Bitcoin investment is far too risky for most portfolios
Many crypto enthusiasts believe bitcoin is “digital gold,” an important new asset class providing attractive expected returns, a durable store of value, and diversification.
But since last fall, the cryptocurrency has failed dismally to do any of those things. Instead, its price has dropped like a digital stone, losing about two-thirds of its value.
From an all-time peak of $68,990 (U.S.) in November, it fell to a low of $17,630 in June. It has since recovered a small portion of lost ground, trading at around $21,700 last Friday, according to investing.com.
This poor performance comes as it was starting to make inroads in the mainstream investing world. A few major investment firms like Fidelity Investments have started to include small allocations of bitcoin in conventional portfolios alongside stocks and bonds.
But in my view, bitcoin isn’t ready for average investor portfolios. Its recent price behaviour shows it’s still far too risky for most average investors who are typically investing with their retirement savings on the line.
At the root of its riskiness is the fact that it is a speculative asset whose value is determined by what investors think it is worth, with no underlying “fundamental” value in the traditional sense. Unlike stocks, for example, you don’t own a share in a company’s profits, cash flows and dividends.
Untethered to fundamentals, it might do really well, or really badly, or anything in between. It all depends on investor sentiment, which can be fickle.
Of course, it still has true believers who think it has many of the favourable investment attributes often associated with gold, but with important added benefits.
For one thing, its supply is limited more tightly than gold, with an ultimate cap of 21 million bitcoins.
On the demand side, it benefits from the network effect. As more people use bitcoin, it could become more valuable to each user. That in turn may encourage even more usage by each existing user, as well as attracting additional new users, thus potentially driving exponential growth.
That potent potential combination leads enthusiasts to expect huge price gains over time, albeit with plenty of volatility.
Bitcoin believers range from young people with small sums to invest, to prominent tech billionaires such as Elon Musk (of Tesla Inc.), Michael Saylor (of MicroStrategy Inc.), and Jack Dorsey (of Block Inc.), who use ample personal and company wealth to support their beliefs.
For most of its history, bitcoin prices reflected the independent streak of its buyers, making it largely independent of stock market movements. Prior to the pandemic, correlations between prices and major stock indices were very low, similar to gold. That fuelled the expectation that bitcoin would help diversify conventional stock and bond portfolios.
Proponents also started to view bitcoin as a trustworthy store of value, a means of retaining purchasing power for future use. Of course, its prices have historically been far more volatile than cash (the store of value benchmark), or gold (an established alternative). But it could easily be sold if necessary and its proponents expected it to enjoy strong price gains over time.
Also, similar to gold but unlike cash, the cryptocurrency’s supply is independent of central banks and therefore proponents expected it to provide a good hedge against inflation. Prominent holders like Tesla, MicroStrategy, and Block have accumulated billions of dollars worth of it on their balance sheets.
While its prices prospered alongside tech stocks in the early stages of the pandemic, bitcoin started declining from its November peak, with a sharp plunge in the second quarter of 2022.
It was partly driven by crypto industry business failures which included: crypto lender Celsius Network LLC; crypto broker Voyager Digital Ltd.; linked cryptocurrencies TerraUSD and Luna; and hedge fund Three Arrows Capital Ltd.
These business failures sapped investor confidence in bitcoin alongside the rest of the crypto industry. In addition, rampaging inflation, rising interest rates, and slowing economic growth created a worsening climate for both investors and the tech industry. No one could be sure how bad it would get.
Institutional investors who had started to include bitcoin in portfolios were now looking to unload riskier assets, and now that included bitcoin. Some tech enterprises sold the cryptocurrency to reduce debt and raise cash as external financing dried up. Most prominently, Tesla sold more than $900-million U.S. worth during the second quarter.
All that put selling pressure on the cryptocurrency and the price dropped precipitously. This time bitcoin and tech stocks were highly correlated and sold off together, thus providing little or no benefit from diversification.
In the second quarter, the tech-heavy NASDAQ 100 Index fell 22 per cent, while bitcoin prices dropped 58 per cent, acting like just another risky asset.
The current environment warrants caution for average investors. Central banks haven’t finished raising rates and no one knows reliably how much the economy will slow.
There is a realistic possibility the economy could end up in deep recession, in which case riskier investments would likely get hammered some more. Given its recent price behaviour, that scenario would likely hurt bitcoin severely.
Of course, believers have seen big sell-offs before. Many view current prices as a buying opportunity for those who can be patient. Even if prices drop further, there’s still a strong chance they’ll recover at some point and reach new heights down the road.
The thing is, with speculative investments, the outcome is highly uncertain. Based on the history of technology investments, there is also a significant risk that bitcoin owners will at some point move on to some new thing leaving prices to languish in the digital dust.