Focus on Bitcoin

James C. Denton, CFP®, Managing Partner

Contributor: Aaron Anderson, CFP®, CFA, Partner & Financial Analyst

 

December 4, 2020

 

Bitcoin, Ethereum, Ripple, Litecoin, Libra, etc … I suspect you have heard about at least some of these crypto-coins, and if you have any financial interest at all, you’ve probably thought about maybe investing in one or another of them[1].

I must start by saying that neither Bitcoin nor any of its siblings or cousins are securities.  None have been approved by the SEC or FINRA or any other of the regulatory agencies that oversee and give legitimacy to my practice, and there is no indication that such an endorsement for lack of a better term is forthcoming anytime soon.  As a result, I am unable to sell it, and LPL Financial, or I as their representative cannot make a professional recommendation for or against investing in any of these “currencies”.  That said, I will offer my views on the research I have done on the topic for my own purposes.

I suggest you start with a little research on the 17^th century “Tulip Mania” before pulling the trigger.  Here’s a starting point.

https://en.wikipedia.org/wiki/Tulip_mania

Simply put, the Tulip mania took place when, for some reason, someone decided that Tulip bulbs had investment value.  Before it was over people were selling their castles to buy tulip bulbs.  All as a result of word-of-mouth creation of demand.  “My brother-in-law, my barber, my tax guy, made a lot of money in it so perhaps so can I”.  It’s a classic example of how greed can take on a life of its own as an investment motivation and it didn’t end well.

It’s my opinion that crypto currencies are a present-day mania that may follow a similar path.  Modern social interaction around water coolers and coffee tables, and Facebook and similar social media which didn’t exist in the 17^th century, have given legs to the crypto-currency phenomena causing it to grow faster and more explosively than tulips did, but I believe the final result can potentially, and likely will be just as disastrous.

 

Crypto as an electronic currency:  To be sure there probably will be a place for electronic forms of currency.  That said, there already is and has been for a long time, an electronic substitute for cash.  This may be an oversimplification, because proponents see crypto currencies as much more than just a currency substitute, but it’s called debit cards. In my opinion though, there’s got to be something tangible behind anything I invest in and there is nothing tangible behind crypto currency.  Ultimately, Bitcoin and its’ siblings are nothing more than computer entries.   

Worse yet, there is no universal method of assigning real value, just a nebulous agreement between a buyer and seller that the bits and bytes on a computer database somewhere have a specific value at a specific point in time and only at that specific point in time, and for that specific transaction.  Every use is a negotiation of value in its own right.

And finally, and this point will be developed in a little more detail later in the article, there is no third party oversight of any kind on the individual “coins” – no regulatory supervision, no governmental or industry oversight to ensure integrity, continuity of operations, or acceptable business practices.

 

Crypto currencies as an investable alternative to gold:  Gold has always – from the beginning of recorded history – been used as a universal currency; as a store of value, an inflation hedge, or a hedge against social collapse.  I know of a woman who made a bulk-gold purchase in the seventies because she expected Armageddon and the second coming.  It hasn’t happened yet, but she’s ready when it does (or at least she thinks she is).  Her investment return has been nowhere near what she could have achieved in the stock market, but that’s not the point.  She was looking for a place to put some of her “treasure” that she knew (or hoped?) would have value, regardless of economic, political or social upheaval.  Gold has this same purpose today, and this universal attribution of value makes it a viable investment.    

Gold investors can be every bit the true believer, and some have done quite well.  Others get their butts handed to them but at the end of each cycle (and it is very cyclical) they still have something tangible left that they can either hold into the next cycle, or can sell to buy food, shoes, shelter, whatever.  This durability of tangible value, along with its limited supply, is the reason it continues to have value.  One of these days, Elon Musk or Richard Branson will lasso a distant planet made of gold and bring it back to Earth.  When that happens, gold will lose its value as an investment.  But until then, people will love their gold chains, watches, wedding bands, and critical components in electronic inventions of all sorts, and gold will continue to have a tangible commercial value, and therefore act as a “store-of-value”.   I don’t normally recommend gold as a significant portfolio component, but we have owned it in small amounts for specific asset allocation purposes and it has worked for us as an investment like any other.

 

Crypto currencies, however, have absolutely no basis in fact, no tangible value.  It’s all a hypothetical creation stored on a database somewhere[2].   If a specific crypto-coin collapses because of fraud on the part of the creator (Who is he/she?[3] Who’s supervising him/her? What are their intents?) or the database where the records are stored is destroyed by a cyberattack, or investors just lose interest (like tulip bulbs?), what will you have left?  Not even a pretty garden.

 

A limited supply?  Most if not all crypto-coin sponsors state that the supply is “capped” (i.e., limited).  This is a key consideration, since supply is ultimately a critical if not controlling factor in the value of anything.  The more there is of something, the less one will pay for more of it.  There is supposedly a limit to how much Bitcoin “can be mined” (mining is another interesting discussion, but let’s set that aside for now.  But with respect to any “limits”,) Sez who?  There is no regulation.  There is no governmental or known and trusted universal entity guaranteeing that the existing supply is finite, that it can’t be expanded at some point, or that any new supply (or even existing supply for that matter) is authentic.  The “creator” (see previous issues) is fully able[4] to increase the supply any time he/she chooses, and what will keep him/her, or his successors, from doing so?   Or a fraudster or provocateur from counterfeiting[5]?   

