A store of value, a medium of exchange, a unit of account. Bitcoin is all things to all investors, just not at the same time.
“It’s a date. You eat ’em.”
— Indiana Jones and the Raiders of the Lost Ark © 1979
Just as you wouldn’t use a date (a type of fruit) for a door stop, kerosene as cooking oil, or chilled monkey brains as a dessert, it’s important to understand what advocates of bitcoin within an investment portfolio are proselytizing.
Bitcoin has been touted by some of the biggest names on Wall Street as a potential hedge against inflation within a portfolio, and that narrative has been conflated with declaring cryptocurrency as an “investable asset.”
Which begs the question, what is an “investable asset” anyway?
In general, and according to traditional metrics, an investable asset ought to meet these criteria:
- generate steady, reliable cash flow on a contractual basis, like bonds
- deliver earnings through exposure to economic growth or from the creation of products or services that are desired, like equities
- provide consistent and reliable diversification benefits to a portfolio, with limited correlation with other assets
- dampen portfolio volatility
- reliably hedge inflation or deflation as a store of value
So how does bitcoin fare?
Although it’s possible to earn a yield from cryptocurrencies when they are used in staking, for instance in a proof-of-stake process, or as a tool for the provision of liquidity, by most traditional metrics, these programmatically promised yields are often considered a far cry from the contractual obligations that most investors are used to when it comes to fixed income.
That having been said, it’s not unusual for centralized cryptocurrency exchanges to offer yields in excess of 7% on dollar-based stablecoin deposits, far above the current savings rate offered in the U.S.
Investors who claim that bitcoin has no cashflows assess the nascent asset from the lens of bonds, which is probably inappropriate.
To begin with, a bond is a claim to a debt that a government or company owes to the holder of the bond.
In return for taking the risk that the issuer of a bond (the borrower) never makes good on the principal, the bondholder (the lender) receives an annual coupon payment (the yield).
For cryptocurrencies, yields are governed by autonomously operated and immutable smart contracts, outside of inherent smart contract risk (vulnerabilities and exploits), the risk of non-payment is a non-starter, an algorithmic and programmatic impossibility.
But, it’s entirely possible that the yield tokens (typically issued by the smart contract platform provider) could end up worthless — insofar as the principal itself is concerned, the risk of loss is minimal if not negligible.
The problem of course (from most traditional investment perspectives) is that the principal itself is seen as of dubious “value.”
Whether it’s dollar-based (or backed) stablecoins or some other cryptocurrency, participating in yield generation when it comes to decentralized finance or DeFi requires an assumption as to the “value” of the principal being staked.
And because DeFi yields can vary dramatically, many traditional investors see cryptocurrencies as failing to generate the “steady” coupon payments that are typical of bonds.
Yet such assertions also ignore the fact that bond yields are far from stable, the coupon (interest payment) may be, but the actual yield, catering for demand, supply and inflation, is what investors care about and that almost never is.
Take the benchmark 10-year U.S. Treasury yield from the week of November 20, 2021.
Concerns over the Omicron variant of the coronavirus saw yields plummeting (yields fall when bond prices rise), as demand for haven assets soared.
So an analysis of bitcoin (or other cryptocurrencies) in comparison to bonds alone can be misleading.
Some have argued that bitcoin, as currently structured and unlike equities, do not generate earnings tied to economic growth.
This is true.
Outside of compelling investment narratives, bitcoin in and of itself has no traditional “economic rationale” akin to that of equities that can foreshadow the upward trajectory of its price based on external economic factors.
While the benchmark S&P 500 index has in aggregate had a long-term upward price trajectory because positive global growth enables its constituent companies to add to earnings, there is no parallel in the cryptocurrency space.
But again, this view ignores the fact that the S&P 500 is far from a static benchmark.
The top five companies on the S&P 500 (all tech), make up a fifth of the value of the index and most of these companies were not even constituent stocks of the benchmark just two decades ago.
