Cryptocurrencies: To buy or not to buy?
The discussion around cryptocurrencies occupies much of the air-space in investment news and the dialog offers vastly different perspectives regarding investment potential and strategy. At this point, cryptocurrencies can no longer be dismissed as a passing fad. Bitcoin’s market value is over $1 trillion, surging 1000% in the past year alone. Brokerages such as Morgan Stanley are recommending cryptos be added to investment portfolios and large companies such as Tesla and Paypal are beginning to accept them as forms of payments. Even financial institutions are preparing to trade and manage cryptocurrencies for investors. However, there are still important questions to answer regarding if investing in cryptocurrencies is the right call for you.
First, it is important to know that investment in Bitcoin and other cryptocurrencies involve high risk with potentially high reward. Therefore, choosing to add Bitcoin or other cryptocurrencies to your portfolio depends on your risk tolerance and investment goals.
One of the primary reasons investors have for adding cryptocurrencies to their portfolios is for diversification. Similar to real estate or gold, some believe that Bitcoin has the capacity to serve as a hedge against inflation. Historically, Bitcoin has had low correlation to traditional asset classes like the S&P 500, which would offer diversification benefits. However, it is important to note that as Bitcoin has increased in popularity, its correlation to the overall market has also increased. Cryptocurrencies can potentially serve as alternative assets, but it is important to understand that over time their market correlation will likely increase and reduce their diversification benefits.
Another common reason for investors to add cryptos to their portfolios is for capital appreciation potential. Bitcoin has experienced drastic increases in value, rising from $314.50 on January 2, 2015 to more than $64,000 this year. There is potential for even more value increases as institutions and retail providers adopt the use of cryptocurrencies. However, these increases have been accompanied with extreme volatility, accompanied with high risk for investors. Before choosing to add cryptocurrencies to your portfolio it is important to consider the following:
- The Unknown of Future Regulation. Currently, cryptocurrencies are widely unregulated and the future of regulation is still unknown. Regulation could potentially increase confidence in investing in cryptocurrencies, or it could potentially lead to stifling taxation policies or outright bans on cryptocurrency use. For example, Beijing has already shut down domestic crypto exchanges and has banned banks and other financial institutions from transacting Bitcoin, offering a digital yuan controlled by their central bank as an alternative.
- The Environmental Costs. Bitcoin and many other cryptocurrencies require massive amounts of electricity to mine and trade. Bank of America estimates that for every $1 billion that inflows into Bitcoin there is an environmental impact equivalent to putting 1.2 million cars on the road. The current network emits over 60 million tons of carbon dioxide into the atmosphere and the source of electricity used to mine the cryptocurrency comes from questionable sources (i.e. unreliable reports on whether the energy is sourced from renewables or from fossil fuels).
- The Potential for Competition. There are thousands of cryptocurrencies available for trade and purchase. Ethereum, Litecoin, and other cryptos all have the potential to devalue digital currencies like Bitcoin. Some argue that other than being the first successful cryptocurrency, there is not much that intrinsically makes Bitcoin special, bringing into question the long term value of the asset. Furthermore, central banks are exploring the potential of blockchain technology (what Bitcoin is based on), which could provide future competition for the cryptocurrency. Alternatively, many experts argue that Bitcoin’s value will continue to rise as more institutions and investors adopt the currency.
These considerations are important when considering whether or not a cryptocurrency investment is right for you. There are several known factors: cryptocurrency is inherently volatile (although that may decrease as the asset class matures), there are immense environmental impacts (particularly with Bitcoin), there are many different cryptocurrencies to choose from, and the future innovations in the digital market are still unknown. That being said, if the capital and diversification benefits of investing in cryptocurrencies align with your portfolio and investment goals, then there are a few essential standards to follow.
First, your investment in cryptocurrencies should be no more than 2-3% of your investment portfolio. Swings of 10%-20% within a week are not uncommon and it is not necessary to have a large allocation to have a significant impact on your returns. This also protects your portfolio from worst-case scenarios that come with volatility. Second, when investing in cryptocurrencies consider diversifying your investment across a number of the major options. Each cryptocurrency has different properties that react to market situations independently. This, to some degree, protects your investment from the intrinsic volatility of cryptocurrencies.
In summary, if you ask, “Should I invest in Bitcoin?”, our answer would be, “It depends.” Given the volatility and uncertainty of cryptos, there may be too many unknowns for the investor who is cautious and cannot tolerate fluctuations in the value of an investment. Alternatively, if you see the value of adding this emerging technology to your portfolio, then you might consider making cryptocurrency a part of your portfolio, with the understanding that there are risks involved that cannot be controlled or anticipated.
We welcome a discussion regarding where this may or may not fit into your investment strategy. Please reach out to us if you would like to explore this or other alternative investments. We can be reached at (480) 214-9596 or firstname.lastname@example.org. Thank you!