Why bitcoin remains an investment risk and a currency puzzle

With saving and investing, for most people, it’s best to stick to simple assets with easily understood characteristics. Bitcoin does not meet that test and there is also a regulatory risk
Owning bitcoin is a bit like owning a lottery ticket: low odds but a potentially immense payoff. That is one scenario and probably argues for a small allocation. There are, however, other scenarios

Paul Podolsky

Published: 6:45am, 12 Apr, 2021

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Two perspectives are useful in thinking about bitcoin: within the sweep of history and as part of a portfolio. From either perspective, I am not attracted to it.

Bitcoin is a currency, like the dollar or renminbi. The fundamental question of a) how much currency to create, and b) who should be allowed to make that determination has never been fully resolved. Bitcoin is another chapter in that history.

While most people find talking about the money supply boring, the question of how much currency to create is critical for social stability. If either too little or too much money is created, the economy and society become unstable. If the money supply grows at an appropriate rate, the consequent stability creates the requisite conditions for innovation, boosting the standard of living.

Throughout history, currencies have come in two forms, those whose supply is flexible and determined by committee, and those whose supply is constricted and determined by some non-human force, such as nature for gold or an algorithm for bitcoin.

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A flexible system can reduce economic volatility by expanding and contracting the money supply as needed. A fixed system eliminates the risk of inflationary money printing.

The inability to adjust the supply of money can be catastrophic. Some of the worst periods of economic growth occurred in the 1930s, when central bankers tried to maintain a gold peg during an economic crisis. A terrible depression followed.

Freeing masses of people from being tied to the gold standard consumed years of economic debate before central banks finally abandoned the policy. On the other hand, Zimbabwe and Weimar Germany are examples of how much damage a flexible money supply can create. Intuitively, I am much more attracted to flexible systems that can evolve.

Today, the draw of bitcoin is due both to its novelty and to central banks in the developed world pursuing novel policies that might translate into inflation. Also, unlike gold, which is difficult to use in transactions, bitcoin can be used to conduct commerce.

The central bankers creating money believe the economic circumstances – high unemployment, millions hungry – justify their policy and do not believe that what they are doing will translate into high inflation. I agree. The enthusiasm for bitcoin is a hedge on central bankers making a mistake.

Bet on bitcoin only if you subscribe to the Theory of the Greater Fool

In a portfolio, currencies play a specific role. Unlike stocks, bonds or real estate, currencies have no claim on an underlying cash flow and have zero expected return. Currencies rise and fall against each other, but they cannot rise in aggregate.

Adding a return stream to a portfolio that does not produce a return makes sense if it reduces risk. For bitcoin, that could occur in two ways. First, if the domestic currency is likely to rapidly lose value. Second, if this asset reliably rises in value when other assets fall in value, meaning that investing in bitcoin is diversifying.

Certainly, if major investors were to decide to make an allocation to bitcoin, more demand would meet limited supply and the price would rise. In this sense, owning bitcoin is a bit like owning a lottery ticket: low odds but a potentially immense payoff. That is one scenario and probably argues for a small allocation. There are, however, other scenarios.

As the Covid-19 pandemic recedes, money printing is likely to decline. This has already occurred in China. Moreover, I do not understand the technology that limits how much bitcoin can be produced and, as far as I can tell, most people do not. Bitcoin is less than 20 years old. What if something better comes along or technology shifts and the price plummets?

The correlation benefits of bitcoin are also uncertain. A good portfolio contains assets that rise in value over time, but rise at different points in time, thus dispersing the risk. With bitcoin, these relationships are less clear because the history is so short.

If global money printing produces global inflation, it seems logical that bitcoin would go up in value. Yet the big appreciation in bitcoin has come at a period of falling inflation. If inflation does come, would investors choose other assets instead, such as inflation-linked bonds, gold, other commodities or real estate? It is also true that ascertaining the correlations of any currency is fraught.

Finally, there is the regulatory risk. Given that bitcoin is not centrally managed, it is attractive for criminals as well as investors. How will regulatory entities respond to bitcoin, particularly if its popularity grows? I do not know. If the regulation shifts, the value of bitcoin could fall significantly.

I welcome the evolution of financial systems and find bitcoin an interesting step in that process. However, when it comes to saving and investing, I am attracted to assets that are simple and whose characteristics are understood. For me, bitcoin does not meet that test, or it meets it in such a murky way that, at best, I could hold a very small allocation as a sort of experiment.

Paul Podolsky is an investor, author and podcast host, see: paulpodolsky.com. He spent over 20 years on Wall Street, most of that time with Bridgewater Associates

David Dodwell is away