Should You Invest In Bitcoin?

Summary/TL;DR

Bitcoin is the best performing asset of all time, returning an average 115% rate of return per year since 2011. It has a few key characteristics, such as its fixed supply, that make the likelihood of this positively trending price action continuing reasonably high. Historically a small portfolio allocation of only 2-5% has had a tremendous impact on long-term returns (even when it was rebalanced annually) and would have provided minimal risk.

Introduction

Bitcoin is yet again dominating headlines as, at the time of this writing, its price knocks on the door of $100,000. And now that retail investors have a convenient and inexpensive way to invest in it through various ETFs, its natural to ask if could serve a role in your portfolio.

In today’s post, I outline a basic case for including the crypto-asset as a small part of one’s portfolio. This post is for educational purposes only and should not be considered individual investment advice.

Bitcoin’s Historical Performance

Bitcoin has been, by far, the best performing asset in all of history. Charlie Bilello, the Chief Market Strategist at Creative Planning and an exceptional data visualizer, publishes a weekly chart to show the annual performance of various asset classes relative to one another. The most recent iteration of this chart can be found below:

Since 2011, Bitcoin’s average annualized rate of return has been 148% (compared with “only” 14% for the S&P 500), rising from a price of $0.30/coin to about $95,000 today. The reasons for this unbelievable price appreciation are hotly debated, but its history cannot be denied.

The proverbial disclaimer present in all financial discussion is that “past performance is not an indication of future returns.” And this is true. The fact that Bitcoin has performed well in the past does not mean that it will continue to do so in the future. There must be reasonable expectations, independent of its atypical history, for its outperformance to persist. Otherwise, adding Bitcoin to one’s portfolio could only be classified as “speculation”, a pernicious behavior that is destined to end in disaster if pursued as a long-term strategy.

Investment vs Speculation

I believe there are many reasons for expecting Bitcoin’s impressive price appreciation to continue. Namely, its fundamental characteristics of possessing a maximum supply, representing a decentralized monetary network which solves the “double spending problem”, and presenting institutional investors with an immutable treasury asset, all serve as strong rationale for characterizing Bitcoin as an investment, as opposed to a speculative, asset.

Recall from a previous post that the overall supply of Bitcoin is capped at 21 million coins. Contrast this with the nature of fiat currencies to which, as history has taught us, there is no maximum supply. Governments can, have, and will continue to, print fiat currency ad infinitum to fund their spending addictions. Given these circumstances, the fundamental laws of supply and demand dictate that the price of Bitcoin, when priced in fiat currency, will trend positively over time.

The above point is only true, however, if individuals always possess a demand for Bitcoin. While I would suggest that an immutable digital ledger incapable of being diluted is intrinsically valuable in-and-of itself, let’s grant that it isn’t for the sake of argument. In other words, “what does Bitcoin do that would make people continue to want to own it?” Again addressed in a previous post, Bitcoin solves one of the oldest and costliest of problems in the history of finance – the “double spending problem”. It provides both an instruction manual and an asset native to that instruction manual on how two private individuals many transact with one another without the need for a third-party intermediary. As long as this continues to be valuable to people, which it will be, Bitcoin will always have a demand.

Finally, Bitcoin presents institutions with an immutable treasury asset. What does this mean? Anytime a company has a profit (retained earnings), it is faced with a few decisions, the least attractive of which is to keep it as cash or Treasuries on their balance sheet and slowly have its value eroded away. Alternatively, they can invest the earnings into growth-oriented projects, but this carries substantial risk. Other options include distributing the cash to shareholders as dividends (which are taxed as such), or repurchasing shares of their stock in the publicly traded markets. Now, and for the first time ever, they also have the ability to purchase an immutable digital asset. And unlike buildings or shares of stock, digital assets are not subject to physical entropy. A hurricane can’t destroy the Bitcoin on their balance sheet, and an economic downturn doesn’t threaten it either. As a purely digital asset that is fixed in nature and can’t be diluted by a third party, it arguably represents the perfect treasury asset. And if it begins to be used for this purpose to the extent that network effects take hold, then Bitcoin will always have a demand.

For these reasons, I believe that investment in Bitcoin can safely be excluded from being characterized as “speculative”. This doesn’t mean that some speculation isn’t still present, as nothing is entirely absent of speculation, but it does ground an allocation to Bitcoin in reason.

Asymmetrical Risk Profile

For reasons that I’ve yet to fully comprehend, investment in Bitcoin is almost universally characterized as “risky”. It is true that Bitcoin is very volatile, but it’s precisely because of its volatility that Bitcoin presents investors with a truly unique risk profile that is highly asymmetric to the upside. This is because a very small initial investment, therefore presenting a very small initial risk, can potentially produce large gains.

For example, let’s say I have a $1,000,000 portfolio and decide to invest 5%, or $50,000, into Bitcoin. In the worst possible outcome, in which Bitcoin goes to $0, the lowest my portfolio could fall to is $950,000, a miniscule setback which I could easily overcome from the growth of other investments in my portfolio. Those who have even a little investment experience understand that volatility of this nature (a 5% move in the market) is very normal and is experienced multiple times per year by even conservative investors.

Historically, portfolio positions of as little as 2-5% have produced outstanding gains for Bitcoin investors, even if the portfolio was rebalanced annually.

Since 2015, a 2% allocation to Bitcoin, rebalanced annually, would have outperformed the S&P 500 by just over 3% per year, while a 5% allocation outperformed by over 7% per year! Meanwhile, the drawdowns of all three portfolios look identical over this time period despite Bitcoin’s characteristic volatility. In fact, the 5% Bitcoin portfolio never underperformed the 100% S&P 500 portfolio by more than 2%!

This behavior is precisely what is meant by “asymmetrical risk”. The potential for loss is dwarfed by the potential for outsized gain. For the past 15 years, there has been no asset for which the risk-reward tradeoff has been as favorable as it has been for Bitcoin.

So, Should You Invest In Bitcoin? And CAN You?

Given the above points, I believe that a small initial investment worth 2-5% of one’s portfolio into Bitcoin is exceptionally reasonable. Besides the decision of initial investment size, deciding whether to rebalance annually, past certain price thresholds, or not at all, is between you and your advisor.

However, when you bring this up with your advisor, you might be surprised to learn a few things. First, they are almost certainly going to be unable to tell you what Bitcoin is and how it works. They are also likely to be unaware of its return history that I’ve outlined above. Finally, and perhaps most importantly, you will probably find that they are restricted in their ability to provide advice around Bitcoin and even to invest in it for you. Most broker dealers that I’m aware of disallow their advisors from purchasing the Bitcoin ETFs on behalf of their clients. And those that do have placed limits on how much can be purchased.

If you find yourself in any or all of these boats, reach out to me. As an independent advisor, decisions as to what can and cannot be discussed or invested in are between only myself and my clients.