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Does Bitcoin warrant a small allocation in portfolios?

On January 10, the Securities and Exchange Commission (SEC) approved the first U.S. exchange-traded funds (ETFs) that can directly invest in Bitcoin.

Until then, investors who wanted direct exposure to digital currencies had to trade on crypto exchanges and incur significant transaction fees. Or there were some ETFs that came out in 2021 that use futures contracts to gain exposure to Bitcoin price movements, but owning futures contracts rather than the underlying asset leads to differences in return due to the cost of carry.

These new ETFs that the SEC approved, however, are known as ‘spot’ price Bitcoin ETFs. Essentially, the term ‘spot’ indicates the fund’s direct holding of Bitcoin rather than a derivative based on Bitcoin’s price. And because the funds actually hold Bitcoin instead of derivatives, the ETF prices should, in theory, mirror the actual Bitcoin price movements in the cryptocurrency market.

So, for all of the investors that haven’t wanted to deal with digital wallets, remember complex keys, or register on a cryptocurrency exchange—these ETFs offer an easy way to gain exposure through the same brokerages you would use for trading stocks, bonds, and other ETFs.

In many ways, this development reminds me of when gold ETFs launched in the early 2000s, which offered an accessible avenue to invest in gold via a common brokerage account rather than purchasing actual gold bars.

The only notable difference is in security. Most of the physical gold owned by gold ETFs is held in a giant vault underground in London. With Bitcoin, security is a valid concern as there is always a risk of cyber theft. ETF providers won’t have an underground vault, but they do employ third-party custodians to securely store Bitcoin in offline ‘cold storage’ locations.

But I think it’s a bit ironic that the SEC’s social media accounts were hacked, and a false notice of approval was sent out just a day before the ETF filings were actually approved. There is no doubt that this space is rife with risk.

Should you invest in spot Bitcoin ETFs?

Investing in something simply because it has been going up recently or you fear of missing out on future returns isn’t a good reason to invest in spot Bitcoin ETFs. You really should only be investing in Bitcoin ETFs if you see value in doing so.

I’ve consistently been publishing content on cryptocurrency since 2017, and what has changed the most over time has been the complete demise of the case for Bitcoin as a currency capable of replacing government money—nearly all of Bitcoin’s proponents agree that it is extremely unlikely, if not impossible.

People often laugh about the guy who bought two pizzas for 10,000 Bitcoin in 2010 because it would now be worth over half a billion dollars. Using any medium of exchange shouldn’t cause potential for regret. My family gets pizza delivered once a week using US dollars and never once have I needed to worry about whether using my currency would be a mistake.

Even though proponents have seemingly acknowledged Bitcoin’s shortcomings as a medium of exchange, I still hear people promote its status as a store of value is shaky at best—but that isn’t something that should cause price to soar.

Bitcoin more closely aligns with collectibles

Regardless, because Bitcoin prices are not based on economic fundamentals, but rather depend on speculation about the adoption and use of cryptocurrencies, the uncertainty and resulting high volatility completely undermine the idea of it being a store of value.

The idea of buying cryptocurrency to ‘buy blockchain’ doesn’t really make sense either.

Owning Bitcoin doesn’t give someone any ownership in the underlying blockchain. Even if it did, the blockchain technology that underlies Bitcoin does not power the same blockchains used by the wide range of governments, corporations, and financial institutions utilizing blockchain technology.

The idea that blockchain might revolutionize the world is valid, but ‘buying blockchain’ would be like somehow buying ‘http’ which is the foundation of any data exchange on the Web – it might have been part of the function, but the real commodity was the specific URLs.

Bitcoin isn’t a commodity either, but the idea that it’s a form of ‘digital gold’, which may be true from strictly a sentiment perspective but couldn’t be further from reality otherwise.

If anything, Bitcoin is more closely aligned with collectibles like art, baseball cards, and Beanie Babies that have aesthetic or emotional value, but that derive their pricing from scarcity in supply and level of demand.

Implementing a bad idea vs missing out on a good one

It would be easy to categorize me as anti- Bitcoin or anti-cryptocurrency, but that isn’t necessarily true. I’m simply more concerned about implementing a bad idea than missing out on a good one.

Building a diversified portfolio requires you to combine exposures with various risk and return characteristics that behave differently over time. By combining exposures that zig with others that zag, the volatility of a portfolio’s overall returns is reduced. That, in turn, allows the portfolio’s returns to compound at higher rates.

