Bitcoin is a ubiquitous topic these days, both in the finance industry and at backyard barbeques. My colleagues and I are often asked about it by friends and clients. What is it? Should I buy some? How might it fit into my financial plan and my portfolio?
What is Bitcoin? Bitcoin is a currency, just like dollars, euros, or yuan. It is theoretically similar to precious metal currencies, like gold, in that its supply is limited. There is only so much gold on the planet, and the programmer who created Bitcoin built a maximum number of coins into the code. Also, like other currencies, it does not directly generate any cash flow and it only has value if people agree that it has value. Unless you can find a bank that will pay you interest on your Bitcoin deposit, owning Bitcoin is like the Canadian dollars in your sock drawer from your 2019 trip to Windsor: it earns nothing. The only way you profit is by selling to someone else later at a higher price.
The following applies to all currencies: you only want to own euros/gold/Bitcoin if at least one of the following is true.
1. You think you can sell it to someone else at a higher price
2. You plan to use it to buy goods and services.
Bitcoin bulls say that it should be worth more in the future because the supply is limited and demand will increase as more parts of the economy accept Bitcoin as payment for goods and services. I am skeptical, because until you can pay your taxes in a currency, widespread commercial adoption is very unlikely as businesses do not want to take unnecessary currency risk. El Salvador recently became the first country to accept Bitcoin as legal tender, but that country represents less than 0.05% of the global economy. I don’t think that nation’s decision will start a trend to be followed by large economies whose fiat currencies are already considered to be global standards. Meanwhile, prudent consumers won’t use Bitcoin to pay for things until they are confident that tomorrow’s cost of a sandwich/car/haircut in Bitcoin will be the same as its cost today.
Bitcoin is nothing special among cryptocurrencies, just the first. The exciting part of the idea is the underlying blockchain technology, which is being replicated many places in other cryptocurrencies and other unrelated applications. Blockchain is to Bitcoin as the Internet is to the Netscape. Netscape was one of the first internet browsers and is now bankrupt. If a large developed economy, like the United States, did want to integrate a cryptocurrency into its monetary system, why use Bitcoin? They could just as easily create a new currency.
If you have reasons to believe that a currency will be worth more tomorrow than today, then Buy, Buy, Buy! And be ready to Sell, Sell, Sell when your expertise informs you that the price will go no higher. If you don’t have confidence of a currency’s future price, then buying it is a cointoss. :-)
Either way, this is a trade, not an investment. Once again, you only make a profit by selling to someone else later at a higher price; currencies do not generate cash flow like a business. For the assets that our clients entrust with Exchange Capital, we focus on building financial plans that are backed by future expected returns of assets that generate their own internal cash flows. We think this is more prudent than attempting to make a series of lucky trades.
Andrew Stewart, CFA, CAIA is Chief Investment Officer and Partner at Exchange Capital Management, a fee-only, fiduciary financial planning firm. The opinions expressed in this article are his own.