Many of us know the story of Dutch speculators in 17th-century Netherlands spending a lot of money on tulip bulbs. Prices spiked between December 1636 and February 1637 on the then-rare striped variety. This short-lived market boom affected some personal fortunes and undermined trust when buyers couldn’t come up with the money to complete the exchange.
In this instance, we’re looking at an example of a luxury good masquerading as an investment. But a quick trip through investing history reveals more than one smart investor lured into thinking they had the inside track on the hot new thing. In the 1800s, we see another example with the downfall of the South Sea Company, which managed to entangle Sir Isaac Newton and many other investors.
Newton’s story will sound familiar. He managed to get out before the bubble burst with a 100% profit. But within months, he bought shares at the top of the market before going on to lose more than $3 million. Again, we’re not short on stories, which leads to today’s current fascination with things like Bitcoin.
There are several well-done explainers, so I won’t wade into the deep end trying to explain what crypto assets[1] do or what they’re for. Instead, I think it’s valuable to understand what they represent in the big investment picture, while keeping a fundamental question in mind: does this fit into my overall investment strategy?
For example, Bitcoin and other cryptocurrencies purport to be currencies (i.e., a medium that may be exchanged for goods and services). Traditional currency markets can be tricky, even for experienced financial professionals, and they may not be suitable investments for your portfolio. If traditional currencies wouldn’t be a good fit for your portfolio, what makes cryptocurrencies different?
There are also concerns regarding the impact that cryptocurrencies (particularly Bitcoin) may be having on the environment. Before becoming available for purchase and sale, cryptocurrencies are initially created through a technical process called mining, which requires significant amounts of computing power. A recent study noted that as of April 2020, China accounts for over 75% of Bitcoin mining activity, primarily due to cheaper electricity and large areas of undeveloped land.[2] This same study also concluded that the energy consumption of global Bitcoin mining activity and its corresponding environmental impacts have become “a non-negligible issue.” This poses a question of whether Bitcoin is compatible with environmental, sustainability, and governance (ESG) strategies.
Unlike traditional stocks, Bitcoin and other crypto assets require a digital wallet in order to be held. As of today, you cannot directly hold Bitcoin in a typical brokerage account (although there are services that attempt to streamline the process, a digital wallet is still required). The “account number” for a digital wallet is usually delivered in the form of a set of cryptographic keys, which are lengthy, alphanumeric sequences that must be managed and safeguarded, lest the wallet be compromised or access to it be lost.
Additionally, as with virtually all investments, investing in Bitcoin carries its own risks. Crypto assets are generally considered quite volatile, and Bitcoin is no exception. Figure 1 below shows the 60-day volatility of Bitcoin over the course of its lifetime. For comparison, Figure 2 shows the GARCH volatility estimate[3] for the US dollar from April 1, 2007 through March 31, 2021.[4] Over this time period, the dollar’s volatility reached an apex of 18.26% on December 19, 2008. Meanwhile, Bitcoin’s volatility has routinely crossed 10%, stretching beyond 20, 60, and even 100% over its lifetime. Do other investments in your portfolio experience similar volatility? Should they?
Figure 1: Bitcoin 60-day price volatility, shown over the lifetime of Bitcoin. The red line is the BTC/USD price volatility, while the blue line is the Bitcoin price in USD.
Source: https://charts.woobull.com/bitcoin-volatility/
Figure 2: USD Index GARCH volatility, shown from April 1, 2007 to March 31, 2021.
Source: https://vlab.stern.nyu.edu/analysis/VOL.DXY%3AFOREX-R.GARCH
To be clear, this newsletter isn’t an argument against crypto assets, blockchain, or other new financial technologies. Instead, it’s a reminder that history is littered with people who thought they’d found the next big opportunity only to discover the tradeoffs or losses were much greater than expected. Now, Bitcoin, non-fungible tokens (NFTs), and other financial tools sit in the spotlight. In fact, several prominent financial news channels have begun listing the price of Bitcoin alongside mainstream indices, such as the Dow and S&P 500. However, when it comes to evaluating Bitcoin as an investment opportunity, there are far more moving parts than its recent popularity and prominence.
The point remains that no matter the investment decision, we still need to ask the right questions and make decisions based on what will get us closer to our financial goals. Of course, for most of us, these decisions will never make headlines or encourage people to call us financial geniuses. But they will get us closer to what we’ve decided matters most to us.
[1] Cryptocurrencies are only one class of crypto product out there. There are also security tokens, utility tokens, and tokenized assets, to name a few.
[2] Policy assessments for the carbon emission flows and sustainability of Bitcoin blockchain operation in China, Jiang et al., available at https://www.nature.com/articles/s41467-021-22256-3.pdf.
[3] The generalized autoregressive conditional heteroskedasticity (GARCH) process is a broadly accepted method of estimating volatility in financial markets.
[4] This time period is intended to track the lifetime of Bitcoin, but it was extended to 2007 in order to illustrate the impact of the global financial crisis of 2008 and 2009 on the US dollar’s volatility.
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