Bitcoin & Cryptocurrency Fever: What’s It All About?
Have you caught cryptocurrency fever? Or, are you at least wondering what it is all about? Odds are, you had not even heard of the term until around 2018 when Bitcoin began growing in popularity. Now, it seems as if everybody is mentioning cryptocurrency and more specifically, Bitcoin.
If you are feeling angst about this trend and unsure if it is right for you, you are not alone. Psychologists and popular culture refer to these feelings as “FoMO,” or Fear of Missing Out. It is natural to want to jump on the bandwagon.
But, before you start loading up on Bitcoin or any other form of cryptocurrency, let’s take a closer look at what you may be getting yourself into. Although it is an interesting development with a number of promising possibilities, it is still relatively new, volatile, and considerably risky.
What is Cryptocurrency?
Cryptocurrency is essentially a kind of money – or currency. It was introduced in 2009 by a pseudonymous Satoshi Nakamoto. Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption. Pair “encryption” with “currency,” and you have cryptocurrency. Thanks to electronic security – or encryption – it exists as Nakamoto described- in a presumably secure, sound and limited supply.
Bitcoin became the first cryptocurrency, and is still the most well-known kind. According to CoinMarketCap, Bitcoin had a market cap of nearly $600 billion as of January 22, 2021, with its closest competitor Ethereum at $140 billion. Market caps drop considerably after that, but there are plenty of others. As of September 30, 2020, a CFA Institute Cryptoassets Guide reported: “More than 6,000 different cryptoassets exist, and many new ones are created each month.”
How do you possess cryptocurrency?
Unlike traditional money, cryptocurrency only exists as computer code. You cannot touch it or feel it. There are no paper notes or metal coins involved. No central bank issues the cryptocurrency, and no regulator or nation state stands behind it.
But increasingly, holders are spending cryptocurrency in ways that emulate “regular” money (although limitations remain) – and potentially even adding to its uses. There is also growing interest in trying to build or at least preserve wealth by trading in cryptocurrency, which some describe as being like “digital gold.”
Except there is no bank to complete the transaction. Instead, bitcoin “miners” compete against one another for the role. Each block is secured with a complex mathematical equation. The first miner to solve the equation gets to add the new block to a blockchain. The winning miner is then rewarded handsomely for their effort. They are paid with bitcoin, which can currently be valued at tens of thousands of dollars for settling a single block.
The CFA Institute’s Cryptoassets Guide describes cryptocurrency security as follows: “This is the real breakthrough of blockchains: creating timely, bad-actor-proof consensus across all copies of a decentralized and distributed database. Today, more than 40,000 computers are independently verifying every single bitcoin transaction.”
In other words, blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest, as any attempted “cheating” by cryptocurrency holders or miners should be promptly detected.
How does cryptocurrency differ from “regular” money?
In comparing cryptocurrency to regulated fiat currency – or most countries’ legal tender – there are at least two components to consider: limiting supply and maintaining spending power.
- Limiting Supply: Obviously, if a currency “grew on trees” it would cease to have any value to anyone. That is why central banks like the U.S. Federal Reserve, Bank of Canada, and Bank of England are tasked with limiting their currency’s supply, without strangling its demand. For Bitcoin, supply is limited to a maximum of 21 million coins. While cryptocurrency proponents offer explanations for how supply and demand will be managed, some systems will undoubtedly be more effective than others at sustaining this delicate balance, especially when exuberance- or panic-driven runs might outpace reason.
- Maintaining Spending Power: Neither fiat currency nor cryptocurrency are still directly connected to the value of an underlying commodity like gold or silver. Thus, both must have another way to maintain their value, or spending power, in the face of inflation. In most countries, the nation’s central bank is in charge of keeping its fiat currency’s spending power relatively stable; only the government can add or subtract from its supply of legal tender. For cryptocurrency, there is no central bank, or any other centralized repository or regulator. Stability is instead backed by its underlying blockchain.
While cryptocurrency fans offer explanations for how its supply and demand will be managed, it is not yet known how effective the processes will be in sustaining this delicate balance, especially when exuberance- or panic-driven runs might outpace otherwise orderly procedures.
Why would anyone want to use cryptocurrency instead of legal tender?
For anyone who may not be a big fan of government oversight, the processes are essentially driven “by and for the people” as direct peer-to-peer exchanges with no central authorities in charge. At least in theory, this is supposed to allow the currency to flow more freely, with less regulation, restriction, taxation, fee extraction, limitations and similar machinations. Moreover, cryptocurrency transactions are anonymous.
