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This is a seemingly very simple question that can get very intense responses depending on whom you ask. There are those that believe Bitcoin is a scam and that no reasonable investor should invest a dime. Others believe it is the currency of the future and that the value of Bitcoin will go much higher as it becomes more widely adopted. But what is the truth? How should an average investor think about the decision of whether to invest? Should Bitcoin have a place in a globally diversified portfolio?

Cryptocurrency bitcoin

When investors ask themselves whether they should add any investment to their portfolio, they should consider the long-term risk and reward characteristics of the asset and how adding the asset will affect the risk and return profile of their portfolio. There have been some studies done that show a small allocation to Bitcoin can improve the risk-adjusted returns of a diversified stock and bond portfolio. Unfortunately, there are some reasons to take these results with a grain of salt.

Bitcoin has only been around for about 12 years, which is a very short history relative to other asset classes. Drawing any conclusions based on the historical data seems questionable, particularly when you consider that Bitcoin was extremely illiquid for the first half of its existence. It is also unreasonable to assume that the risk and return profile of Bitcoin over the next 10 years will be anything close to what it has been since its inception.

If you are not willing to invest in Bitcoin based on the historical risk and return characteristics of the asset, are there any other reasons to include it in your portfolio? To answer this question, you must define what you think Bitcoin is. Is it a currency? Is it a substitute for gold? Is it a good inflation hedge?

For now, defining Bitcoin as a currency seems unreasonable. Although transactions are made every day in Bitcoin, it is far too volatile to be used broadly as a currency. Even if you think it is a currency, that would not be a reason to hold it in a diversified portfolio, except perhaps as part of a cash allocation. But most investors want their cash invested in safe securities that will maintain their value. Bitcoin is far too volatile to be a substitute for cash.

The argument that Bitcoin is becoming a substitute for gold is also gaining some traction among investors. Advocates for the cryptocurrency see Bitcoin, like gold, as a safe-haven asset that is devoid of any government intervention. Some also argue that Bitcoin has similar characteristics to gold. Specifically, they cite the limited supply of Bitcoin and its low correlation to other asset classes.

While there is little government intervention now, it seems likely that Bitcoin and other cryptocurrencies will face more regulation the larger they become. In fact, one of the reasons Bitcoin has dropped sharply recently is because China announced stricter regulations for cryptocurrencies.

While it is true that Bitcoin has a low correlation to stock and bond markets, research shows that the correlation itself is extremely volatile. Short-term correlations can be much higher than longer-term correlations, which means it may not offer any safety if stock or bond markets decline sharply.

With inflation on the rise recently, some have suggested that Bitcoin could be a good hedge against inflation. Although it is possible that Bitcoin’s price would increase if the inflation rate continues rising, there is no clear linkage between the two and, thus, no reason to have confidence in Bitcoin’s inflation-hedging ability. Additionally, Bitcoin’s short history does not provide support for the “Bitcoin as inflation hedge” argument. In this regard, it’s worth noting that the recent sharp decline in the price of Bitcoin has occurred while inflation is at its highest point in years.

A close examination of Bitcoin leads us to conclude that there is no reason to expect an allocation to Bitcoin to enhance the risk and return characteristics of a diversified portfolio. Is there any other reason to own it?

If you believe that Bitcoin will eventually achieve its lofty goals of becoming a reliable currency and store of value or perhaps just want to be a member of the community of Bitcoin owners, it might make sense to purchase some Bitcoin. The key is to make sure you limit the size of your investment to only a small portion of your investable assets. Bitcoin could go up sharply just because it is an asset with growing demand and limited supply, but there is also a non-zero probability that you could lose your entire investment. The threats to Bitcoin include greater regulation and new competitors that could improve on Bitcoin. Any major hack on the Bitcoin infrastructure or problems with the existing trading platforms could also lead to a major decline in demand.

Bitcoin, other cryptocurrencies, and the blockchain technology that supports these networks is an evolving technology and we will continue to monitor developments in this area. But for now, buyer beware.

Filed under: Investing

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