By Ashley Bleckner, CFP®, MA
Recently bitcoin has had a record-setting run. On December 19, 2017, a single bitcoin is valued at over $18,000. For perspective, bitcoin values were in the $300 – $400 range for the majority of 2015, and the price of an ounce of gold today is a mere 1/8th of bitcoin’s current price.
Those who invested in bitcoin years ago are likely rejoicing. But, should you join them? To answer this, our animal instinct may be at odds with our rational self. So, let’s look at the issue.
First, what is bitcoin? Bitcoin is a crypto-currency used by online firms and businesses worldwide. One of the biggest advantages of bitcoin is its facilitation of international trade. By design the currency can cross borders easily.
For the purposes of investing, bitcoins are like any other currency (or commodity) investment. This means when it comes to your investment return, bitcoins face the same distinct challenges as gold, oil, or fine art. As exciting as investing in bitcoin sounds (and despite the recent run-up in price) there are at least three fundamental problems with the investment right now:
PROBLEM #1: YOU CAN LOSE MONEY AFTER INFLATION (KNOWN AS NEGATIVE REAL RETURNS)
When you invest in bitcoins (or gold or commodities or currency), you are betting exclusively on price appreciation. Or rather, you’re betting that the price of bitcoins will go up relative to the U.S. dollar. This means bitcoins are different from more conventional investments like stocks, bonds and real estate because they don’t offer an opportunity to generate cash.
- Stocks are a slice of business ownership. Businesses earn a profit and as an owner of that business, you are entitled to a slice of that profit. The profit can either be re-invested into the business (to increase the value) or paid as dividends to investors. Either way, a stock generates cash.
- The same is true for bonds which distribute cash. With a bond, you (usually) get back your original investment, plus interest.
- Rental property exists with the goal of generating cash for the investors (above and beyond the costs to maintain the property)
Unfortunately, that’s not the case for commodities (bitcoins, gold, etc.). These sorts of investments do not generate cash. Instead, investors can only hope they rise in value with the price of inflation.
Despite their volatility, commodities do not usually outpace inflation. This means the real return of the currency doesn’t increase in value because that’s exactly what inflation is – a decrease in the value of currency. Therefore, not only must your investment appreciate at the rate of inflation, but it must also go above and beyond inflation. Otherwise, you are likely looking at a negative real return after expenses with an investment like bitcoin.
In short, bitcoins and similar investments are at a big disadvantage when it comes to generating an investment return. Bitcoins don’t generate cash like stocks, bonds and rental real estate do, and they have the added challenge of real returns.
PROBLEM #2: MEAN REVERSION
Mean reversion is a fancy way of saying: “what goes up, must come down – and vice versa.” All investments are subject to mean reversion, and bitcoins are no exception. Mean reversion itself isn’t a bad thing, but it’s still worth noting when it comes to investing in bitcoins specifically.
That said, if you are going to get an investment return from bitcoin, you don’t want to be buying at the peak of the market. And, recent run-ups in price suggest that it’s possible we are at the top of the bitcoin market… or, at least on the way.
PROBLEM #3: REGULATION
Future regulation adds to the uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns. (1) Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.
Pro Tip: Invest Only as Much Money as You Can Stand to Lose
We recommend thinking of investing in bitcoins as you would think about buying a lottery ticket. You could win big; however, as historically shown with commodity markets, the odds are good that you’d make more money with a low-cost, diversified investment.
(1) “Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014