While there is no parallel to growth in earnings with cryptocurrencies, such a view also assumes that “earnings” are the only possible determinant of “value.”
Ultimately, earnings are most closely tied to value creation and while there can be no doubt that the bulk of demand for cryptocurrencies at this current stage of their evolution is speculative, that’s not to say that demand for them will not one day be associated with their use to derive value from services rendered by the blockchain, whatever those services eventually evolve to become.
Diversification & Volatility
Because bitcoin and cryptocurrencies remain relatively resistant to an indisputable and objective assessment of value, correlations with other asset classes have tended to be inconsistent.
Average correlation of bitcoin with the S&P 500 has ranged from -0.26 (a negative correlation suggests that two assets move opposite to each other in terms of price) to 0.51 (a positive correlation suggests prices of the two assets move in tandem).
Bitcoin also has inconsistent correlation with gold, commodities and bonds.
While bitcoin’s “investable” value may be debatable, its addition into a portfolio based on diversification alone has sound basis in Nobel prize-winning economist Harry Markowitz’s “Modern Portfolio Theory” or MPT, a mathematical framework for choosing an optimal spread of assets.
MPT posits that a rational investor should seek to maximize their returns relative to risk (measured by means of the volatility in returns).
While an investor seeking high returns without volatility might not necessarily gravitate towards cryptocurrencies like bitcoin, given that they have a tendency to plunge and soar in value, the genius of MPT is that it’s not necessarily an asset’s own riskiness (volatility) that is important to an investor, as much as its contribution to the volatility of an overall portfolio.
And that is primarily a question of correlation, specifically the correlation of bitcoin with other assets.
Consider the mix of assets a rational investors might hold, from geographically diverse stock indices, to bonds, real estate to commodities — the assets that yield the richest returns — stocks and real estate — also tend to be the two that move in the same direction at the same time.
While the correlation between stocks and bonds is weak (0.2–0.3 over the past decade), the pandemic has tested this assumption, with stocks and bonds trending in the same direction at almost every juncture.
Far from reducing volatility during periods of stress in equity markets, putting stocks and bonds in a portfolio this past eighteen months has actually exacerbated volatility, rather than dampened it.
Whether that correlation between stocks and bonds is transitory or the shift will ultimately prove durable is a different story altogether.
And it is perhaps in this regard where bitcoin may have an edge.
Bitcoin is highly volatile, but its short history has also seen higher than average returns and importantly, since 2018, the correlation between bitcoin and stocks represented by the MSCI All Country World Index has been between 0.2–0.3.
Over longer time horizons, the correlation between bitcoin and equities is even weaker, making it an excellent potential source of diversification.
Which would explain its appeal to some big Wall Street names, including the billionaire macro hedge fund manager Paul Tudor Jones, who has said publicly that he aims to hold about 5% of his portfolio in bitcoin.
Inflation Hedge & Store of Value
Because the history of bitcoin is limited, focusing on its ability to hedge against inflation is to miss the forest for the trees.
Even gold, which has been prized for millennia has had a patchy track record when it’s come to its alleged ability to hedge against inflation, demonstrating such properties over centuries, but not within a typical investor’s lifespan, unless of course you’re Duncan MacLeod.
To serve as a reliable and consistent store of value, an asset would typically not have frequent and large price declines — presumably you wouldn’t want your refrigerator swinging from being full to empty over the course of a day because meal planning might be challenging.
And in this regard, even compared against U.S. equities, bitcoin has struggled to “store” its value — with more frequent and larger price declines over its 12.5 years of existence than the stock of American companies since 1928.
Bitcoin has also had too short a lifespan to be properly measured up against inflation because until fairly recently, in the period after the 2008 Financial Crisis (and covering all of bitcoin’s lifespan), price increases have been muted.
As such, bitcoin’s comparison with gold as an inflation hedge is inconvenient at best and misleading at worst.
Unlike bitcoin, gold has fundamental uses, fluctuating from the aesthetic to the industrial, but it is the demand from investors that sets its price.