If the world were filled with only good, honest people, cryptocurrency and its related technologies could represent a better, more “boundary-less” system for more freely doing business with one another, with fewer of the hassles associated with international commerce.
Unfortunately, in real life, this sort of unchecked exchange can also be used for all sorts of mischief – like dodging taxes, laundering money or funding terrorism, to name a few.
Even if I don’t plan to use cryptocurrency, should I hold some as an investment?
If you do jump in at this time, know you are more likely speculating than investing. Like any relatively new, highly volatile pursuit, it entails considerable risk.
Regulatory Risks – First, there is the very real possibility that governments may decide to pile mountains of regulatory roadblocks in front of this currently free-wheeling freight train. Some countries have already banned cryptocurrency. Others may require extra reporting or onerous taxes. These and other regulations could severely impact the liquidity and value of your coinage.
Security Risks – There is also the ever-present threat of being pickpocketed by cyberthieves. It has already happened several times, with millions of dollars of value swiped into thin air. Granted, the same thing can happen to your legal tender, but there is typically far more government protection and insurance coverage in place for your regulated accounts.
Technological Risks – As we touched on above, a system that was working pretty well in its development days has been facing some serious scaling challenges. As demand races ahead of supply, the human, technical and electric capital required to keep everything humming along is under stress.
Cryptocurrency and Evidence-based Investing
Then again, every investment carries some risk. If there were no risk, there would be no expected return. That is why we also need to address what evidence-based investing looks like. It begins with how investors (versus speculators) evaluate the markets.
What is a bitcoin worth? A dollar? $100? $100,000? The answer to that has been one of the most volatile bouncing balls the market has seen since tulip mania in the 1600s.
In his ETF.com column “Bitcoin & Its Risks,” financial author Larry Swedroe summarizes how market valuations occur. “With stocks,” he says, “we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending … we have historical evidence to make the appropriate estimates.”
You cannot do any of these things with cryptocurrency. Swedroe explains: “There simply is no tangible relationship between any economic or financial parameters and bitcoin prices.” Instead, there are several ways buying cryptocurrency differs from investing:
- Evidence-based investing calls for estimating an asset’s expected return, based on these kinds of informed fundamentals.
- Evidence-based investing also calls for us to factor in how different asset classes interact with one another. This helps us fit each piece into a unified portfolio that we can manage according to individual goals and risk tolerances.
- Evidence-based investing calls for a long-term, buy, hold and rebalance strategy.
Cryptocurrency simply does not yet synch well with these parameters. It does have a price, but it cannot be effectively valued for planning purposes, especially amidst the extreme price swings we are seeing of late.
When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.
Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they do not provide clarity about future wealth. And, unlike holding cash in fiat currencies, they do not provide the means to plan for a wide range of near-term known expenditures. Because bitcoin does not help achieve these investment goals, we believe that it does not warrant a place in a portfolio designed to meet one or more of such goals.
Cryptocurrency, blockchain technology, and/or their next-generations could evolve into universal tools with far wider application. Only time will tell what might happen.
What if I decide to buy some cryptocurrency anyway?
We get it. Even if it is far more of a speculative than investment endeavor, you may still decide to give cryptocurrency a go, for fun or potential profit. If you do, here are some tips to consider:
- Think of it as being on par with an entertaining trip to the casino. Nothing ventured, nothing gained – but do not venture any more than you can readily afford to lose!
- Use only “fun money,” outside the investments you are managing to fund your ongoing lifestyle.
- Educate yourself first, and try to pick a reputable platform from which to play. (CoinDesk offers a pretty good bitcoin primer.)
- If you do strike it rich, regularly remove a good chunk of the gains off the table to invest in your managed portfolio. That way, if the bubble bursts, you will not lose everything you have “won.” (Also set aside enough to pay any taxes that may be incurred.)
Last but not least, good luck. Whether you win or lose a little or a lot with cryptocurrency – or you choose to only watch it from afar for now – we remain available to assist with your total wealth, come what may.
You may notice, we sometimes capitalize Bitcoin as a proper noun, and we sometimes leave it as lower case. General practice is to capitalize the entity, “Bitcoin,” but to use lower case for the coins themselves. Think of it like the difference between “the U.S. Dollar,” vs. “a dollar bill.”
What’s a Blockchain? Using bitcoin to illustrate, a block is essentially a bitcoin transaction waiting to be settled. Think of it as being like a written, but uncashed check; it’s not real money until the transaction is verified and added to a permanent ledger.