(If you compare two portfolios with the same average return and different levels of volatility, the lower volatility portfolio will have higher compounded returns and a greater ending value than the portfolio with higher volatility.)

Of course, every new exposure added in the name of diversification comes with a diminishing marginal benefit, so you must carefully weigh the expected net benefits versus the degree of uncertainty.

Bitcoin certainly behaves differently than traditional asset classes such as stocks and bonds, but it doesn’t offer any expected premium for bearing the risk of Bitcoin’s price movements. That increases the already high uncertainty around the net benefit from including such an exposure to a portfolio.

Bitcoin prices depend mostly on speculation about its adoption and use. While the increase in institutional adoption has helped drive price higher, it still lacks an enduring economic rationale that would allow anyone to expect Bitcoin to general positive real returns over time.

Perhaps that will change over time. 

Because I’m generally more concerned with implementing a bad idea than missing out on a good one (a preference for minimizing Type I error for all you quant geeks), I’m not a believer in Bitcoin as a strategic diversifier.

Two reasonable ways to think about Bitcoin investing

If you’re thinking about investing in Bitcoin, I think there are two reasonable ways to go about it:

The first is treating it like an investment in an individual stock.

That actually seems to be the most logical approach. While the risks of owning individual stocks are a bit different, there are some decent parallels between the betting nature of owning an individual coin like Bitcoin or Ethereum or whatever your coin of choice may be.

Carving out some part of your portfolio to actively trade can actually be a good thing if it helps you stay the course with your long-term allocation. If you hit it big with your active portfolio, great. If you don’t, at least you’ve limited your exposure to speculative assets.

The second way to incorporate Bitcoin into your portfolio is as a strategic part of your long-term allocation.

With more products coming to market, I suspect more and more people will be interested in this route.

If that’s the case, here’s how I think about allocating to a new exposure: I start by considering the relative market weight of that exposure compared to the relative weights of your other portfolio assets.

For example, the global stock and bond markets have market capitalizations of roughly US$75 trillion and US$135 trillion, respectively. Bitcoin’s market value is just over US$910 million as of this recording, but let’s round up to US$1 trillion. So an asset allocator’s starting point might be 0.50% of a portfolio to Bitcoin (US$1 trillion divided by US$200 trillion).

If you go either of these routes with Bitcoin or other cryptocurrency exposure, I strongly suggest you follow a set strategy and try to remove emotional decision-making as much as possible.

 

Peter Lazaroff, CFA, CFP® is Plancorp’s Chief Investment Officer, a financial advisor, speaker, and author of the book Making Money Simple. This article is an edited transcript from a recent episode of Peter’s podcast, The Long Term Investor.

 

12 Comments
richard goers
January 28, 2024

in discussing adding BTC to portfolios raises some interesting observations on active v passive, diversification v concentrated and debasement of fiat v inflation// some stocks are more volatile than BTC [base instrument for crypto] such as NVDA [recently but the underlying issues is BTC 21 million limit as the driver on the supply - demand equation / compare the SP500 returns v inflation adjusted [now what CPI to use as cpi is manipulated by statistical methods or you can use M1 or M2 = which shows SP500 real returns which can be negative up to today, as far back as you want in historical prices = so all the storm und drumm in stock price trends, after inflation it goes nowhere / then you get active v passive = timing v time in => given only ~ 5% of stocks ever listed made 100% of the wealth generated you get a plug for active [more work, higher risk more reward] so why buy the SP500 when most stocks in the index are dogs or dogs with fleas] - evident buy the FAANG or 'magnificent 7' / then you get assets that are illiquid [art, wine] that make X % more than stocks = get some liquidity into that space [argument for BTC as was posted in this article] and then you get the alt crypto digital assets that do resemble stocks like ETH or some crypto platforms [Uni, AAVE] that earn revenue and can share with liquidity providers [owners of the native tokens] = so the bet is on developing a new financial system based around trustless - again pointed out in the fraud by banks [AML and fees] = and then the behavioural stuff of the FIRE movement [retire early] and retail trading based on sentiment [gamestop] = put this all in the mix and what a bonfire of the vanities we have - volatility abounding - then of course, the petrol, intra day option trading or expiring options pushing the price around [short term v long term value] - so my point, I guess is => in active v passive, active pays off for effort - so then AI into markowitz mean variance portfolios = so out with the old thinking in with the new, or are we tweaking at the edges on asset composition, weights trouble is with blockchain [not BTC] tech development you need to be down the rabbit hole, all the way = so maybe it is that 5% on BTC is 5% on alternative digital tokens ecosystem [some 3,000 of the bandits], think back to the stock dot.con [1995 - 2000] and you know there must be an Amazon, FaceBook, Google, NVDA in there - as the new tech + AI = what an amazing time to be starting in financial markets without the baggage of the 60:40 portfolio thinking [and the 1960s thinking] and the motivation to retire early ..... knowing that it seems, the ravages of inflation on returns and the cost of money ... and all you need to do is ask an AI bot for advice = good luck, pays your money, takes your chances = then use leverage as another story

