Investing in Crypto
By Robert B. Dunn, CFP®
Rarely a day goes by when someone doesn’t ask me what I think of Bitcoin or if they should add some “coin” to their investment portfolio. Before I answer that question, let’s be clear about what we’re talking about when we say Bitcoin. Bitcoin (BTC) is just one of roughly 8,000 cryptocurrencies—decentralized digital currencies that have no central bank or administrator. There are no tangible bitcoins you can hold. There are only balances monitored on a blockchain, communally sustained public ledger. Popular alternatives such as Ethereum, Tether and Dogecoin work essentially the same way.
Crypto reminds me of the early days of the internet. I know it’s hard to believe, but the web was largely unknown a quarter of a century ago. Early adopters mocked “old timers” who didn’t get it. Everyone was trying to figure out the web’s practical application. Investors found themselves walking the tightrope border between getting burned and getting labeled as old fogeys. Crypto could fall into the same camp. There are practical applications for crypto, but no one knows how ubiquitous one coin will be, how universally it will be accepted, and how it will actually be used or monetized.
What you’re getting for your money
With a publicly traded stock or bond, you’re essentially buying the future potential cash flows of that company. The company provides a service or takes raw materials, turns them into products and sells them for a premium. As a shareholder, you participate in that value-creation transaction. Each stock has thousands of individual investors and independent analysts digesting the company’s balance sheet and products--and reassuring the market: “Yes, this price is reasonable.”
With cryptocurrency, it’s a different story. You’re purchasing a digital concept at this point that’s based on an algorithm. Don’t get me wrong. Plenty of smart people have opined about crypto’s potential use and some have tested the efficacy of these ideas. For the most part, the trials have not been wildly successful. Another stumbling block for crypto comes down to ease of use. You must either store it on your own device or trust another entity to custody the coin. Heaven help those who forget their complex passwords (it happens more than you think). There are no friendly client service reps on crypto exchanges to help you reset your log in and gain access to your money.
The news media and social media platforms tout the bold early adopters who’ve made millions in crypto. It’s true, some have. There are also celebrity influencers that people blindly follow since there has been some demonstration of their success. This may be part of the reason that people may compare crypto to the Tulip Bulb frenzy. As stated above, there is no proven, sustainable demonstration of a coin to date. So, the reason to acquire coins is for speculation—and for sounding cool. It’s not yet a long-term investment strategy.
Volatility x 10
Also make sure you have the stomach for volatility if you want to play in the crypto pool. Last month, Bitcoin plunged about 30% in one day and Ether dropped more than 40% in 24 hours.
With an average daily volatility of 3%, crypto is 10-times more volatile than major exchange rates and 5- to-7 times more volatile than the stock market. A recent Deutsche Bank report said Bitcoin should remain "ultra-volatile" due to its limited tradability. A few large purchases or market exits could significantly impact Bitcoin’s supply-demand equilibrium.
If you got unnerved by the market’s free fall during the early days of the pandemic, crypto might not be for you.
Is the risk and volatility worth it? As comprehensive financial planners, our objective is to create the highest probability of success for our clients. Currently, we do not see how cryptocurrencies increase your odds of improving your financial situation. Even if you are in a good financial situation and have some excess cash to tap, what are you gaining by taking a risk on crypto? There are other ways to obtain above-average (risk-adjusted) rates of return by using conventional assets that are regulated and liquid.
However, if you can stomach risk, need an adrenaline rush and have some “fun money” lying around for speculation, then why not dip your toe into the crypto pool? I hope you win big, buy an expensive toy and call me up to gloat: “I told you so, Bob!” Just know that crypto is still in its infancy. Its pricing structure and volatility makes it borderline gambling. You can call it investing, speculating or diversifying, but putting your money into crypto is like buying chips at the casino. As long as you know how much you can afford to lose and as long as you won’t be devastated if you come out on the short end of a bet, then consider crypto a form of entertainment. Maybe you’ll beat the odds and be pleasantly surprised with a windfall that helps you attain a “reach” goal that might have been difficult to hit otherwise. That’s fine provided a loss doesn’t impact the foundation of your plan.
We realize that the dearth of information about coin is what makes the potential value so great. Just know speculation is one of the main drivers of crypto’s lofty valuations. Risk and reward are related. In the current state, crypto currencies represent a significant unknown, so the reward should be large to early investors—if they’re right.
Crypto as a hedging tool?
It’s a nice rationalization, but we haven’t seen any evidence that crytpo is an effective hedging tool. While certain bonds tend to move in the opposite direction of stocks, and real estate, commodities and Treasury inflation protected securities can be used to hedge against rising inflation, crypto seems to move up or down without any correlation to the stock market, bond market, interest rates or monetary policy. If there is any correlation, it would have to be coincidental. Safety and security
When you invest in stocks or bonds, you’re putting money into a regulated market and holding your account at a reasonably secure financial institution—an institution you can call or visit in person. With crypto you have two options:
1. Either you encrypt it on your hard drive and devise a very lengthy password to secure it.
2. You store it on Coinbase or one of the other virtual crypto exchanges. The problem with the Coinbases of the world is the lack of consistent and reliable regulatory oversight on the institutions holding your funds. There have been numerous reports of people stealing money from people’s crypto accounts and there’s no way to protect it or track it down. Last time I checked, there was no shareholder service number to call at Coinbase if you have a problem.
Fees and expenses
Fees and transactions costs are not trivial for crypto investors. That’s ironic since crypto was founded on the belief that transactions should be seamless and inexpensive since they sidestep traditional financial institutions. But fee schedules at cryptocurrency exchanges are designed to encourage frequent trading in large transactions worth thousands of dollars. Fees often decrease with an increase in amount and frequency of trades. As such, small and infrequent orders are not cost-efficient at cryptocurrency exchanges.
If you decide you want to speculate in crypto, that’s fine. Just remember that if you’re buying and selling frequently—i.e., cashing out positions within a year of buying them—you’re subject to short-term capital gains. That means your gains are taxed as ordinary income, which could be up to 37% depending on your tax bracket and potentially even higher under the proposed Biden tax plan.
Bottom line: Crypto currencies are not backed by any asset or promise of any sort. It is an interesting technology that may provide value once it has found a good use. If you have lots of time, excess cash, and tech savvy, then crypto investing is okay if you consider it a hobby, not a core part of your retirement plan. Invest responsibly.
ROBERT B. DUNN, CFP® is the President and Managing Partner of Novi Wealth