Should I be investing in cryptocurrencies? - An investor's guide to the Bitcoin conundrum
Friday 30th July, 2021
"Should I be investing in cryptocurrencies?"
This seems to be the question on everybody's lips at the moment, from experienced, long term investors to those who have never considered investing before, but don't want to miss an opportunity to turn a quick buck. I have been asked this question by numerous clients and friends and also been in a number of fairly heated debates on this topic, with one individual accusing me of selling my clients short by not actively encouraging them to purchase a portfolio of cryptocurrencies.
Like everybody else out there, I have questioned whether I am missing a trick here. It is hard not to be tempted by the lure of massive returns on your money over an incredibly short time. I have therefore looked at it as forensically as I can to determine whether there is any merit to holding cryptocurrencies for the investors I work with. Now, it is important to point out that I work with medium to long term investors. If you are looking for an investment that will triple in value over a year, I am probably not your man.
In order to answer many of the questions I am asked, I have put together a fairly in-depth article to look at all aspects of cryptocurrency. I will look at the historical aspects of asset bubbles and also look at whether a cryptocurrency is an investment or a currency, or neither. I will look at the hurdles (government regulation, corruption, market manipulation) facing cryptocurrencies and whether these are insurmountable or not. I will end with a summary of my views and whether long term investors should be holding cryptocurrency or not.
I hope you find this article useful, but if you have any questions, please feel free to give us a call. We are always happy to help.
There can be no hotter topic in investment circles than cryptocurrencies at the moment, particularly amongst the young. I frequently engage my much younger and far more tech-savvy cousin in very interesting conversations about the merits of cryptocurrencies and investing in them. He makes really good arguments and clearly understands the underlying structure of cryptocurrencies far better than I do.
When I chat to people heavily invested in cryptocurrencies many of them are following basic principles of investing, by diversifying across a number of different cryptocurrencies all at once. They have every intention of holding the currencies for the long term, thus hoping to ride out any fluctuations and benefit from long term growth.
The question I am often asked is why I am not recommending that my clients invest at least some of their portfolio into cryptocurrencies? The easiest way to answer this is that I have never before recommended investing into any currency for growth. As far as I am aware, most portfolio managers out there don’t use different currencies within a portfolio as anything other than a hedge against fluctuations in different currencies.
However, this would be a poor answer to the question, because the deeper question is whether cryptocurrencies are an investment and therefore a growth asset, or are they money and therefore only for facilitating transactions or speculating? This may be a silly question to ask, because the answer seems to be right there in the name, cryptocurrency. However, as demonstrated above, people are treating these currencies as investments. They are diversifying their crypto portfolio and planning to hold for the long term.
In the article below, I will explain why I am not comfortable recommending clients invest in cryptocurrency. I will also try and clarify whether these are investments or currencies.
I need to point out that I am not a currency specialist and I am pretty sure that there is a lot that I am missing out in this article. I am simply trying to take an analytical approach to answering a common question about investing in cryptocurrencies.
I am also not one of those crypto-deniers who are railing against any change to the status quo. I think that cryptocurrencies are definitely the future, however, what that will look like or what form it will take, I cannot say. Once again, the future of cryptocurrency is not the question. It’s whether you should be holding some as part of your portfolio.
Know your history
My starting point when looking at this question is to look at history. The history of investment and speculation can really offer some great insights into investment trends today. George Santayana, the great philosopher and poet said, “Those who cannot remember the past are condemned to repeat it". Nowhere is this truer than in the history of investment.
There is a long history of market bubbles imploding with disastrous affects for investors and the economy as a whole. These bubbles are almost always linked to the introduction of some new technology or asset.
Understanding whether cryptocurrency is a market bubble, is also important. "Why?" you may ask. I will illustrate this with the famous story of Joe Kennedy, who sold all his stock just prior to the 1929 Wall Street crash, because the shoe shine boy was giving him stock tips. His view was that when the shoe shine boy starts giving you tips, the market has become too popular for its own good and its timew to get out. By looking at history, we can get an idea of when a spike in interest in an asset morphs into a bubble and rapidly becomes too popular for its own good.
Cryptocurrencies are a new technology and there can be little argument that the increase in investor interest and precipitous rise in the value of the various cryptocurrencies looks very much like a bubble. It therefore makes sense to see if there are any parallels between bubbles in the past and that which is a currently happening with cryptocurrencies.
