Bitcoin… cryptocurrency… non-fungible tokens (NFT’s)… have seeped into our national lexicon, but what the heck is all this?
To help understand, we can define these various things under the umbrella of “digital assets.” “Assets” are things of value we own whether they be stocks, bonds, homes, cars, cash, etc. And “digital” are things we use and store on our technology. For example, we listen to digital music, which is downloaded over the internet and played on our various devices.
Digital assets are relatively new and it can be difficult for us to wrap our heads around owning something of value that we can not actually touch. But then again, we don’t touch our investments in our Schwab account, however we have grown comfortable with this arrangement because we know these investments can be sold for cash. In this respect, digital assets are really no different.
Bitcoin
Bitcoin was the original digital asset. It came into existence in 2009. All digital assets since have flowed from the success of Bitcoin. And I would maintain that Bitcoin stands alone among digital assets for purposes of investment.
Why is this?
Put very simply: the wide and growing acceptance of Bitcoin coupled with its fixed supply creates scarcity that is likely to drive its value into the future.
At present, there are roughly 19 million bitcoin in circulation. Over the next 118 years (that’s not a typo, the year 2140) the supply of Bitcoin will reach 21 million. That’s it. 21 million is the maximum number of Bitcoins that will ever exist.
To frame the scarcity of Bitcoin consider this: In the United States alone, there are over 40 million millionaires. It would be mathematically impossible for every millionaire in the U.S. to own one Bitcoin because there are only 19 million Bitcoin currently in circulation. And this is just in the United States. Bitcoin is a global network.
But is Bitcoin safe?
This depends on what is meant by safe. The Bitcoin network consists of thousands of network terminals (nodes) spread across the globe. No one entity, or group, controls the network. It is what is known as a decentralized network. Transactions in Bitcoin are recorded on a public, decentralized ledger known as a blockchain and the global network verifies its authenticity. This process of blockchain verification is also known as “Bitcoin mining.”
Bitcoin miners compete with one another to verify the latest block on the blockchain, which happens every ten minutes. The first to verify the block, which then has to be confirmed as valid by the rest of the network, is rewarded in new Bitcoin. And this is how the supply of Bitcoin grows slowly and will continue to grow over the next 100+ years.
The Bitcoin network, and its blockchain technology, have proven to be safe and secure. But “is Bitcoin a safe investment?” is an entirely different question. The price of Bitcoin reached its all-time high in November 2021. In the following three months it lost nearly 50% of its value. In other words, this is a volatile asset with sharp and sudden drops as well as powerful moves higher.
Does Bitcoin belong in an investment portfolio?
Bitcoin pays no dividend. Investors in Bitcoin are simply expecting the price to go higher. This is different from most investments, but not all. Investors in Amazon, Google, and Warren Buffet’s Berkshire Hathaway do not earn dividends, but have been rewarded handsomely nonetheless due to the success and validity of the underlying businesses.
Another investment that is often incorporated into portfolios but does not pay a dividend is gold. Gold is thought of as the original currency and a hedge against inflation. Gold tends to rise as the value of the dollar falls. Many think of Bitcoin as “digital gold” because of its limited supply and store-of-value properties. Arguably, both gold and Bitcoin are global currencies somewhat beyond the reach of government control.
The correlation (or, the degree to which their prices move together) between Bitcoin and the stock market are typically fairly low. At the same time, the price of Bitcoin is far more volatile than traditional diversifying investments like bonds or gold. For these reasons, portfolios can achieve a meaningful gain in diversification with a low allocation to Bitcoin. In fact, just allocating 1%-3% of a portfolio to Bitcoin will allow an investor to gain real diversification and participate in the potential upside of Bitcoin, but not expose the overall portfolio to significant drawdowns when Bitcoin’s price inevitably takes a significant fall.
– Hank Nicholson, CFP
