Swedroe: Bitcoin & Its Risks

December 04, 2017

Third, when making an investment, one should be able to estimate its expected return and its potential dispersion of returns, as well as its correlation to other assets, so that we can see how its addition impacts the risk/return of the entire portfolio. With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With bitcoin, none of the preceding analysis is possible.

Bitcoin is purely speculation, and smart investors don’t speculate. It’s important to understand that no one has yet to provide a fundamentals-based valuation model for bitcoin. And for good reason. There simply is no tangible relationship between any economic or financial parameters and bitcoin prices.

That said, the absence of evidence is not proof of the lack of explanatory power. However, this means bitcoin’s price currently is being driven by what may be nothing more than the enthusiasm of true believers. The risks of trying to short bitcoin are just too great. That, in turn, means sophisticated investors cannot correct the mispricings of speculators. And bubbles happen when only one side (the optimists) is able to express its opinion about valuation.

Even Isaac Newton, after losing a fortune in the South Seas Bubble, learned that while he could predict the motion of heavenly bodies, he could not predict the madness of crowds. It’s certainly possible that today’s sky-high prices are being driven not just by bitcoin’s enthusiasts, but by those (perhaps residents of countries such as China, Russia, Thailand and North Korea) concerned by, and trying to avoid, the high risks of capital controls and expropriations. If that is the case, this certainly could be a speculative bubble.

Conclusions

These are all issues investors should consider if they are thinking about an investment in bitcoin. They should also keep in mind the extreme nature of the price swings, with daily losses as high as 80%, and be sure they can stomach them. At the very least, investors should ask themselves how they would react if the price suddenly collapsed. Most importantly, remember that the benign neglect of cryptocurrencies by regulators can quickly turn into outright prohibition on trading and even usage.

Finally, one of the things we are most proud of at Buckingham Strategic Wealth and throughout The BAM Alliance is that none of the investment recommendations we give are based on our personal opinions. Instead, they are based on evidence from peer-reviewed academic journals. In the case of bitcoin, there is no literature on which for us to rely.

Thus, we cannot make any recommendation on whether or not purchasing bitcoin is a good investment. Nor is there any way to determine its value, as there are no cash flows to evaluate. In fact, we have to say that an investment in bitcoin should be considered purely a speculation at this point. That may change in the future. But unfortunately, when it comes to the future, our crystal balls remain cloudy.

Postscript: If you’re interested in some additional thoughts on “fundamental” and “speculative” demand for bitcoins, I’d highly recommend John Cochrane’s blog on the subject.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

 

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