To Bit or Not to Bit: What Should Investors Make of Bitcoin Mania?

Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are used. No central bank issues the currency, and no regulator or nation state stands behind it.

Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a limited supply of 21 million [1], of which more than 16 million are in circulation. [2] Transactions are recorded on a public ledger called blockchain.

People can earn bitcoins in several ways. They can buy them using traditional fiat currencies [3] (legal tender) or they can “mine” them. Mining occurs from compiling recent transactions and solving a complex mathematical puzzles with powerful computers to receive new bitcoins.

For the past decade, cryptocurrencies were the delight of digital enthusiasts and people who believe the age of fiat currencies will end. This niche appeal is reflected in their market value. For example, at a market value of $16,000 per bitcoin [4], the total value of bitcoin is less than one tenth of 1% of the total value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months has received a great deal of media attention.

What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value?

You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.

EXPECTED RETURNS OF BITCOIN

Companies often seek external sources of money to finance projects they believe will earn profits in the future. When a company issues stock, it offers investments future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand when they exchange their cash today for an uncertain but greater amount of expected cash in the future. By investing in stocks and bonds today, you expect to grow your wealth tomorrow.

Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Besides the potential for providing positive returns, another reason to hold government bonds is to gain certainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.

Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.

Short-term currency movements are unpredictable. There is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it gives value that can manage near-term known expenses in those currencies.

With this framework in mind, holding bitcoins is like holding cash; it can pay for some goods and services. But most goods and services are not priced in bitcoins.

Much volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility spells uncertainty in the amount of future goods and services bitcoins can buy. This uncertainty suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for goods and services using bitcoins.

If bitcoin is not currently practical as a substitute for cash, will its value appreciate?

SUPPLY AND DEMAND OF BITCOIN

The price of a bitcoin is tied to supply and demand. The future supply of cryptocurrencies may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another[5]. The quantity of future supply may have no limit.

As far as future demand for bitcoins, there is a slight probability that nothing will come of it (no future demand) and a slight probability that it will be widely adopted (high future demand).

Future regulation adds to this uncertainty. While recent media attention has made bitcoin more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential for fraud and false “guarantees” of high investment returns. [6] Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.

These factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors transact at that price.

WHAT TO EXPECT OF BITCOIN

So, should we expect the value of bitcoins to appreciate? Maybe. But as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today.

None of this denies the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open ledger that can easily record transactions in a verifiable and permanent way. This has significant implications for banking and other industries.

Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash, they don’t provide a way to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these goals, it does not warrant a place in a portfolio.

If, however, you have a goal not mentioned here, and you believe bitcoin is well suited to meet that goal, keep in mind the final piece of our asset allocation framework: What percentage of all eligible investments do the value of all bitcoins represent? When compared to global stocks, bonds, and traditional currency, their market value is tiny. So, if an investor decides bitcoins are a good investment, we believe their weight in a well-diversified portfolio should generally be tiny.[7]

Questions?