It seems like not that long ago that the world’s most popular Crypto exchange, Mt. Gox, abruptly shut down in 2013, and 850,000 Bitcoin vanished along with it. What formerly belonged to mostly cypherpunks, dark web market vendors, and anarcho capitalists, less than 7 years later the crypto economic landscape has changed tremendously, with banks, funds, university endowments, and even governments contemplating portfolio exposure. That begs the question: Should crypto be included in my portfolio?
What even is Crypto?
Crypto[currency] is a digital asset (as defined by the SEC) built on the blockchain, an open, public, decentralized, distributed-ledger technology that stores and updates new records, called ‘blocks,’ that are linked together using cryptography. Each block contains cryptographic hashes of previous blocks, timestamps, and other relevant transaction data. Once a block has been recorded, the data cannot be altered in any way without alteration of all previous blocks, which requires consensus of the majority of network’s participants.
Digital Gold
Due to Crypto’s unprecedented ascent into public awareness, token fundamentals, utility, back-end technology, public adoption, and market price discovery, it has been classified by regulators and other officials as a new asset class. To that effect, Tyler and Cameron Winklevoss, CEO and founders of the U.S.-based crypto exchange Gemini (and infamous Harvard students who conceptualized Facebook), frequently compare Crypto to the premier precious metal, citing Bitcoin as ‘Digital Gold’ and ‘Gold 2.0.’ While many contest whether Crypto (Bitcoin specifically) has any intrinsic value whatsoever, Crypto proponents counter that Bitcoin’s advantages include but are not limited to: Greater scarcity, durability, portability, fungibility, and, over time, store of value.
YoY Performance
Since Bitcoin was the first Crypto ever created, has the largest market cap, and longest market history, we’ll use Bitcoin’s index for market performance. Bitcoin’s annual return from 2010-present (Closing, Jan. 1 - Dec. 31 each year) comes to 1048.60%. This rate of return is astronomical and exponentially has outperformed every other asset class, and this ROR factors in 2014 and 2018 when Bitcoin’s price plummeted -75.24% and -72.60% respectively. For reference, the average annual returns from traditional asset classes over the past 15 years (2005-present) are as follows: Real Estate (~10%), REITs (8.35%), S&P 500 (9%), Russell 2000 (7.92%), Emerging Markets (5.33%), High Grade Bonds (4.15%), High Yield Bonds (7.35%), Gold (9%), Silver (6.92%), and Cash (1.3%). Now, we are not of the belief Bitcoin and/or any crypto can sustain those types of returns over time. In fact, if you analyze Bitcoin on a logarithmic chart, you’ll see Bitcoin’s market cycles are becoming increasingly longer and decreasing in rate of growth (from low to high, low to low, high to high, etc.), therefore each market cycle has yielded a lesser return versus the previous market cycle.
Non-Correlated Asset
One of the strongest and most interesting arguments for including Crypto in your portfolio is its value as asset diversification. Over time, Crypto has shown to be completely uncorrelated to any traditional market, in market rallies, corrections, and consolidation phases. Anyone who suffered through the 2008 Financial Crisis witnessed first hand how a then-believed ‘diversified’ portfolio containing equities, bonds, commodities, and precious metals, saw uniform price crashes virtually simultaneously.
Fractional Shares
Since its inception, Bitcoin (and other cryptos) have been obtainable in fractional quantities, which is convenient and more cost-effective for traders and investors to optimize buy orders, portfolios, and precise budgeting and fund allocations. Compare this to traditional markets, where the public remains widely limited to only exchanging whole units of shares, and has only recently began to introduce fractional shares.