Bitcoin and gold have no cashflows and are generally not used as a medium of exchange, but they can have decorative value (gold) or an emotional attachment and are best classified as that class of assets considered “collectible.”
Like a classic car or a baseball card, a collectible can’t be “valued” using traditional metrics, but they can be priced based on how others perceive that collectible’s desirability and its scarcity and it is in this respect that bitcoin shines as an asset class.
While a fool is often derided as someone who knows the price of everything but the value of nothing, anyone assessing the “investable” nature of bitcoin needs to don the cap of the fool because that is precisely the skillset necessary to profit from the cryptocurrency.
It’s important to distinguish between cash-generating assets (like equities and bonds) that can be both valued and priced, and collectibles that can only be priced.
To consider an asset “investable” an investor would first need to assess its value, compare that value against the price and then act on that comparison, either by buying (if the price is less than value) or selling (if the price is greater than value).
As bitcoin and cryptocurrencies increasingly enter the mainstream, it becomes all the more important to understand what game investors should be playing when it comes to the nascent asset class — are they playing the pricing game or the valuation game?
Valuing bitcoin is exceedingly challenging — from cash flow analysis to the cost of production, none of the standard approaches to valuing traditional assets yields a useful framework for bitcoin.
But even if bitcoin can’t be valued, at least not in the traditional sense, it can be priced.
Playing the pricing game is a much simpler exercise than playing the valuation game and requires an “investor” to in essence become a “trader.”
When a trader prices something, they make a judgment on whether that price will go up or down in the following time period and then make a pricing bet accordingly.
The “thing” being priced has little relevance, so long as there are sufficiently liquid and deep markets to play the pricing game for that “thing.”
To win, a trader simply has to be right more often than wrong about the direction and to exit before the wind shifts when playing the pricing game.
Whereas price is determined by demand and supply, this demand and supply should not be confused for that of the underlying asset that bets are being taken on, but rather the demand and supply of bids and asks in a market, which are in turn determined by sentiment and momentum.
Incremental information, like news, stories and rumors, that shift sentiment, will move price, even if those shifts have no long term consequences for “value.”
To play the pricing game, a trader (formerly known as an investor) will need to arm themselves with the weapons of the trade (pun not intended) and in the case of bitcoin, that includes everything from technical indicators, price charts, to investor psychology (keeping an eye on Twitter helps too).
Decision-making timeframes will need to be adjusted accordingly as well — instead of buying to hold indefinitely, a trader may be very short term (minutes) to mildly long-term (weeks to months).
And one of the key skills of the trader is to be able to gauge the market mood and momentum shifts ahead of other traders, which typically requires a unique skillset that the average investor generally doesn’t possess.
That set of skills includes market amnesia (recognizing that what has happened in the past has little to no correlation with what will happen in the future), responsiveness (not holding on to losing positions) and gambling instincts (the culmination of all of the former skills).
One of the biggest risks when it comes to playing the pricing game is that momentum shifts can appear instantaneously and arbitrarily, wiping out months of profits in a few hours or even minutes.
But the biggest danger when it comes to playing the pricing game, is assuming that you’re playing the valuation game.
Any serious debate about bitcoin necessarily requires an assessment as to whether it is an “investable asset” at least according to traditional metrics.
For investors who are carving out a portion of their portfolios to plonk it on bitcoin, it’s important to be clear as to the intention behind such a move — it’s not for diversifying a portfolio, or even hedging against inflation, it’s to leverage trading skills to supercharge portfolio returns.
Because valuing bitcoin is such an intractable problem, the only option is to price it and recognize that in the long term, the price attached to bitcoin will depend on what other traders will pay for it.
Since it’s not possible to value bitcoin, a critical ingredient needed for an investor “valuing” the nascent asset is absent, which means that the only thing left behind is to trade.
Anyone can trade bitcoin and become fabulously wealthy in the process — just know that they did so because they are a good trader, and not necessarily because they are a good investor.