S2H
January 26, 2024

I still haven't figured out what bitcoin is. It can't be a currency as it isn't a real medium for exchange. It isn't equity as you don't own part of a company. It isn't debt. So yeah, agree with Peter and the posters above that it isn't an investment and personally I wouldn't touch it. It's probably closest to art in that its value is completely arbitrary; beauty in the beholder.

I'll be fascinated to see where it goes though as:
- Tesla has taught me never to underestimate the power of a cult; and
- as long as billions of people live in autocratic countries, and someone is willing to convert bitcoin to USD, I can see a demand for it.

Blockchain is really cool tech though. I think that's got a lot of potential as a digital ledger.

James Smith
January 26, 2024

Hi Tony, Using the term "Investing" when a person is "Speculating" is a serious issue.
Just re-write the article by replacing the term "Investing" with "Speculating" and let us see how it reads.

AP
January 26, 2024

Agree with all comments here. Cryptocurrency is a scam - the 'emperor's new clothes' that offers no real investment thesis other than 'FOMO'. It appeals to poorly-educated left-wing types that see it as a revolution against 'the man' and the financial system as a whole, which they deem to be geared (under some mysterious conspiracy) against them. Somewhat ironically, it is the very thing that will now rob vulnerable people of their money - either through misguided 'investment' or by fraud/scams by those who use the crypto 'system' to defraud others (read about OneCoin as a good example). Bill Gates was correct when he said that the value in crypto is based on the Greater Fool theory; in that it requires only a bigger fool than the current owner to generate demand. Once crypto becomes regulated (which it eventually must), the demand from the cybercriminals who use it as their means of value exchange will evaporate.

BTC
January 26, 2024

Lol the only "scam" is the ever increasingly debased fiat currencies. You say Bitcoin offers "no useful, productive service for society" and yet it has significantly better ratings in each monetary property (durability, portability, divisibility, uniformity and limited supply) than the US dollar, any other fiat currency or even gold. Any money or means of transacting value will inevitably lead to a use case for criminals and fraud. Clearly no one here has typed "JP Morgan fraud" into a Google search recently (talk about harmful to society). For those of you thinking is Bitcoin worth including in your portfolio, a portfolio of 98% S&P 500 tracking index and 2% Bitcoin would have returned twice that of a portfolio with 100% S&P 500 tracking index fund. Bitcoin is the asset with the best Sharpe Ratio. Had any of you any real.concept of what Bitcoin is you would realize it is not a get rich quick gimmick. It is a don't get poor slowly asset.

CC
January 25, 2024

Bitcoin, and other cryptocurrencies, serve no useful, productive service for society, but is a great way for cybercriminals and money launderers to hide their wealth and their transactions. I would argue it is harmful to society and so institutions should not be encouraging retail investors to speculate in it

big_richard
February 02, 2024

lmao people still think criminals are going to use a PUBLIC LEDGER to hide their transactions

Peter Thornhill
January 25, 2024

Just remember two definitions.
INVEST: The use of money productively so a regular income is obtained.
SPECULATE: To undertake commercial transactions involving serious risk for the sake of large profits, especially to buy and sell in the hope of profiting from fluctuating prices, sometimes in an antisocial way,

You cannot INVEST in bitcoin!

Nic
January 25, 2024

Totally agree Peter. This shouldn’t be promoted to anyone as a realistic option for investing. The dangers of taking cryptocurrency closer to any sort of mainstream is dangerous and wrong.

CY
February 06, 2024

Using words like 'dangerous' and 'wrong' are highly emotive and subjective. One should do their own due dilligence and objectively weigh the pros/cons before passing judgement.

Mark Hayden
January 26, 2024

Well said Peter, investing and speculating are very different.

big_richard
February 02, 2024

You just made those definitions up on the spot lol
Most be hard coming to terms with the fact you missed out on a lot of easy gains here

 

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