Tulip Mania
To start with, we can look at the first well recorded asset price bubble which happened between 1634 – 1637. The introduction of the tulip bulb to Europe kicked off a frenzy to own these prized flowers. The desire to own them stemmed from the remarkably vivid colours of the blooms and demand quickly outstripped supply. As with so many of these types of markets, it was believed that the value of tulips could only go up and up and there are stories of investors selling houses and investing their life savings in order to purchase one or two bulbs that would make them rich.
It got to the point where a single tulip bulb could sell for the equivalent of tens of thousands of pounds. However, the prices could simply not be sustained. The pool of people who could afford to buy a bulb grew smaller and smaller until the prices became completely unsustainable. The bubble burst and the price of tulip bulbs fell like a bolt from the sky, leaving many investors completely wiped out.
The South Sea Bubble
This bubble arose over the period of 1711 to 1720. It involved trade in the shares of the South Sea Company, which was a British trading company set up to exploit trade in the South Seas, which was expected to expand dramatically with the cessation of the War of the Spanish Succession. Such was the confidence of the company that trade would be very profitable, that in 1720 it underwrote the British National Debt, which stood at £30 million, on a promise of 5% interest from the Government. In addition to this, in return for a loan of £7 million to finance war against France, the House of Lords passed the South Sea Bill, which allowed the South Sea Company a monopoly in trade with South America. Everything was looking very promising.
In light of all these favourable signs and the company’s incredible confidence, investors piled into South Sea Company stock, causing the share price to rocket. Once again, the prices became unsustainable and the company’s returns were not as favourable as everybody had expected, resulting in the bubble collapsing. The precipitous fall in the value of South Sea Company share prices left many investors crying into their prematurely filled champagne glasses.
The Rail Road Bubble
The introduction of the train to Britain was a revolutionary occurrence and changed the way people travelled and goods were transported across the UK. This resulted in railroad company stock prices soaring over the 1840s. It seemed that one could not get enough of a good thing and there was ostensibly no limit to the rise in railway generated returns. In the glut of investment that followed many unnecessary and economically unviable railway lines were built. Due to the massive exuberance, many railroad companies were created, and grand plans for new railway lines proposed, with little thought of practicality or cost. Often the schemes were simply just plain fraudulent.
More and more people jumped aboard the railway investment band wagon, with investors allowed to purchase stock on margin, requiring only a 10% deposit.
However, soon more experienced investors began to realise that the railways were not as lucrative as once thought, and many of the railway companies were simply shells with pie-in-the-sky proposals for further projects. At this point, the investment quickly dried up and the share prices fell, leaving many investors destitute.
The Dot-Com Bubble
Over the 1990s there was a huge increase in internet-based companies and values soared through the roof. Who can forget the image of the dot-com millionaire complete with bad tan, convertible and brick mobile phone? The internet created a whole new economy and the opportunities were endless. Between 1995 and its peak in March 2000, the Nasdaq Composite stock market index rose 400% on the back of investor demand for more and more internet stock. Once again, this huge investor exuberance meant that the fundamentals of the companies being invested in became unimportant. All a company needed to attract money was an idea. Investors poured money into concepts in the hope of striking it rich.
Unfortunately, as the excitement settled and the larger institutional investors gained control of their FOMO, they realised that many of the companies were not really companies at all. Many of the concepts were paper-thin and unsustainable. So, they quickly decided to take profits and run. The sell-off happened suddenly with investors talking about getting on a plane in New York rich and climbing off in California poor. The impact was devastating, with many reputable companies also seeing their share prices burrow down like a home sick mole.
Credit Crisis
In 2008 we, as investors, got hit in the head by the two-by-four plank that was the Credit Crisis.
“Alright,” you may say, “But how is that a bubble?”
Well, it was a property bubble which was built on giving cheap loans to people who could not really afford them. This was achieved by parcelling up all this cheap, unstable debt along with a sprinkling of secure and stable debt and selling it all as a complex mortgage-backed security. These securities would be sold on and on in a high stakes game of sub-prime mortgage hot potato.
With this cheap credit, home ownership became a reality for millions of people who could never before have dreamed of owning a house. Mortgaged up to their necks, they could finally have their slice of the pie. House prices soared.
When this bubble burst the fallout was horrendous. Large global banks collapsed, people lost their houses, massive quantitative easing by governments became the norm and the jobs market fell through the floor. It took years for the world’s economies to recover and there is talk of a whole generation of young people who have seen their progress up the economic ladder stalled as a result of it.
There are many other examples of economic bubbles that I have left out. These include:
- The Mississippi Bubble of 1715
- The Wallstreet Crash of 1929
- The Nikkei Bubble of the 1980s
The reality is, that if I took all the bubbles into consideration, this would morph into a book rather than an article.
