Bitcoin and lesser-known cryptocurrencies are receiving intense media coverage these days. Many wonder whether this electronic “money” represents a “paradigm shift” and should deserve a place in their planning strategy. While their prices have soared, that is the past. What about the future?
Cryptocurrencies surely represent a financial services innovation, but many uncertainties surround their technology potentially impacting returns that investors may realize. While promoters point out spectacular price gains, that increase creates no price floor. Furthermore, the total value of all tradeable cryptocurrencies is miniscule relative to the global aggregate value of all stocks and bonds, so the allocation in diversified portfolios should be small.
For much of the past decade, cryptocurrencies were the preserve of a small group of digital enthusiasts and those who believed that fiat currencies were coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $57,000 per bitcoin,1 the total value of bitcoin in circulation is less than half of a percent of the value of all investible stocks and bonds.
Cryptocurrencies such as bitcoin have only recently emerged, and there are thousands out there. Dogecoin (DOGE), with little practical use, has a market cap of $65 billion. Unlike traditional currency, no paper notes or metal coins are issued. No regulator or nation state stands behind any of them, and no central bank is involved. Highly debated variables should be considered, such as difficult technological nuances. Some users have lost access to millions of dollars’ worth of bitcoin simply due to forgotten passwords that can’t be rectified.2 You can’t just call your local bank or brokerage firm to help you. Investors in regular stocks and bonds are not accustomed to such issues. Tax calculations also are a filing nightmare.
Cryptocurrencies exist only as a form of computer code and are stored in a “digital wallet.” Bitcoin has a finite supply of 21 million,3 of which more than 18.5 million are in circulation.4 Transactions are recorded on a decentralized public ledger called a “blockchain” with complex algorithms to validate these entries.
People can earn bitcoins in several ways. That includes buying them using traditional government-backed currencies3 or by “mining” them — receiving newly created bitcoins as payment for the use of powerful computers to compile additional transactions into new “blocks in the transaction chain” through solving a highly complex mathematical puzzle.
Expected Returns
Stocks and bonds are considered “productive assets” unlike cryptocurrencies. The value of those securities comes from future cash flows generated from activities with presumed economic value. Companies seek external sources of capital to finance projects intended to generate future profits. When a company issues stock, it offers investors a residual claim on a proportionate share of future profits earned. When an entity issues a bond, it promises investors a stream of future cash flows, including future repayment of principal when the bond matures. The price of a stock or bond reflects the return the marginal investor demands to exchange their cash today for an uncertain amount of cash expected in the future.
Most government bonds, compared to corporate bonds, provide a more certain promise of payments as cash flows. That greater certainty of positive expected returns is an important reason to hold government bonds reduces the volatility of future cash flows when planning for income.
Unlike bonds, holding cash provides no expected stream of income. One US dollar in your wallet today does not entitle you to more dollars in the future, no matter how long you hold it. The same is true for holding a digital currency like bitcoin in a digital wallet. Holding cash in either form has no expected return or expected stream of income, except as currencies unpredictably appreciate or depreciate relative to each other. Cash is a useful store of value only to manage near-term expenditures in the same currency. However, most goods and services are not priced in bitcoins.
The exchange rates between bitcoins and traditional currencies involves enormous levels of volatility. Bitcoin has gained or lost more than 40% in price in a month or two. High volatility implies a high level of uncertainty in the amount of future goods and services that bitcoins can purchase. This heightened uncertainty, combined with high transaction costs for converting bitcoins into usable currency, implies that cryptocurrencies fall very short as a means for managing near-term, much less daily, expenses.
Supply and Demand
The price of a bitcoin is tied to the forces of market supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit and stop future supply. The future supply of cryptocurrencies as sector, however, may be very flexible: new types are developed and technological innovation makes many cryptocurrencies close substitutes, implying that future supply of “cryptocurrencies” may be unlimited.
Future demand for bitcoins if unpredictable: there is a non‑zero probability5 that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand). Buying and selling something based only on what others guess its future worth might be is not investing — it is speculation.
Future regulation increases the uncertainty. As far back in 2014, the U.S. Securities and Exchange Commission warned potential investors that any new exciting and cutting-edge investment has the potential to give rise to fraud due to implied false “guarantees” of high investment returns.6 Cryptocurrency SCAM, created as a joke, has a market cap of $2.5 million. It is unclear what impact future laws and regulations in different jurisdictions may have on any cryptocurrency or even its continued existence.7 The Fed recently asserted that research on the digitalization of the U.S. dollar is a “very high-priority project.”8
But probabilities of high or low future supply or demand are only one input into bitcoin prices. Today’s price is fair, given that investors willingly transact at that price. No investor has an unfair advantage over another in knowing the true probability of future demand reflected in bitcoin’s price today.
Exhibit 1: The Risk Continuum
What to Expect
So, will cryptocurrencies continue to appreciate? Perhaps, just as Federal Reserve easy monetary policies fueled other financial booms as well as today’s bubbling stock boom. Stock valuations have risen to their richest levels since the dot-com bubble in 2000. The Fed has kept interest rates artificially near zero for the past year and signaled those rates will not change for at least two more years. Consequently 10-year Treasury bond yields are well below current inflation. Risky companies borrow at the lowest rates on records. This encourages speculation in cryptocurrencies as well in this environment.
In the framework for planning a diversified portfolio strategy for retirement or other goals, financial theory suggests that the baseline for portfolio design should be the weight of all investable securities in the global market. A goals-based approach based on stocks, bonds, and traditional currencies integrated with robust dimensions of expected returns has helped many informed investors successfully pursue financial experiences.
In the short term, cryptocurrencies may outperform other investments. Even if blockchain technology is here to stay, it is not clear that cryptocurrencies will last in their present form. Unlike stocks or bonds, cryptocurrencies do not offer positive expected returns for growing wealth and reducing allocations to traditional securities like stocks and bonds that do. And they do not allow for easy exchanges for near-term expenditures as do traditional cash equivalents. Therefore, we do not believe cryptocurrencies warrant a place in most portfolios.
When reading the latest headline or experiencing FOMO due to a friend getting rich, consider that sticking with informed strategy grounded in modern financial science is a more reliable long-term strategy for wealth planning. Studies in the aftermath of the dot-com bust twenty years ago found that almost all the big winners publicized in popular magazines had very little left to show of all their paper wealth. Don’t confuse a playcheck with your future paycheck in retirement.
- Per Bloomberg, the end-of-day market value of bitcoin was $57,698 USD on May 7, 2021.
- Nathaniel Popper, “Lost Passwords Lock Millionaires Out of Their Bitcoin Fortunes,” New York Times, January 12, 2021.
- Source: Bitcoin.org.
- As of March 12, 2021. Source: Coinmarketcap.com.
- Describes an outcome that is possible (or not impossible) to occur.
- “Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014.
- James Areddy, “China Creates Its Own Digital Currency, a First for Major Economy,” The Wall Street Journal, April 5, 2021.
- Greg Ip, “What Happens to Stocks and Cryptocurrencies When the Fed Stops Raining Money?” Wall Street Journal, May 8, 2021.