“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” – Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
In the financial industry, investors are regularly exposed to new fads. The latest is bitcoin, which has surged 30000% since August 2011, providing an astounding annualised return of 160%. Bitcoin’s performance has sparked debate amongst investors as to whether it should be treated as a regular asset class, in the same league as traditional investments such as equities or fixed income.
Bitcoin sits within a class of rapidly emerging products known as cryptocurrencies – money that has no physical shape or form, and only exists in the digital world. Instead of being supplied by a central bank like conventional currencies, bitcoins are created by solving complicated algorithmic searches with computers. Also, increases in the stock of bitcoin are predetermined – with the algorithm determining the rate at which new bitcoins are created until the limit of 21 million is reached. Its transactions are open to the public, and supposed to be void of transaction fees. Given these qualities, bitcoin has been hailed by some as the future of money.
To make the case for an asset’s inclusion in a portfolio, it needs to have a positive expected return over the long-term, and act as a diversifier. Bitcoin potentially satisfies both criteria. With the increasing digitisation of the economy, we may see a greater shift towards non-cash transactions executed through digital means. This would, increase the utility of cryptocurrencies, potentially leading to price appreciation and a positive expected return. Besides that, bitcoin has shown itself to be relatively uncorrelated to most traditional asset classes. Of course, correlations should be interpreted with caution, given how unstable they can be. Nevertheless, current patterns suggest that bitcoin may be, in theory, a useful diversifying asset.
Still, the risks from treating bitcoin as a mainstream asset far outweigh its potential benefits. In asset pricing theory, the intrinsic value of an asset (e.g. a stock or bond) is equal to the discounted value of its future cash flows. However, bitcoin has no such cash flows. This means that it doesn't have any fundamental value, only that which is assigned to it by market speculation. Bitcoin’s value is derived from the market’s expectations of it eventually maturing into a credible currency on a par with traditional fiat money like the dollar and sterling. Whether such an outcome takes place is difficult to predict. Cryptocurrencies may play an increasingly large role in the digital economy, but it’s too early to say whether bitcoin will be in it; there are many other digital currencies out there. To make an outsized bet on bitcoin’s future is therefore just that: a gamble, not an investment.
Further, since the price movements of bitcoin are derived from speculation, it is extremely susceptible to violent swings in sentiment and the formation of bubbles. For example, bitcoin endured a massive 74% collapse between early 2014 and 2015, before surging by a dizzying 170% per annum to reach its present value. Such movements make it virtually useless as a credible store of value – an essential characteristic of all credible currencies (or any investment asset, we would argue). Besides that, the outsized volatility of bitcoin returns dwarf even those of highly risky assets like emerging market equities and junk credit, making significant holdings of bitcoin unfeasible for investors, save for the extremely risk tolerant.
The allure of fads like bitcoin is tempting, especially given how lucrative its returns have been. Nevertheless, past performance isn’t indicative of future performance. Given its outsized volatility and uncertain future, bitcoin isn’t a product worth including within portfolios by any significant amounts. The financial system is always in the process of creating new, innovative, and potentially useful investments with which to diversify. Bitcoin isn’t one of them yet.