Now, a key thing to take from these bubbles is that the bursting of the bubble did not spell the end of the relevant industry or market. Tulips continue to be sold around the world at (relatively) reasonable prices. Trade within the South Sea continued, but with more moderate expectations. The most well run and economically viable railroad companies still transported goods and people, with profitable routes maintained. Following the Tech Bubble, we still have Microsoft, Apple, Amazon and so many other incredible companies. The problem quite often is not the idea or the industry, it is rather people’s irrational exuberance which makes them blind to flaws and failings that would normally be glaringly apparent to all.
If we look at cryptocurrencies, there are apparently 6000 different cryptocurrencies listed in 2021(according to Statista - • Number of crypto coins 2013-2021 | Statista). This is a substantial increase from the 2013 level of 66. This is the point where we look at the cryptocurrency market and ask ourselves, “Does this look like a bubble?”
During every one of these bubbles, there have always been people who have said, “What? a bubble? This isn’t a bubble. You better get invested or else you will miss out on being a millionaire!”
These are generally the people who make the most money out of selling the instruments. Alternatively, it is your friends, or acquaintance from the pub. They have invested and they are making an absolute packet!! The FOMO kicks in and the next thing you know, you are standing there with a load of cryptocurrency and a knot in your stomach. I speak from experience. As an investment professional, I am bombarded by the constant temptation to get on the crypto band wagon. I often have to question whether I am missing out. What if this is the one time in history when the price just keeps climbing and I miss out completely? If it is, I am really going to kick myself.
Now if crypto does behave like a bubble, and we also accept that cryptocurrencies do have a place in the world’s future financial system, then which of the 6000 available currencies is going to survive? I can’t imagine it will be many. That means that a lot of investors are going to take a powder. The question you need to ask yourself is, “Are the rewards sufficient to risk being one of them?”
Is cryptocurrency an investment?
This is a crucial question to answer. Many people are staking their financial futures on crypto continuing to grow in value. They realise that some of the cryptocurrency options will fall along the wayside and therefore spread their investment across a wide range of different currencies to reduce the risk of this happening. They see the fluctuations in value and the volatility and they therefore use time honoured investment strategies like “buy quality and hold for the long term” to ride out fluctuations and achieve growth over time.
However, if it is not an investment, you have to question whether these strategies are going to work. What does quality look like and how do you determine it? Does long term still mean 10 years plus?
So, what is investing? Investing is the act of purchasing an asset in the hope of achieving future growth and returns. An investment is therefore the asset that has been purchased to provide that appreciation in value or income over time. There are a number of different assets that can be treated as investments. These include cars, paintings, wine, shares, corporate bonds and gilts, antiques, watches, gold, precious stones, commodities and property, to name just a few.
With assets like cars, paintings and wine; the value derives either from rarity, uniqueness or quality.
With assets like shares, you purchase a right to share in the growth in a company and its profits. If the company performs well, you receive dividends, as well as the increase in the value of the share’s underlying value on the stock market. You can look at the management of the company, its debt ratios, its margins and numerous other factors to make a reasonable assessment of it’s future performance.
With gilts or corporate bonds, you lend money to a government or company and in return, they pay you interest. You receive this coupon as your “return” but these can also be traded on the bond market and the underlying capital value can increase or fall. However, if you hold the bond for the full term, your principle is paid back to you in full along with the interest already received.
Oil is a remarkably useful commodity crucial to our current way of living (and also ending it!!). Its value therefore comes from our need to run our cars, run our industries, generate energy, make plastics etc.
Lastly, with a house, the investor can rent it out to receive a return from their property. They will also hopefully see the actual capital value of the property increase over time.
Hopefully you are starting to get the idea here. The investor buys an asset and hopefully, over time, the asset increases in value or provides a regular income or both.
With a cryptocurrency, what is the underlying asset? In other words, how do you determine its value? Main stream currencies generally achieve their value in relation to other currencies. Determining the value can be quite complex. For example, Stirling can be up against the Dollar, but down against the Euro. The currency’s value relative to other countries is affected by a number of different things such as:
- Demand for a particular currency relative to another
- How well the economy of that currency is performing (for example Brexit resulted in Stirling losing considerable value, reflecting the markets view of the UK’s economic future)
- Inflation in a country can cause a currency to increase or decrease in value
- The interest rates applied in a country can make a substantial difference to the value of a currency. If interest rates are increased, the currency will become more attractive to depositors and similarly, if interest rates are reduced, the currency becomes less attractive
- Changes in the value of commodities can impact the value of a currency belonging to a country that is particularly reliant on that commodity to generate revenue. We can therefore see a big slide in the value of the Saudi Riyal when oil prices fell during the Covid pandemic
As you can see, with mainstream currencies there are all sorts of factors that impact the value of the currency and most of these are associated with economic circumstances within the nation associated with that currency.
