Before Investing in Crypto Currencies, Read This

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Bitcoin and similar cryptocurrencies (now numbering in the thousands) are the subject of much popular debate and media attention. Can something that exists only in cyberspace truly be equivalent to gold? Given bitcoin’s dramatic price changes, up and down, as well as promotional advertising like the sample above, it is not surprising that many are speculating about its possible place in portfolio designs. Who is more likely to gain wealth—the crypto creators or their buyers?

“Everything you don’t understand about money combined with everything you don’t understand about computers.” — HBO’s Last Week Tonight with John Oliver, March 11, 2018

Exhibit 1: Bit Player

Price of bitcoin for the last 10 years, March 2011–February 2021

illustration, Exhibit 1: Price of bitcoin for the last 10 years, March 2011–February 2021

Source: Dimensional Fund Advisors. This material is not to be construed as investment advice or a recommendation to buy or sell any security or currency. Investing involves risks including possible loss of principal. There is no assurance that any investment strategy will be successful. Past performance is no assurance of future results.

During its relatively short existence, bitcoin has proved extraordinarily volatile, sometimes gaining or losing more than 40% in price during a month or two. Any asset class subject to such sharp swings may be a narcotic for traders but of limited value either as a reliable medium of exchange (to replace cash) or as a risk-reducing or inflation-hedging asset in a diversified portfolio (to replace bonds).

Assessing the merits of bitcoin in a portfolio strategy can be problematic. Adding it to a portfolio could mean reducing the allocation to conventional investments such as stocks, property, or fixed income. The owner of stocks or real estate generally expects to receive future income from dividends or rent, even though the size and timing of the payoff may be uncertain. A bondholder generally expects to receive interest payments as well as the eventual return of principal. In contrast, holding bitcoin is much like holding gold. Even if bitcoin or gold are held for decades, the owner may never receive more bitcoin or gold. Also unlike investments based on stocks and bonds, it is not clear that bitcoin offers investors positive expected returns regardless how long the owners hold onto it.

Putting aside squabbles over the future value of bitcoin or other cryptocurrencies, there are other sobering issues investors should consider impacting their financial security:

  • Bitcoin is not backed by a governmental issuing authority and exists only as computer code, generally resides in a so-called “digital wallet,” accessible through a password chosen by the user. Many of us have forgotten or misplaced computer passwords from time to time and have had to contact the sponsor to restore access. No such avenue is available to holders of bitcoin. After a limited number of password attempts, a user can permanently lose access. Since there is no central authority responsible for bitcoin, there is no recourse for the forgetful owner: a recent New York Times article profiled the holder of more than $200 million worth of bitcoin that he can’t retrieve. His anguish is apparently not unusual — a prominent cryptocurrency consulting firm estimates that 20% of all outstanding bitcoin represents stranded assets unavailable to their rightful owners.1
  • Mt. Gox, a Tokyo-based bitcoin exchange launched in 2010, was at one time the world’s largest bitcoin intermediary, handling over one million accounts in 239 countries and more than 90% of global bitcoin transactions back in 2013. It suspended trading and filed for bankruptcy in February 2014, announcing that hundreds of thousands of bitcoins had been lost and likely stolen.2
  • The UK Financial Conduct Authority cited numerous concerns as it prohibited the sale of “cryptoasset” investment products to retail investors last year. Among them were the inherent nature of the underlying assets, which have no reliable basis for valuation; the presence of market abuse and financial crimes in cryptoasset trading; extreme price volatility; an inadequate understanding by retail consumers of cryptoassets; and the lack of a clear investment need for investment products and referenced them.3

The financial services industry has a long tradition of innovation. Cryptocurrency and the technology surrounding it could prove to be a historic breakthrough in coming years. For those who enjoy the thrill of speculation, trading bitcoin may hold considerable appeal. But those seeking financial security and peace of mind in planning for a secure retirement should consider the concerns of the UK Financial Conduct Authority above before making a serious investment.

Reserve your gambling for Las Vegas or Niagara Falls.

  1. Nathaniel Popper, “Lost Passwords Lock Millionaires Out of Their Bitcoin Fortunes,” New York Times, January 12, 2021.
  2. Alexandra Harney and Steve Stecklow, “Twice Burned – How Mt. Gox Bitcoin Customers Could Lose Again,” Reuters, November 16, 2017.
  3. “Prohibiting the sale to retail clients of investment products that reference cryptoassets,” Financial Conduct Authority, June 10, 2020.