The lack of governmental oversight is often cited by the true believers as a positive element, but how can that be.[6]  I don’t care how Libertarian one may be, there’s always a place for governmental oversight because individuals cannot be expected to self-regulate, and there is a place for consideration of “the common good”. 

 

Storage and protection is an issue.  There is no central record of who owns what or how many bitcoin!  This is another one of those nebulous complicated aspects of the entire proposition, but ultimately you’re responsible for your own accounting and security.  A finite bitcoin itself is simply a chain of characters the system recognizes (or does not recognize) as authentic.  But there is no centralized record of who owns that character-stream.  If the computer where your records are stored is lost or stolen, your bitcoin are gone.  If you lose your password, your bitcoin are gone.  If you die without passing on to a third party, what you own and how to access it, your bitcoin are gone.[7]

 

Bitcoin as a means of anonymous transactions:  One last caveat, and this is important!  An original “attractive” feature of crypto currency – how it got started in the first place - was its anonymity and lack of transparency to tax and police authorities.  Money launderers, drug dealers, terrorists, tax evaders in general love it because they can store funds and transact business outside the eyes of the IRS and other international police forces.  Even if you didn’t plan to use it that way yourself, the fact that others could made the concept – the currency itself - more valuable for everyone.  That feature is gone, at least from a legal perspective.  Crooks will continue to act like crooks, and some may even get away with it, but the gendarmes and revenuers are getting more sophisticated and successful in their ability to track these activities.  You can expect their efforts to continue, and to become ever more successful, and theoretically some of those enforcement actions could blow back on you. 

More to the point for the law-abiding among us, if you decide to take the plunge, even for legitimate purposes, you are required to disclose your activity on your income tax return, and extensive buying, selling and trading digital currencies or other investments could complicate your income tax reporting.  And tax evasion is still tax evasion, whether you use cash or crypto. 

 

It's a long and nuanced conversation, and every red flag I can throw at you, a true believer will have an answer for.  I, the skeptic, on the other hand, will have a “what if” for those answers.  And there are probably who knows how many additional issues – some of which I have not addressed and many, no doubt, that I am not even aware of.  As the investor, you are left to sort all of this out for yourself.  Are you up to the task? 

 

A Speculative Investment that you are fully prepared to lose. The one suggestion for bitcoin or any other crypto-currency that makes any sense to me, is to put 1 to 2% (only!) of your investable capital into an ETF or mutual fund of different crypto currencies, against the possibility that the true believers are correct and someday it will be very valuable⁷.  It’s always possible that they may be right. 

Bitcoin has a wide and rabid following.  At present.  The criminal class continues to like it and probably is the most if not only active user group for its transaction-based purposes.  This article, however, for the most part addresses its efficacy and attractiveness as a potential investment.  Bitcoin specifically is getting very wide coverage right now, lots of attention and therefore lots of growth at a time when a whole new generation is joining the investor class, learning how to make money investing, and what it means and feels like to lose.  Bitcoin has been very good to some of these people and has ruined others.  But a small commitment, buy and hold with a 20-year time horizon could turn out to be a very good investment.

But you’ve got to be prepared to lose it all.  It’s like poker … if you can’t afford to lose then you better not play.  The small amount suggested – 1 to 2% - yields a pretty small nominal number for most of us, and that is exactly the point.  If your total assets are not adequate that a 2% investment would have any meaning, then either you shouldn’t be in it at all or alternatively, it’s a lottery ticket.

 

Eschew Obfuscation – Any writer aspires (or at least should) to clarity but sometimes it can be pretty darn hard.  Unfortunately, sometimes all efforts for clarity only serve to further confuse.  The more I anticipate objections, the “yeah, buts” and “youdon’tknowwhatchertalkinabouts”, the more cumbersome and overwhelming the overall discussion becomes.   You’ve got objections, I’ve got answers, some of which (for both of us, perhaps) are simple preconceived notions, biases or misconceptions.

I acknowledge that some of what is presented here is over-simplification.  Perhaps in some ways I have demonstrated a lack of knowledge of the intents, processes and reality of how crypto currencies work.  The truth of this further illustrates the overall problem I see with the entire concept.  It may sound arrogant, but I’m a pretty bright, informed and experienced participant in the financial world, and if I can’t get my head around it, then many of you probably are going to have the same problem. 

There is an argument to be made for risk taking, for chance taking, for “putting it on red and let it ride”.  But it is a rare individual who has a solid enough grasp of the idea of crypto currencies, let alone how that idea has been transformed into a working system worthy of your investment dollars sufficient to actually justify more than a token investment to that idea.  Ultimately, if you invest in bitcoin, or any other crypto currency, that’s what you are buying … an idea! … a concept!  A proposition of future value, without any substantial, tangible, practical economic value today, at the moment of your purchase.  And nobody can tell you for sure whether it’s even going to exist next week.