Bitcoin investing is far too risky for most portfolios
Many crypto enthusiasts consider bitcoin to be “digital gold”, an important new asset class that offers attractive expected returns, a lasting store of value and diversification.
But since last fall, the cryptocurrency has failed to do any of these things. Instead, the price has dropped like a digital rock, losing about two-thirds of its value.
From an all-time high of $68,990 (US) in November, it fell to a low of $17,630 in June. It has since regained a small portion of lost ground, trading at around $21,700 last Friday, according to investing.com.
This poor performance comes as it began to make inroads into the mainstream investment world. A few large investment firms such as Fidelity Investments have begun to include small allocations of bitcoin in conventional portfolios alongside stocks and bonds.
But in my view, bitcoin is not ready for average investor portfolios. The recent price behavior shows that it is still far too risky for most average investors who typically invest with their retirement savings on the line.
The reason for the risk is the fact that it is a speculative asset whose value is determined by what investors think it is worth, with no underlying “fundamental” value in the traditional sense. Unlike shares, for example, you do not own a share in a company’s profits, cash flows and dividends.
Untethered to fundamentals, it can do very well, or very poorly, or anything in between. It all depends on investor sentiment, which can be fickle.
Of course, it still has its true believers who believe it has many of the favorable investment properties often associated with gold, but with important additional benefits.
First, the supply is more strictly limited than gold, with a maximum cap of 21 million bitcoins.
On the demand side, it benefits from the network effect. As more people use bitcoin, it can become more valuable to each user. That in turn can encourage even more usage by each existing user, as well as attract more new users, thus potentially leading to exponential growth.
The potential combination leads enthusiasts to expect huge price gains over time, albeit with a lot of volatility.
Bitcoin believers range from young people with small sums to invest, to prominent tech billionaires like Elon Musk (of Tesla Inc.), Michael Saylor (of MicroStrategy Inc.) and Jack Dorsey (of Block Inc.), who spend heavily personally and company wealth to support their faith.
For most of its history, bitcoin prices reflected the independent streak of its buyers, making it largely independent of stock market movements. Before the pandemic, the correlations between prices and major stock indices were very low, similarly to gold. It fueled the expectation that bitcoin would help diversify conventional stock and bond portfolios.
Proponents also began to view bitcoin as a reliable store of value, a means of retaining purchasing power for future use. Of course, prices have historically been far more volatile than cash (the store of value) or gold (an established alternative). But it could easily be sold if necessary, and its advocates expected it to make strong price gains over time.
Like gold, but unlike cash, the cryptocurrency’s supply is independent of central banks, and so proponents expected it to provide a good hedge against inflation. Prominent holders such as Tesla, MicroStrategy and Block have accumulated billions of dollars on their balance sheets.
While prices boomed alongside technology stocks in the early stages of the pandemic, bitcoin began to fall from its peak in November, with a sharp drop in the second quarter of 2022.
It was fueled in part by business failures in the crypto industry that included: crypto lender Celsius Network LLC; crypto broker Voyager Digital Ltd.; linked cryptocurrencies TerraUSD and Luna; and hedge fund Three Arrows Capital Ltd.
These business failures weakened investor confidence in bitcoin along with the rest of the crypto industry. In addition, rampant inflation, rising interest rates and slowing economic growth created a worsening climate for both investors and the technology industry. No one could be sure how bad it would be.
Institutional investors who had begun to include bitcoin in portfolios were now looking to offload riskier assets, and now that included bitcoin. Some tech companies sold the cryptocurrency to reduce debt and raise cash as external funding dried up. Most prominently, Tesla sold more than $900 million in the United States during the second quarter.
All this put selling pressure on the cryptocurrency and the price fell rapidly. This time, bitcoin and tech stocks were highly correlated and sold off together, thus providing little or no diversification benefit.
In the second quarter, the tech-heavy NASDAQ 100 index fell 22 percent, while bitcoin prices fell 58 percent, serving as just another risky asset.
The current environment warrants caution for the average investor. The central banks are not done raising interest rates, and no one knows for sure how much the economy will slow down.
There is a realistic possibility that the economy could end up in deep recession, in which case riskier investments are likely to be hammered even more. Given the recent price behavior, this scenario is likely to seriously hurt bitcoin.
Of course, believers have seen big sales before. Many see today’s prices as a buying opportunity for those who can be patient. Even if prices fall further, there is still a high chance that they will recover at some point and reach new highs down the road.
The fact is that with speculative investments the outcome is highly uncertain. Based on the history of technology investments, there is also a significant risk that at some point bitcoin owners will move on to something new that will leave prices disappearing into the digital dust.
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