Does Cryptocurrency Belong in Your Portfolio?

Cryptocurrencies have entered the mainstream. What began as a white paper written by the mysterious Satoshi Nakamoto in 2008, titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” has morphed into several cryptocurrencies currently valued at approximately $2 trillion dollars. Bitcoin is the first and most well-known cryptocurrency and is gaining momentum worldwide. In fact, The President of El Salvador recently announced that Bitcoin will be accepted as legal tender—a first for a nation.

The foundation behind cryptocurrency’s rise is its ability to be used across borders without government or central bank influence. It may be argued that there are strong benefits to a decentralized currency. Just imagine if on your next trip overseas you weren’t concerned with converting dollars into foreign currency and you could use your digital wallet wherever you travel. And yet, recent ransoms paid in cryptocurrency to cybercriminals reflect the “Wild West” nature of this space which largely avoids detection by regulators and legal authorities.

"This technology has many uses beyond digital currencies..."

One of the most interesting attributes of Bitcoin is the use of blockchain technology, which enables every transaction to be stored in a database operated by individuals all over the globe and is inherently transparent. To conceptualize blockchain technology, imagine the blockchain as a global bank vault with rows of glass boxes. Anyone in the vault can see inside the box, but the contents are only accessible to the keyholder. This technology has many uses beyond digital currencies including securely sharing medical data, serving as marketplaces for NFTs (non-fungible tokens), as well as providing supply chain, logistics, and data monitoring. For example, more than 450 airlines can now use IBM’s blockchain-based vaccine passport to quickly clear international travelers to fly.

Beyond blockchain technology applications, Bitcoin is also a scarce “resource.” The number of Bitcoins that can be mined is set in the code; its growth is predetermined and not subject to central bank policies. As such, does it serve as a good store of value? A store of value is a commodity or asset that will retain purchasing power into the future—a particularly useful thing in an inflationary environment—and can be saved, retrieved, and exchanged in the future. Gold is a good example because its physical properties and limited supply contribute to its relatively consistent value and use over time. While Bitcoin is theoretically scarce, its price is unstable, making it a poor store of value for now.

"While Bitcoin is theoretically scarce, its price is unstable, making it a poor store of value for now."

So, does cryptocurrency belong in your investment portfolio? At Clifford Swan, our investment approach centers on valuing businesses by the cash flows they generate. In his legendary book, Security Analysis, Benjamin Graham said, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” When we invest your money for you it is only done after careful analysis by our team of research analysts. Our primary focus is to preserve and growth wealth. Importantly, we want to understand the businesses we are investing your money in, the cash flows they generate, and management’s focus on deploying that cash so that it can benefit shareholders. Bitcoin and other cryptocurrencies do not possess the qualities we look for when investing a client’s capital. Here are a few of the risks we see with an investment in Bitcoin or other cryptocurrencies:

1. REGULATION AND TAX:
One of the lures of cryptocurrency is anonymity, but recently the IRS determined that cryptocurrencies like Bitcoin are “property” that is reported on and taxed the same way as owning stocks. Over the past 10 years, Bitcoin has returned an astronomical 200,000%. The U.S. government certainly wants to tax those gains like they do all other property. Since the cryptocurrency market has surged, governments throughout the world have the regulation of this market in their crosshairs. Increased regulation, taxation, and the possibility of abolishment are all possible outcomes for cryptocurrencies. In fact, it’s likely that governments will issue their own Central Bank Digital Currencies (CBDCs) in the coming months and years; China and the EU are already testing the viability of digital currencies. It is quite possible that privately created cryptocurrencies could be displaced.

2. VOLATILITY RISK:
The ride to 200,000% gains has been extremely rocky. Since 2012, Bitcoin has endured 14 selloffs of more than 30%, six of more than 50%, and three of more than 80%. If, like the U.S. dollar, Bitcoin or other cryptos are ever going to be a standard medium of exchange for goods and services, the volatility must decrease. Otherwise, if you were running a restaurant that accepted Bitcoin, the funds you received could be down 10% by the time you open the restaurant the next morning. To gain widespread adoption, the instability will need to subside, and businesses be willing to accept payment. For now, volatility persists.

"To gain widespread adoption, the instability will need to subside, and businesses be willing to accept payment."

3. EXCHANGE SECURITY RISK:
Bitcoin and other cryptocurrencies can’t be purchased directly in a brokerage account. For example, Schwab and Fidelity don’t allow the direct purchase of Bitcoin. Investors are only able to indirectly purchase cryptocurrency at custodians like Schwab and Fidelity via managed funds, and these funds typically charge high fees. The direct purchase of cryptocurrencies is done through digital wallets and exchanges. Many of these exchanges have been hacked in the past and millions of dollars of digital currencies stolen. It remains to be seen if cryptocurrency exchanges can prevent the loss of client assets from determined hackers. Bitcoin has also gone missing when individuals lose passwords to digital wallets. Without a worldwide regulatory body in place to protect investors, the possibility of your cryptocurrency funds being stolen is high. The decentralized nature of cryptocurrency is part of the bull story, but it is also a hindrance as there is very little regulatory framework in case of hacking or exchange failure. Much of the U.S. financial market is regulated by the government. Many banks and brokerage firms protect client assets through FDIC and SIPC insurance, so if a bank or a brokerage firm were to fail, U.S. government insurance will be there to protect some portion of investor assets. Bitcoin and other cryptocurrencies currently lack these guardrails.

Clifford Swan continues to evaluate cryptocurrencies as an alternative asset class. However, given the characteristics described above, we do not view crypto as a viable investment at this point. If the risks don’t deter you from putting some funds into cryptocurrencies, then perhaps the most sensible approach is to view cryptocurrency as Graham’s “speculative” portion of your portfolio. As with any such investment, we recommend keeping a close eye on your position size and suggest a limit of 5% of your portfolio for this particular asset class. In any case, only use funds to speculate that you could afford to lose entirely, without affecting your long-term financial wellbeing. One way to consider the appropriateness of cryptocurrencies in your portfolio is to imagine your reaction if one of the several drawdowns that have occurred in the past were to happen again. Would you purchase more Bitcoin if it declined 50% from your original purchase price, or would you sell? If the answer is “buy more,” then you may have the fortitude to invest in Bitcoin or other cryptocurrencies.

If you decide to buy cryptocurrency directly (versus indirectly via a managed fund) you might consider the following channels:

ROBINHOOD ACCOUNT
The app can be downloaded on your phone and cryptocurrency assets like Bitcoin can be purchased in the account. Robinhood only allows taxable accounts to be opened on their platform. No IRAs of any kind (Roth, SEP, Traditional) are allowed to be opened on the platform.

COINBASE
Coinbase is the most well know digital wallet. The company recently went public on the New York Stock Exchange. An individual can open an account on Coinbase through an app on a smartphone or on the website. Once you verify some personal financial information, you can fund the account and purchase cryptocurrency.

OTHER DIGITAL WALLETS 
Some larger tech companies have embraced the cryptocurrency market and have made it easy to purchase cryptocurrency on their platforms. If you have a PayPal or Venmo account, you can purchase cryptocurrencies on their platform and hold it in a digital wallet.

If you are considering participating in this emerging asset class, your investment counselor can articulate the risks and guide you on the appropriate position size for your portfolio.

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The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.