It seems like you can’t go anywhere without hearing about cryptocurrency. There are television commercials, social media ads, and I’d estimate that around 3 out of 5 direct message requests I receive on LinkedIn are people trying to convince me to purchase crypto from them. I’m sure that many of you have had similar experiences.
However, many people don’t really understand cryptocurrency and how it could fit into their portfolio. This is on full display when you look at the number of people who are solely investing in crypto. It’s rarely a good idea to put all of your money into a single asset class but that doesn’t mean crypto can’t have a place in your investment portfolio.
Cryptocurrency
In its most basic form, cryptocurrency is a form of payment that can be exchanged for goods and services online. It’s become so popular in recent years that many companies have begun creating their own currencies. These are called tokens and are meant to be used specifically to purchase the goods and services of the issuing company. Many times, these currencies utilize the blockchain.
According to Investopedia, there are more than 8,000 different cryptocurrencies being publicly traded. This equates to roughly $3.3 trillion worth of bitcoins being traded. When I say “bitcoins,” that is not the same as saying “Bitcoin.” Bitcoin is a specific brand of cryptocurrency. On the other hand, bitcoins are a generic term for digital currencies.
What’s With All the Hype?
There are a few reasons why crypto has grown so popular over the years. To some, it is the currency of the future. These investors are motivated to buy as much of it as they can before it presumably increases in value. Others view the rise of cryptocurrencies as a means of seizing power from the central banks.
On the other hand, there are some who simply value the technology behind cryptocurrency. Specifically, the blockchain. The security offered by blockchain technologies could be used in far more than banking and trading cryptocurrencies. In fact, I’d love to see it utilized in future election cycles.
Finally, there are some who like crypto just because they’re increasing in value. They have no interest in its long-term application or acceptance. But are any of these reasons good enough to make cryptocurrencies a good investment?
Is It a Good Investment?
Of course, these currencies may increase in value. However, many investors still view them as speculations rather than “real investments.” Real investments are those which can be quantified into fundamental and technical analyses. Like real currencies, cryptocurrencies don’t generate cash flow. Therefore, to generate a profit, someone must pay more for the currency than you did.
This strategy—purchasing something that doesn’t generate cash flow but may increase in value—is known as “the greater fool” theory. Despite the name, it’s not suggesting that the person who invests in cryptocurrency is a fool. There are many ways someone could “buy low and sell high.” But, in a well-managed business, value is increased by growing the profitability and cash flow of the operation. Cryptocurrencies don’t currently generate cash flow.
If you see bitcoins as the currency of the future, allow me to point out the greatest difference between them and other currencies. Stability. There are some who would argue that because crypto lacks stability, it is a speculative investment. Speculative investments should only be conducted after deep research and understanding of the topic.
Unfortunately, that’s not what’s happening. So many people are buying into something they don’t understand, and it costs them millions of dollars. Not long ago, I read an article about how many early investors can’t access their “wallets” because they’ve forgotten their authentication key. Essentially, this is a code that was assigned when they made their initial investments in cryptocurrency. So, there are literally millions of bitcoins that will never be realized simply because investors didn’t understand how it worked.
Have An Investment Philosophy
Whenever you begin investing, I firmly believe you should come to the table with an investment philosophy. My investment philosophy has been displayed on our website for over a decade. At this point, I’m pretty set in my ways, and it isn’t likely that I’ll change many things any time soon. I believe the markets are efficient. Likewise, I believe in Modern Portfolio Theory. The key insight of the theory is that an asset’s risk and return should not be assessed by itself but by how it contributes to a portfolio’s overall risk and return.
Additionally, I believe in the Three-Factor Model created by Eugene Fama and his University of Chicago colleague, Kenneth French. This model combines the market factor (stocks vs. fixed income), the size factor (small-cap over large-cap stocks), and the value factor (high book-to-market over low book-to-market stocks).
Similarly, I believe that target band rebalancing (daily or weekly rebalancing of positions that break through the 20% variance) yields more desirable returns over time. I believe these things because the research shows them to be true. All of this is building to answer the question, “Should we invest in cryptocurrencies?”
So, Should You Invest in Cryptocurrencies?
I believe cryptocurrency could have a position as part of a well-diversified portfolio. In fact, I currently own cryptocurrency. It’s part of my overall investment portfolio and is in alignment with my risk score and IPS. Likewise, it aligns with my overall financial plan. However, this is not what I’ve seen recently. What I’ve seen recently is like what we saw with real estate. Investors are taking everything and going “all in” with cryptocurrency. In my opinion, going “all in” on ANY single asset is unwise.
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