Wild Rides: Cryptocurrency
Every so often a new way to (seemingly) make big bucks fast pops up and becomes a hot topic among investors, often catching the attention of those who are new to investing.
In the late 90s it was the “.com boom” when stocks associated with the internet were flying. People were quitting their jobs to become “day traders”, and it seemed very easy to strike it rich in the market.
In the years leading up to the 2008 financial crisis the new thing was to become a real estate mogul. Banks were throwing money at anyone with a pulse, and individuals with little to no real estate experience suddenly found themselves owning multiple homes, flipping them for profit in a hot real estate market.
“What could go wrong?” many thought. After all, conventional wisdom at the time was that residential real estate never went down much in value. Of course, we all know how that ended.
In 2020, partly with the help of new trading platforms catering to smaller investors, and perhaps fueled to some extent by too many people sitting around with lots of time on their hands during the pandemic, two investment crazes bloomed.
The first is cryptocurrencies, the other is meme stocks. In both cases surging prices attracted the attention of waves of buyers, and in both cases we see some shades of past bubbles.
In this article we are going to take a look at cryptocurrencies (“crypto” for short). In a subsequent article, I’ll describe the recent phenomenon known as “meme stocks”.
Currencies are placeholders, a way to store value that can be exchanged for goods and services. Currencies provide a valuable role in any economy, as they replace the need for a cumbersome barter system.
Without currencies, for example, if you wanted to buy a sandwich you would have to locate someone who would trade you a sandwich for some other goods or services you have.
Typically (although not always) currencies have been issued by Governments. Historically they were backed by hard assets such as gold. In early America you could exchange your dollars for a fixed amount of gold, but that ended in 1973 when we went off the gold standard and became what is known as a “fiat” currency, or one whose value derives from Government decree.
I won’t bother describing the complex mechanics of cryptocurrencies, but if you want to read up on the subject I recommend “Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money”.
From an investment perspective one appeal of bitcoin – the most widely held and well known of the cryptocurrencies – is that there is a finite supply.
Bitcoin is “minted” by computers which essentially compete to crack codes which leads to the creation of new virtual coins. But once 21 million units have been created (there have been about 19 million made so far), no more will be created.
Compare that to the US dollar and other fiat currencies that can be printed without limit by Governments, and you can see the appeal of limited supply.
In fact, massive Government spending in reaction to the COVID crisis seems to have kicked off the latest leg of the crypto craze, with bitcoin surging from under $10,000 at the beginning of 2020 to a high above $58,000 in 2021.
Several other cryptocurrencies also surged during that time frame. At the time of this writing bitcoin has continued to bounce back and forth.
This highlights two issues with cryptocurrencies. One is that they have been extremely volatile, which can cut both ways. The other related concern is that there is no easy way to put a value on a cryptocurrency.
It is worth whatever someone else is willing to pay you for it. Compare that to a stock, which represents ownership of a company. The company hopefully earns money and hopefully grows, and we can use the growth rate of the earnings to estimate a value of the business and thus the stock.
Not so with the likes of bitcoin… it is priced entirely based on the whims of the market, which can make for a very bumpy ride. Traditional currencies trade in relation to each other based on the relative financial wellbeing and perceived good management of the issuing countries.
So again, there is something at least partially measurable driving changes in value (which lends relative stability to major currencies compared to what we have seen in crypto).
So how should a prudent investor view crypto as an investment? With some trepidation given the big swings and nebulous value. Those of us who have been involved with the stock market for a while have vivid memories of the “tech wreck” crash of the early 2000s when the Nasdaq, from peak to trough, dropped 78%.
For many but the youngest investors the 2008 global financial crisis is another reminder of how bad things can get in the wake of asset bubbles.
It's tough to say if cryptocurrencies are in a bubble. A fair argument can be made that they represent a viable hedge against traditional currencies. Especially given profligate Government spending and potential inflation (reduction of currency value) that can follow.
However, the volatility and difficulty in assigning a fair value, not to mention the threat of regulatory intervention by Governments, means they should be viewed as high risk. For example, part of the recent selloff in crypto has been attributed to the Chinese Government taking a stronger regulatory stance.
In crypto the risk of Government intervention is particularly high in light of the relative newness of the asset class, and shifting regulatory frameworks around the world.
There is a place for risk in a portfolio, but unless you want to go from investing to pure gambling, you should limit the proportion of your portfolio that goes into such a wild and unpredictable asset class.