April 28, 2022

Where does Cryptocurrency Belong Inside of a Diversified Portfolio?

Cryptocurrency, more commonly referred to as "crypto", is a hot topic these days. It is something that is in the news almost every day in some form or another, and has many investors talking about ways to get rich. In this post, I go into how I view several arguments for cryptocurrency, how to view it as a potential investment, and where it may or may not fit inside of a diversified portfolio.

Crypto began its entrance into the mainstream about 10 years ago with the creation of Bitcoin. Prior to the last few years, cryptocurrencies were largely used to purchase illegal materials on the dark web. Presently, with the increased trading, mining, and daily  exchange of cryptocurrency, its popularity has skyrocketed. Not only is cryptocurrency all the rage, new coins are being created out of thin air and sold to the public, thus value is being created overnight in a way that is not sustainable, predictable, or realistic. Here is how I view a few of the most common arguments for cryptocurrency:

Crypto as a store of value: This argument originates from the mindset that cryptocurrency is a store of value, similar to the way the U.S. dollar has traditionally been viewed. If it is going to be a store of value, it must maintain value over time. It is very difficult to see how something is a store of value when it drops by over 50% multiple times in one year. For something to be a store of value, I would have to be able to place something like a down payment on a house into it and expect it to maintain a relatively level value over the next 12 -24 months. I would not place, nor advise, anyone to place the money they plan to use for a short-term goal into cryptocurrency, which can be up or down 50 to 100% over almost any period. Furthermore, crypto has not been a reliable hedge against inflation in recent months. While inflation has almost tripled over the last year, Bitcoin is down roughly 28% at the time of this writing in April 2022 as shown by the below graphs.

Annual Inflation Rate for April 2021-March 2022

Bitcoin Price over the year ending April 27, 2022

Crypto as a medium of exchange: Crypto as a medium of exchange means that it can be used to buy things, anything from a Tesla to a pizza. We have seen some vendors allow cryptocurrency to be used to purchase things, but it is far cry  from being widespread accepted medium of exchange. Crypto is still largely utilized to purchase illegal materials, execute transactions on the dark web, or in video games that are tied to cryptocurrency. This point drives us back to the argument regarding crypto as a store of value. For crypto to be a successful currency, it needs to be much, much less volatile. It will remain difficult for crypto to become an accepted form of everyday currency when the value fluctuates by multiple percentage points every single day. We saw Tesla begin to accept Bitcoin as payment for vehicles, and then proceed to write down a multi-billion dollar loss in 1 quarter because of the decrease in the value of Bitcoin. For me, cryptocurrency does not pass the test as a reliable medium of exchange, although it may someday, especially with the adoption and research by government entities.

Crypto causing the decentralization of finance: There are a couple of pieces to this argument, and one is that there is no monetary policy governing cryptocurrency. In the case of Bitcoin, there is a fixed number that will remain in circulation. Thus, many point to this as an argument supporting its ability to operate as global currency rather than the U.S. dollar which can be printed at any rate the U.S. government dictates. This is an interesting argument, however, I’m not sure that it solves the fact that cryptocurrency as a whole can simply be created out of thin air. You may have seen many posts on social media about new cryptocurrencies or coins created, and the apparent value that these coins have overnight. Herein lies the problem that I have with the cryptocurrency, there is no underlying value to many of these coins. Some of the more popular coins, like Bitcoin and Ethereum, may have some level value in their network (or the number of nodes they have), but that’s extremely intangible in a financial frame of mind compared to the earnings of established companies on the main stock market exchanges.

Crypto Security: Cryptocurrencies have been touted as being more secure than traditional banking due to blockchain technology. While this may be true in the future, billions of dollars have been stolen from cryptocurrency accounts in the last few years. Particularly some of the newer cryptocurrencies that aren’t quite as established as Bitcoin and Ethereum have been hacked, and remain highly susceptible to future hacks. If the currency or potential store of value is hackable it essentially useless. Hacking is much more difficult with Bitcoin, due to its extensive network, but crypto's rapid growth as a whole demonstrates the difficulty in ensuring its security. This leads into a related issue, the lack of insurance.  If you place money into a savings account it is federally insured in the case of bank failure up to $250,000 per account type and per account holder. This does not exist with bitcoin or any cryptocurrency. If in fact the conventional ways of society goes haywire, the likelihood of you being able to collect your Bitcoin funds is low. Also, the odds of these coins holding value in a doomsday scenario is also probably very low in their current state.  

How to view cryptocurrency inside of a portfolio: Now that we have gone through a few of the main arguments for the future of cryptocurrency, let's discuss how it might be used inside of a portfolio. Cryptocurrency has the potential to return over 100%, but also lose almost 100% in just one year. Even a small allocation to this asset class can have a significant positive or negative effect on the overall portfolio. In general, I think that there are a couple of intelligent ways to invest in cryptocurrency if you have an urge to get involved with this asset class:

  1. Utilize cryptocurrency as an alternative asset in a diversified portfolio. This would involve a portfolio of primarily U.S. and international stocks, bonds, and then 5% of an alternative asset like cryptocurrency. This is a good way to get exposure to this asset without jeopardizing the majority of your portfolio.  
  2. Fully fund all retirement accounts for both spouses, and only then allot any excess cash flow to cryptocurrency. This way, the couple has assured their financial future, but can still invest in emerging assets such as cryptocurrency. For the vast majority of investors, this maximum retirement savings is simply not happening. Many investors are placing the vast majority of their net worth into cryptocurrency, a highly volatile asset, while not taking advantage of vehicles such as 401(k)s and IRAs that are proven to be great builders of wealth over long periods.

So What? The bottom line is that cryptocurrency is a buzzy, emerging asset class that is making its way into investors' portfolios. Despite the buzz, the fact remains that its historical data is very short, and there is still a lack of tangible value in these coins, unlike the value provided by the stock market. Much of the value is speculative and cannot be tied directly to anything. This is especially true with emerging and lesser-known coins, such as the ones making their debut daily on social media, that are not your major cryptos (Bitcoin, Ethereum, etc.). It is important to understand what cryptocurrency is and fully comprehend the potential risk you are assuming with an investment into these assets. I fully believe that cryptocurrency is here to stay in one form or another, but I do not see it as a viable asset class for most investors' portfolios at this time. If it is an asset class that an investor wants to be involved in, I simply caution awareness and education of the risks. I believe that at some point cryptocurrency will become more exchangeable, regulated, and less volatile. At that time, it will be less of a shiny new investment asset and a more usable currency in the economy.

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