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Bitcoin – should it be in your portfolio?

Bitcoin – virtual money – has been in the news again lately with the collapse in its price from a high late last year of over $67,000 to just under $30,000 in late May 2022. Having been a candidate for the title of “irrationally exuberant investment of the year”, it is now looking rather less impressive. But could there be a place for cryptocurrencies in portfolios?

First, a bit of history. Bitcoin was the first of the cryptocurrencies to be created (others include Ethereum, Binance Coin and Tether), and has been around for over a decade, having been created in the aftermath of the Global Financial Crisis to provide an alternative to the traditional banking system which appeared to be failing.Bitcoins are “mined” by participants and there is an open, distributed ledger using blockchain technology that records transactions and is structured so that double ups do not occur. There are over 18,000 cryptocurrencies in existence, although many have little to no trading volume.

Cryptocurrencies, as decentralised payment networks, were viewed as a way to wrest power away from the banks and financial institutions that were considered to be at the root of the massive wealth destruction of the sub-prime mortgage crisis. It theoretically gave hitherto powerless individuals some financial control.

In its early years, the value of Bitcoin remained fairly low and stable. There was a huge run-up in the price in 2017 to US$20,000 per Bitcoin but this dissipated and it seemed as if Bitcoin’s day in the sun was over – until the run all the way up to $67,000. Apart from giving investors an opportunity for active speculation, how does Bitcoin compare to traditional assets?

In a traditional balanced portfolio, equities, bonds and cash all have a specific role to play. Equities offer investors a residual claim on future profits, while bonds promise a stream of future cash flows and the repayment of the principal on maturity. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.

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. 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. Of course, cash can be used to purchase goods and services, but in the case of cryptocurrencies, there are only limited opportunities for such usage, although arguably this may change rapidly as we become more comfortable with virtual currencies.

How can we ascertain the future value of a Bitcoin? Its price is tied to supply and demand and Bitcoin supply is theoretically limited to 21 million, due to the “hard cap” that is encoded in Bitcoin’s source code, which is difficult to change, though not impossible. Other cryptocurrencies, such as Ethereum, have no maximum supply.

The market is currently unregulated but regulators have issued warnings regarding the possibility of fraud and false guarantees of high investment returns. It is likely that cryptocurrencies will attract more attention from regulators over time, particularly as they challenge the power of the large financial institutions.

Even at its peak price, the total value of Bitcoin (which is by far the largest in terms of market cap of cryptocurrencies) in circulation was less than half of a percent of the total value of global stocks and bonds. The immaturity and complexity of the market, the lack of regulation, and the absence of custodial platforms are all factors which lead us to conclude that cryptocurrencies do not currently have a place in balanced portfolios. 

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