Cryptocurrencies, particularly Bitcoin, have been stealing all the news headlines as of late. Therefore, it comes as no surprise that one of the most frequently asked questions by clients recently has been related to Bitcoin. With a surge in popularity, awareness and phenomenal growth of 1543.58%1 in 2017, combined with eye watering volatility of 113%2 and drawdown similar to the 1929 stock market crash in the US, it is easy to see why it has been attracting so much attention recently. As financial planners, continuously evaluating appropriate long-term strategies for our clients, our current answer on Bitcoin is that it does not meet the objective criteria we use to evaluate investments. But, what is Bitcoin and what does it mean for you?
Bitcoin in a nutshell
Bitcoin is the world’s first digital currency. It was invented by an unknown individual using the alias Satoshi Nakamoto, in 2009. Bitcoin’s creator envisioned Bitcoin as a form of money with a mathematically fixed supply and the ability to enable decentralized, peer-to-peer payments. It can be described as self-reliant but there is no oversight, which makes it a lucrative way to anonymously transfer money.
It is indisputable that Bitcoin is quite revolutionary. It solves the double spending problem (i.e. that the same virtual Bitcoin cannot be spent more than once) and it decentralizes the maintenance of the ledger through a democratic system. The blockchain technology has a lot of potential in the proof of authenticity.
So, how does it work? First, when you sign up to Bitcoin, your computer would become a node in the network and you would receive a complete up to date copy of all the transactions that have ever happened within the Bitcoin network. Much like your transaction listings or bank statements, but for the whole universe of bitcoin.
Additionally, you would receive two “keys”. One that is private which you can use to send bitcoins, much like a pin to send money via online banking and a public key which is known to the network, much like your bank details. Both are inherently linked.
When you send Bitcoins to someone you would use your “keys” and a specific “lock” to secure your Bitcoins while they are in transit to the receiver and the receiver would use one of your keys plus a specific “lockpick” to ensure that you are a true holder of a bitcoin and that the bitcoin has not been tampered with while in transit or already spent elsewhere.
Finally, this transaction is verified by miners (accountants) who solve a mathematical problem which ensures that the transaction is genuine and enshrine it into the transaction ledger creating a chain of transactions. For their efforts, they receive new bitcoins. By creating a ledger of linked transactions, it is almost impossible to forge their accounts.
Our thoughts on Bitcoin
The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. Holding cash primarily serves the purpose of managing near-term expenditures. It might be argued that holding bitcoins is like holding cash in relation to being used to pay for some goods and services. However, most goods and services are not priced in bitcoins.
A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.
One should also remember that Bitcoins are a virtual asset, they do not really exist and are only valuable because people attach value to them now and currently the demand is soaring. We would not define Bitcoin or any other cryptocurrency as an investment, as it does not have any intrinsic value such as tangible assets or future cashflows. Unlike stocks and bonds, they do not provide capital for companies to grow. They are not contributing to our economic system through investments or taxes and are known to be a vehicle for money laundering and criminal activities.
Therefore, as an asset today, cryptocurrencies are primarily a speculation. Its value is based on the price a buyer is willing to pay for it, which is based on what that buyer believes others will pay for it. Gold is a great example of a speculation, not an investment. Gold primarily has value because people think it does. Its market value comes from subjective belief making it almost impossible to say what it should be worth. Additionally, due to its short-lived history, Bitcoin cannot provide enough input for new pricing models and today’s efforts are, at best, an educated guess.
Bitcoin is still very young and there is little research and evidence available regarding its characteristics. We view it as our job to provide our clients with rigorous, time-tested investment strategies based on hard data and academic evidence. Due to cryptocurrencies’ relative infancy and lack of long-term performance history, we deem it prudent to exclude it from our long-term investment strategy.
As a purely speculative gamble, not fulfilling the primary purpose of holding cash, as well as failing to fit our investment criteria we believe Bitcoin and other cryptocurrencies to be wholly inappropriate to be incorporated into an investment strategy that is supposed to ensure your financial stability throughout your life, take care of your family and help you achieve your life goals.
By Sam Holmes and Clémence Chatelin on January 11, 2018
The value of investments can fall as well as rise. You may not get back what you invest.
Bitcoins and virtual currencies are not regulated by the Financial Conduct Authority and are not covered under the Financial Services Compensation Scheme.
This article does not give any financial advice and is for general information only.
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