Bitcoin has been continuously featured in the news over the past several years. It experienced a meteoric rise in value and then recently saw its price plunge by 70 percent. Clients, friends and family members have reached out to ask me about this relatively new financial product. Many investors are wondering if it is a good time to buy some cryptocurrency for their portfolio. Here are some points to consider.
What is Bitcoin? To begin, one must first understand what Bitcoin is. According to CoinDesk “Bitcoin is the world’s first successful decentralized cryptocurrency and payment system, launched in 2009 by a mysterious creator known only as Satoshi Nakamoto. The word “cryptocurrency” refers to a group of digital assets where transactions are secured and verified using cryptography – a scientific practice of encoding and decoding data. Those transactions are often stored on computers distributed all over the world via a distributed ledger technology called blockchain.”
If you are baffled by this definition, you are not alone. Yet, this confusion hasn’t stopped many folks from enthusiastically investing in and utilizing this asset. I believe it’s fundamental to understand what I’m investing in before I make an investment. Since it’s difficult to grasp how Bitcoin works, it has been helpful for me to understand how it differs from other investments.
It is not a business: A business creates goods or services and sells them to customers. For example, Apple makes iPhones, people buy iPhones, and the company makes money. Google generates advertising revenue, Simon Properties has rental income, and Walmart sells household items. Investors can buy ownership stakes in these and all publicly traded businesses by owning stocks. As the companies generate more revenue, their stock price may go up over time, and the investor can make money.
Bitcoin doesn’t sell anything or generate revenue, so it is not a business.
It has no cash flow: Investors can also invest in other asset classes, like bonds, to make money. For example, I can buy bonds from Microsoft, which is essentially lending Microsoft money for a period of time. In exchange, Microsoft will give me interest payments through the life of the loan. I will also get my initial investment back when the bonds mature. As a bond holder, I don’t participate in the upside growth of the company, but I do get cash in return for lending my money.
Bitcoin doesn’t pay interest, dividend payments, or any type of cash flow to investors.
It is not a commodity: Commodities like corn, coffee, lumber, and various metals are not businesses and don’t provide cash flow to investors. However, they serve a practical use to society. I eat corn, drink coffee, and use lumber and various metals to build my home and automobile. Therefore, there is intrinsic value to holding these commodities.
Bitcoin isn’t tangible. It can’t be eaten or used to build something and, therefore, cannot be classified as a commodity.
Is it a currency? Bitcoin can be used for the purchase of goods or services. There has also been increasingly broader adoption among companies of accepting Bitcoin as a form of payment. The question is how practical Bitcoin actually is as a form of exchange since its value fluctuates wildly.
There are instruments known as “stablecoins” that peg the value of a cryptocurrency to an actual currency like the dollar. Time will tell whether this can mitigate the extreme price fluctuation for consumers and make it a practical form of exchange.
Still want to invest? Be sure to manage your risk: My confusion around Bitcoin doesn’t mean that the concept doesn’t have merit. There are people much smarter than I am who are huge proponents of Bitcoin and cryptocurrency in general. If you subscribe to that viewpoint, and decide to invest in Bitcoin, it’s important to take a measured approach. Bitcoin is still a relatively new and unproven asset class and the questions I outlined above are real. For this reason, Bitcoin is considered extremely speculative and is not appropriate for many investors. Even for experienced investors with large portfolios, my advice is to only invest money you can afford to lose. Typically, this is five percent or less of your overall portfolio. That way, if the price goes to the moon, you will make a mint. However, if it goes to zero, it won’t derail your ability to reach your financial objectives.
Indirect exposure: If you find the concept of cryptocurrency interesting but are not bold enough to make a direct investment, you won’t necessarily miss out on this trend. Be mindful that if you are invested in companies that adopt Bitcoin as a method of payment and develop systems to accept it more easily, you can benefit through this business decision. While I personally won’t invest in any cryptocurrency directly, I know that I won’t be completely missing this trend because of my indirect exposure through the stock market.
Perspective is important: The most important thing to understand about Bitcoin, which seems to get lost in discussions on this topic, is whether it is necessary to include it within your portfolio. The answer for many investors is no. The purpose of investing is to achieve your financial goals and live the life you want. This can be done with traditional asset classes like stocks, bonds, real estate, and cash. While the joy one gets from discussing the price fluctuation of cryptocurrency over a hot bowl of cholent at the kiddush with friends should not be discounted, it is also not necessary to achieve your goals. It’s important to keep that perspective in mind when considering whether an investment in cryptocurrency is right for you.
Readers are encouraged to ask their personal financial questions, which may be quoted from and addressed in a future column, by emailing [email protected].