Now it is important to note that I don’t regard currencies as investments. Even currency traders are very open that what they do is speculation, looking to make returns off of short-term differences in value between two currencies. The reason it is important to understand how currencies are valued, is to highlight that even with main stream currencies, there is something against which the currency’s value can be determined.
With cryptocurrencies, there is no parent country with economic factors that can be used to determine the currency's value against other currencies. There is no central bank making decisions on the availability of a currency, interest rates or any other economic factor. There is no economy determining the strength of the cryptocurrency. There is no underlying asset that provides it with an intrinsic value. The value lies solely in what people are willing to pay for it.
Some may argue that this is enough, but when (eventually) the cryptocurrency price can increase no further, and it exceeds the amount that the average person is willing to pay for it, what does the owner of a cryptocurrency hold? When a single unit is so incredibly expensive, it is not much use for even the most basic task of facilitating transactions? There are already perfectly good currencies in most economies that adequately support this function and have been doing so for years. The unit of cryptocurrency is not valuable in and of itself. It performs no function within the economy and has no intrinsic usefulness. There is no underlying company that generates and sells a product to create revenue and returns. There is no way of measuring its value beyond human sentiment and we all know how incredibly volatile that is.
Without an explicit way to determine value and increase its value over time, it cannot be an investment. There is no doubt that many people will make lots of money from the rising and falling values of the cryptocurrencies, but this is not investment, it is speculation. To be successful in speculation requires a completely different set of strategies from those used in investing. Many currency traders rely heavily on technical analysis, experience and gut feeling to achieve results. Margins are often small and it requires constant observation. The successful speculator requires a strategy that provides an edge and iron self-discipline. These are not the tools of a long-term investor.
Is cryptocurrency money?
Once again, it seems counter-intuitive to ask this. As I pointed out earlier, it’s right there in the name. It is described as a currency, and it therefore seems logical that it is in fact money. However, for a financial instrument to qualify as money it must fulfil three requirements:
- It needs to be a medium of exchange (you need to be able to buy stuff with it)
- It needs to be a unit of account. In other words, it must enable people to measure and record the value of goods and services and financial transactions. A chocolate costs 89p. Therefore, the pound (and pence) are a unit of account. It allows us to determine the value of the chocolate
- It must be a store of value. To be a store of value the asset must be liquid, universally accepted and have a stable value
Is cryptocurrency a medium of exchange?
Not really. There are not many items that can actually be purchased using cryptocurrency. Furthermore, where an asset can be purchased using cryptocurrency, it is normally only with one of the more mainstream currencies like Bitcoin or Ethereum.
Let’s face it. The primary task of money is to facilitate a transaction. If there are so few items that can be purchased using cryptocurrency, it means that they are simply not fulfilling this requirement.
Is cryptocurrency a unit of account?
Once again, it cannot be successfully argued that cryptocurrency fulfils the requirement of being a unit of account. I have quite literally never been into a shop and seen an item priced in Bitcoin or Satoshis. In fact, this is so far from happening that my spell check recognises the currency of Botswana (the Pula), but does not recognise the smallest unit of a Bitcoin (the Satoshi).
Even when a person is asked to value their Bitcoin account, they give the value in US Dollars to help establish what its value actually is. I therefore think we can safely say that cryptocurrency is not a unit of account.
Is cryptocurrency a store of value?
I think there are a few problems with cryptocurrency qualifying as a store of value. The biggest problem is simply that it is not stable. Cryptocurrency has shown a tendency to rise and fall in double digit percentages. When you consider that a movement of 1% in a day for most established currencies is going some, a double digit fall or rise is simply madness.
Furthermore, it is not universally accepted as a currency. To date, El Salvador is the only country that recognises Bitcoin as legal tender. In addition to this, for cryptocurrencies to function as money, there needs to be a well-developed communication structure, mobile network and internet access. This is clearly not available in many parts of the world, so universal acceptance of cryptocurrencies as money is hampered by this technological stumbling block.
Based on this, I would say that cryptocurrencies do not qualify as a store of value.
I think that, based on all the evidence above, it is hard to argue that cryptocurrencies qualify as money at all.
