The Rise of Bitcoin

Mainstream interest in bitcoin has been growing rapidly in recent months. As often happens, investor curiosity increases along with investment performance. Bitcoin, just this year, is up nearly 800% after rising from about $1,000 per "coin" in January to almost $10,000 as of this writing. But this fabulous performance tends to raise more questions for investors than it answers.

What even is a bitcoin? What are the risks? How would we go about buying bitcoin? What role could (or should) bitcoin, or other cryptocurrencies, play in our investment portfolio?

First, let me come right out and say that I wasn't a computer science major, and my interest in bitcoin and the blockchain technology it's built on is first from a risk management standpoint for my clients and second as an investor. My personal and professional preference is to invest in companies that generate real value and can be expected to do so for years to come. I tend to avoid companies and strategies that seem overly risky, conceptually thin, or that otherwise fall into the category of "product du jour".

If you'd like a deeper dive into the technology behind bitcoin, I'm attaching a link to a recent report from my research partners at Bespoke Investment Group. Parts are a little challenging to read, but it's great information nonetheless.

Let's summarize some of the important portfolio related questions regarding bitcoin technology.

What is bitcoin? From my perspective, a bitcoin is a form of digital currency based on a peer-to-peer money transfer concept created back in 2009. So-called blockchain technology underpins bitcoin and, through a process that's frankly too complicated for me to fully understand, allows for the highly secure storage and transfer of information. The information could be anything, but in this case, it's digital money.

The security of a blockchain is important because it's designed to allow storage and transfer of digital currency without the need of a third party, such as a bank. Instead, a diverse group of theoretically objective computer systems tracks and verifies the data. The strength of the blockchain is supposed to match, or even rival, that of a large bank or credit card company, for example. The technology also allows for privacy, so bitcoin has become a tool for crooks as well as the independent-minded folks who first developed it.

What are the risks? One of the many risks for investors is that bitcoin and other digital currencies are largely unregulated. States and the SEC are getting involved but are in the early stages since the currency is so new. This lack of regulation leads to lots of potentially risky activity, from offers to invest in shoddy bitcoin-based companies to outright fraud as unlicensed firms or agents try to capitalize on growing investor interest.

Other risks revolve around massive volatility and a lack of liquidity. While it's not unheard of for bitcoin to lose 25% or more of its value in a few weeks, the lack of regulation and questionable tangible value lead to what's often a very thinly traded market. If you held bitcoin and wanted to sell it, it's possible that on any given day there could be little or no market and the price you saw yesterday could be a distant memory.

How would you buy bitcoin? Exchanges exist where you could buy and sell the currency, or even just a fraction of it. There are mobile apps as well. Easy, right? Well, I think in the trading arena the brokers, as usual, are making more money than the public. Transaction costs can run from around 1% to 4% of the trade value, not counting extra charges incurred during the exchange process. This is like the early days of stock trading where hungry investors had so little information that brokers got rich charging pretty much whatever they wanted.

Enter the investment companies. Two large fund providers recently announced interest in establishing exchange traded funds (ETFs) that would mimic the price of bitcoin. While this might sound like a good idea, it's going to be problematic since the ETFs would be based not on owning actual bitcoin, but bitcoin futures, for which a market doesn't even exist yet. Regulators have talked about starting this market soon but are unclear about exactly when.

Instead of waiting for the ETF market to firm up, investors could buy into a publicly traded trust from a company called Grayscale that holds bitcoin. Through ticker symbol GBTC, the firm allows investors to buy shares of the fund instead of going through the hassle of buying and selling the digital currency individually. But doing so will cost you. The firm charges a 2% annual management fee and there is currently an almost 30% premium to hold fund shares versus holding bitcoin itself. So, clearly the fund choices are far from perfect in the early days of this market.

What role should bitcoin have in our investment portfolio anyway? One of the most important questions to answer when selecting investments is what purpose they will serve in the portfolio. Is the investment for long-term growth, protection of principal, diversification, speculation, etc?

It might sound ironic given the return numbers I mentioned at the outset, but I don't view bitcoin as a long-term growth engine of an investment portfolio. The reason is that as a digital currency it obviously has value, but it doesn't create value. As a means to an end it's great. Digital currency and blockchain technology could eventually help revolutionize global transfers and payments.

But beyond that bitcoin is largely an investment fad. And for protection of principle, forget about it. Mark Cuban, of basketball ownership and T.V. fame, put it best a couple of days ago when he suggested not investing any money in bitcoin you weren't prepared to completely lose.

While some have suggested holding bitcoin is like holding gold within a diversified portfolio, this doesn't make sense for a variety of reasons. Holding foreign currencies can make sense for diversification, but we're talking about established currencies from established countries (think euros or yen) and not cryptocurrencies.

Instead, it's best to leave bitcoin in the realm speculative investments. If any, a prudent cap on this category might be 2% with an absolute limit of 5% of a diversified portfolio. Any more than that and you're asking for trouble, even though it would have benefitted you this year.

https://www.bespokepremium.com/wp-content/uploads/2017/09/Bespoke-Briefs-Blockchain.pdf

Have questions? Ask me. I can help.