’t necessarily see this as a bad thing, as it affords greater legitimacy to the space, and reflects a maturing industry.

Price performance is remarkably robust

The long term chart for Bitcoin makes absolutely no sense. It looks 100% like a bubble.

However, if you truly believe that bitcoin, and cryptocurrencies, are part of a new asset class, then it is not unreasonable to expect exponential growth in their early years. If so, a linear chart would produce gibberish, and a log chart would actually be a lot more useful. To recap:

A logarithmic price scale is plotted so that the prices in the scale are not positioned equidistantly; instead, the scale is plotted in such a way that two equal percent changes are plotted as the same vertical distance on the scale.

Once you flip it into a log chart, suddenly everything makes more sense. What the log chart show, is that the rate of percentage increase in bitcoin, is actually on the uptrend, despite significant market crashes here and there. Don’t forget that despite significant market crashes, 85% from January 2014 through January 2015, and the 64% from December 2017 through March 2018, bitcoin is still around, and trading volumes are higher than ever.

Crypto is not income generating

Warren Buffet criticizes bitcoin as not being an investment because it lacks intrinsic value:

“If you buy something like bitcoin or some cryptocurrency, you don’t have anything that is producing anything. You’re just hoping the next guy pays more. And you only feel you’ll find the next guy to pay more if he thinks he’s going to find someone that’s going to pay more. You aren’t investing when you do that, you’re speculating.”

I do acknowledge that cryptocurrency is not backed to any underlying income stream or intrinsic value. However, as Union Square Ventures founder Fred Wilson put it, the true value of the bitcoin ecosystem would accrue to the protocol itself and not the businesses that build on top of it.

One way to see it is to view crypto as a store of value (like gold), and an implicit bet on the power of blockchain technology. However at the end of the day, there is no getting around the fact that this is a very high risk asset, that could very well amount to pure speculation.

How to buy Bitcoin

I decided not to include a guide on how to buy cryptos because I recognize that these are highly risky investment products that can exposure you to complete loss of capital. If you are prepared to take on these risks, you should be doing full due diligence on this asset class, and that includes reading up on how to purchase a coin.

Do also note that in this article, I have generally referred to cryptocurrencies generally. That’s because I really don’t know which coin will take off.

What I will say is this. Bitcoin by far is the most mainstream coin. If you want a “blue-chip” crypto (if there is even such a thing), Bitcoin is probably a good bet. There are many limitations in the underlying technology, but its first mover advantage is unparalleled.

If you want to bet on Initial Coin Offerings (ICO), Ethereum is a good bet, because Ether is the platform by which many other ICOs are conducted. Ethereum is also the second largest crypto by market capitalization.

Other coins that I look at, Ripple, VeChain, Cardano, are also highly interesting, and you can check them out if are interested.

Crypto ETFs currently are trading at a massive premium to book, so while they afford greater convenience, security and peace of mind, I don’t recommend them because you are  being exposed to the same underlying risk, but you pay a huge premium for the convenience of an ETF. It makes far more sense to invest directly in the underlying crypto instead.

Closing thoughts

At the end of the day, investing is about considering risk versus reward. Successful investing also requires having an open mind, and being able to spot global trends before the mainstream does.

The way I see it, the risk-reward for cryptocurrency is, as long as you pick the right coin, massively skewed to the upside. However, this is a highly volatile asset class where 10% moves a day are viewed as normal. I wouldn’t advise anyone to put more than 1% of their portfolio into this. You can afford to lose 1% of your portfolio entirely and not have any outsized impact on your day to day life. The upside however, if cryptocurrencies really take off, are truly unparalleled.

 

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