Government regulation
Many people love cryptocurrencies, as it creates a universal currency, that cuts out government regulation and control. However, I think that this may be one of cryptocurrency’s biggest failings.
Control of money is a key lever for a government to control the level of growth within it’s own economy. A country’s central bank plays a crucial role in controlling the amount of money circulating within an economy. By making more money available it increases productivity, lending, and correspondingly the economy grows. Similarly, the bank may be concerned that the economy is overheating or inflation is getting out of hand, so it may reduce the amount of money circulating in the economy, reducing lending, slowing productivity and putting the brakes on economic growth and inflation.
The government can also indirectly impact the value of a currency by increasing or decreasing interest rates. Devaluing the currency can make it less expensive for other countries to buy your country’s products, thus increasing your country’s total exports and strengthening the economy and productivity.
The reason I mention this, is that I cannot see a situation where any government feels comfortable allowing control of this crucial economic tool to pass from its hands. Can anyone see China or Russia giving up this control? In fact, China has taken steps to create a digital currency (DCEP), in order to avoid this situation from occurring. China insists that all digital currencies must be issued by governments and central banks for this very reason. It’s all about control.
When we come right down to it, there are going to be few nations (democratic or otherwise) that will feel comfortable with an unregulated currency, over which they have no control, becoming a major vehicle for facilitating transactions.
In addition to this, there is a huge problem that many cryptocurrencies have a fixed supply. For example, the maximum amount of Bitcoin that can be mined is 21 million. The aim of this fixed supply is to offer stability. However, as we have seen above, the ability to control the amount of money in circulation is a key tool for regulating an economy. It is not possible to create more money, if there is a limit on the number of units of a cryptocurrency that can exist. This makes any cryptocurrency with a fixed number of units impractical and it is unlikely that it will ever become legal tender.
There are cryptocurrencies that allow creation of new coins. For example, Dogecoin allows the creation of 5bn more coins each year. This means that the currency is far more flexible and less susceptible to hoarding and is far more capable of meeting a government’s requirements of a currency. However, it makes it a terrible investment, as the constant creation of new coins will create downward pressure on the value of the coin itself.
Cryptocurrency's problems with crime and manipulation
The last problem to highlight is that the lack of regulation has made cryptocurrency a favoured payment method of criminal elements. It is no secret that many criminals use cryptocurrencies to fund transactions, and the lack of a trail and regulation makes these types of transactions difficult to trace. It is difficult to see the government (or society) allowing this to continue unaddressed. It therefore makes absolute sense that before any cryptocurrency is accepted as legal tender, it will have to succumb to some form of government control.
The fixed supply problem, that we highlighted above, also makes many cryptocurrencies susceptible to manipulation. If we look at Bitcoin, for example, in May 2021, the top 100 Bitcoin wallets were estimated to own 32% of total bitcoin supply (“Bitcoin Whale”, Investopedia) with most of the owners’ identities not known. It would therefore only take a few whale wallets to manipulate the bitcoin market, causing violent price moves. With the option to short the market, it is hard to see how anyone with an ability to manipulate the market price wouldn’t be tempted to take advantage of it.
Final Thoughts
Based on the reasons highlighted above, I do not believe that cryptocurrency is a good investment. It fails all the tests of a good investment and is massively open to manipulation.
Furthermore, the considerable lack of regulation means that these instruments operate in an effective investment wild west. As my old man used to say, “If you choose to live in cowboy town, you accept that you live with cowboys”. Therefore, if it all goes pear shaped you accept the consequences of it with no redress available. I would therefore never recommend any of my clients invest into this type of vehicle. There is so much wrong with it, and the only thing buoying its price up is sentiment.
If you have some money you can afford to lose and you want to speculate then go for it, but do so with your eyes open. Set a stop-loss and also set a maximum level of profit at which you will get out. If either of these is triggered, get out. You accept your loss or you accept your gain. Don’t ride losers hoping they will recover and don’t be greedy.
Cryptocurrency is also not money. It may facilitate some transactions, but it is a long way off of qualifying as legal tender. Trust me, qualifying as legal tender in El Salvador does not a legitimate currency make!
If you are trading it as a currency, remember that cryptocurrencies are potentially open to huge amounts of market manipulation. Speculating on established currency pairs is difficult, and making consistent profits trading cryptocurrencies is nigh on impossible, regardless of what the experts say on YouTube.
If you are looking to build wealth to buy a house or boost your retirement, remember, every substantial fall in value takes you further away from your goal. There are far more reliable ways of generating good returns with a little patience, than risking everything on something as speculative as cryptocurrencies.