Security, Compliance, Custody
For the majority of Bitcoin’s history, the primary security concerns consisted of an anonymous hacker stealing your tokens, or a shady, overseas-based crypto exchange platform abruptly shutting down or freezing withdrawals (“exit-scamming”). However, since the massive price stampede in 2017, the entire Crypto space saw major steps towards abating this fear. Most Crypto exchanges and now IEO’s (Initial Exchange Offerings), especially U.S.-based, are now subject to SEC-mandated KYC (Know Your Customer) identity and document verification, as well as Anti-Money Laundering (AML) & General Data Protection Regulation (GDPR; EU law) compliance. In early 2019, US-frontrunner exchange Coinbase announced all U.S. customers’ US Dollars held on the exchange are FDIC-insured. As far as Crypto goes, any digital assets that are lost due to a Coinbase security flaw, fault, or breach, are fully insured. Later in 2019, Fidelity rolled out its full enterprise-grade Crypto custody service to hedge funds, family offices, and financial advisors, and NY-based Gemini launched its state-of-the-art offline, multi-sig custody service for individuals and institutions.
Supply/Demand
Here’s where things get interesting. When it comes to Bitcoin, there’s a fixed, maximum supply of 21 million. As of 1/21/20, there’s a current circulating supply of 18,173,450 BTC, and the remaining ~2.825 million will be mined even less frequently over the next 100+ years. As market interest increases and capital continues to flow into the Crypto market, demand will outpace supply, fundamentally driving up price. However, a few factors not often accounted for are the amount of actual BTC out of circulation. This includes funds stored on physical hard drives lost or damaged, and BTC wallet private keys lost, forgotten, or otherwise unrecoverable. It’s difficult to determine roughly how much BTC is lost, but it’s estimated about 20% of all BTC is unrecoverable, possibly as much as ~30%. There are a number of services that offer BTC recovery at large commission fees, but they are far from reliable and add another layer of security concerns. An interesting technological development to keep an eye on as it regards to this matter is quantum computing. While it is still very much a work in progress, it’s theorized that quantum computing’s generational technological leap will be able to process data exponentially faster than current processes, thus theoretically enabling the possibility of running an algorithm to attempt and solve for lost or forgotten BTC wallet private keys. However, the consensus is this is ‘probably 10 years away.’ In the meantime, with demand increasing for a fixed supply and decreasing supply due to mining reward ‘halvings’ every four years, economics 101 supports a fundamental argument for higher prices in the medium-term.
Market Interest
While on the subject of supply, demand, and market interest, let’s not forget demographics. An independent financial advisor reported that of his millennial investors, roughly 90% would prefer Bitcoin over gold, 71% of millennials would invest in Crypto if it was available at a traditional financial institution, and 43% trust Crypto exchanges over the stock market. This view is unsurprising, as the Millennial generation came of age during the 2008 Financial Crisis, housing market collapse, and subsequent record-high government bailout, record-high inflation, national and global debt, and suffered (and continue to suffer) first-hand from record student loan debt. Regardless of your opinion on the crypto space’s viability, in the next few years Baby Boomers are set to begin ‘The Great Transfer of Wealth,’ during which a massive $68 trillion of wealth will move from the hands of the older generation to the younger, more crypto-friendly hands of Generation X, Y (Millennials), and Z.
Allocation
Disclaimer: This is not financial advice. Now, considering the above fundamentals of this nascent asset class, what kind of allocation into Crypto would make sense for your portfolio? Well, this depends on a variety of factors, including your age, risk tolerance, custodial preference, proclivity to technology, etc. While many investors have made gargantuan sums of realized profit in short periods of time, the nascent Crypto space has only existed since 2009. The entire space is collectively entrenched in rapid technological development and is widely considered a high-risk, high-reward, VC-esque (venture capital) investment atmosphere. As such, it is probably not wise to go all-in Crypto, let alone any one asset class or sector. However, often times the biggest risks provide the biggest rewards, and sometimes even a small risk that yields a high ROI can handsomely inject some alpha to your annual returns. And while many fearful investors lament over an impending recession, which may or may not be hot air, one thing is for certain: Traditional markets are not as uncorrelated as once believed.
