As noted in our primer piece, The Buzz about Bitcoin, news about cryptocurrency is everywhere, as are stories of fortunes being made. Here, we tackle the question of Bitcoin’s investment merits. We will get into the core investment questions around Bitcoin, but first it’s important for an investor to understand the type of investment something like Bitcoin represents in a portfolio.

A speculative investment

Given its current stage of development and the factors that seem to drive its value, we think it is wisest for investors to view Bitcoin as a speculative investment. As we will discuss below, Bitcoin may become a long-term “buy-and-hold” investment worthy of a much higher price. But it’s also plausible that it fades away. So, what is a speculative investment? First, it is not synonymous with a bad investment, as long as it is properly sized in a portfolio (small), and the investor understands the risks (big). Money can be made in a speculative investment, but a profitable strategy requires the very rare ability to know when to get out. Those who don’t time the investment correctly can lose whatever they’ve gained—a so-called “round trip”—or worse.

Speculation happens when a tidal wave of capital piles into an asset that is believed to be in short supply. The current investment environment is the perfect catalyst for speculative activity. The chart below of Bitcoin’s remarkable parabolic price rise of the last year occurred in the context of a $3.5 trillion increase in the Federal Reserve’s balance sheet and a cumulative $6 trillion in COVID-19 relief injected into the economy and financial markets.[1] We don’t view this as a coincidence.

There have been many positive fundamental developments for Bitcoin and other cryptocurrencies in the last several months.  And they raise a legitimate question about whether Bitcoin should play a permanent role in an investor’s portfolio. As discussed below, our answer is not yet. Bitcoin’s price in the months ahead will likely be shaped by perceptions of when the liquidity spigot will be tapered or shut off, as well as the general appetite for risk-taking by investors. 

Bitcoin as a strategic asset class: What would it take?

An investor should understand a long-term investment holding and the purpose it serves in the portfolio. That’s an abundantly obvious statement, but often a challenge when it comes to Bitcoin. 

Is it a currency*?

Not yet, and maybe never. There is no question that transactions are moving away from cash, and many would like to find cheaper forms of electronic payments and transfers. There have been a number of high-profile companies in recent months announcing that they would accept Bitcoin on their platforms, as well as banks announcing that they would trade and hold Bitcoin for their clients.

Behind the headlines, though, Bitcoin faces real challenges in becoming a broadly used means of transactions. It lacks the scalability and energy efficiency to compete with high-volume processors like Visa and Mastercard (see Exhibit 2).*For our purposes, we define currency as a medium of exchange for goods and services; not just cash.

It could play a growing role in large business-to-business payments, but that would make it half a currency at best. In a recent survey, less than 5% of corporate treasurers expected to use or receive cryptocurrencies in the next 18 months.[2] Meanwhile, just about everyone—from payment processors to central banks—is working on their own form of digital currency. The payment processors are seeking to compete with Bitcoin, while central banks seem focused on co-opting it. The race is on to find a better mousetrap.

The more Bitcoin is viewed as a challenger to—or substitute for—fiat currencies like the dollar, the more likely it is that regulators step in. Some Bitcoin advocates believe a degree of government regulation would enhance the cryptocurrency’s legitimacy and actually speed its adoption. However, that could be a slippery slope. Consider the view of Treasury Secretary Janet Yellen: “To the extent [Bitcoin] is used, I fear it’s often for illicit finance.”[3] Yellen and the Federal Reserve have both supported technology initiatives to make easy payment systems available to more people. But their preference as regulators could be for the US government to develop a “digital dollar” for such purposes rather than allowing the decidedly decentralized philosophy behind Bitcoin to thrive.

Is it a store of value?

It could be, but it hasn’t been around long enough. The most famous store of value is gold, and Bitcoin is often referred to as “digital gold.” A store of value is an asset that retains its value, or purchasing power, and does not depreciate over time.[4] Having risen from zero to over $50,000 per coin in 10 years would seem to pass the test! Yet, true stores of value like gold have proven themselves over centuries—not one decade. 

The inherent volatility of Bitcoin poses a challenge to its potential as a store of value. Constant volatility is likely to dissuade a broad swath of investors from viewing Bitcoin as a store of value, a concept rooted in a craving for stability. While its overall price rise has been spectacular, there have been countless short-term rallies or sell-offs of 50% or more. The price of gold fluctuates, but not like that. Exhibit 3 shows a large gap in price volatility between Bitcoin and gold. The gap has narrowed some in the last three years but remains significant.

Stores of value are often viewed as hedges against inflation and currency debasement. This may prove to be the strongest rationale for Bitcoin’s long-term role in a portfolio. But we still rate this as aspirational. The strongest case for Bitcoin as an inflation hedge is its prescribed scarcity. Total supply is limited to 21 million coins, with 18.6 million already mined.[5]  Meanwhile, the supply of broadly defined fiat currency and debt has exploded in recent years; theoretically, there are no limits on further expansion.  

Milton Friedman, the legendary Nobel prize-winning economist, famously said, “Inflation is always and everywhere a monetary phenomenon.”[6] There is an argument to be made, given liquidity creation by central banks and the stunning series of multitrillion- dollar COVID-19 relief packages, that in subsequent years there will be “too much money” to keep the inflation rate within the low and narrow band it has been in for the last decade. Bitcoin’s mandated supply limit stands as a notable contrast, making it a potential store of value. 

Stores of value typically have some other societal benefit beyond being a portfolio inflation hedge. Gold is used in industry and in jewelry. Art provides aesthetic value to the public via museums or homeowners. In other words, part of what makes it a store of value is not just low supply, but high demand for a tangible purpose. Bitcoin is not tangible at all. That is part of its allure as a speculative investment—a mysterious digital phenomenon most people don’t understand, except that they hear it’s “the future.” If Bitcoin is going to provide tangible societal benefits, it could be as a superior, highly sought-after means of transaction. As discussed earlier, though, that is no sure thing. 

Is it a brand?

Yes. While there are thousands of cryptocurrencies, Bitcoin is the biggest and has the highest name recognition. Its market capitalization is five times that of Ethereum, the next-largest cryptocurrency.[7] Some argue that Bitcoin’s first-mover advantage will allow it to dominate the space—another reason to think its value will rise.

It is not uncommon for people to refer to “Bitcoin” when they are actually talking about cryptocurrencies in general. This is the most powerful sort of branding, like Kleenex or Band-Aid. But there is no guarantee that Bitcoin will retain its position as the leader. For every Kleenex, there is a Betamax—a brand that is first but loses its status because consumer preferences turn in other directions.

Conclusion

Bitcoin has become a binary debate in financial markets. Investors are either convinced that it is a transformational asset that will be enormously important for the economy and portfolios; or that it is a mania-driven fad destined to fall back to earth, and then disappear. To illustrate the point, look at the headlines below, all appearing within a month of one another:

“…CIO Says Bitcoin Could Eventually Climb to $600,000” — Yahoo!Finance, February 3, 2021
“Worth Exactly Zero…Crypto and Bitcoin, a Pure Techno Babble” — Seeking Alpha, February 5, 2021
“Bitcoin: A Solution in Search of a Problem” — BCA Research, February 26, 2021
“Bitcoin at Tipping Point of Mainstream Acceptance” — CNBC, March 1, 2021

Our position stakes out a middle ground. The nearly tenfold increase in Bitcoin’s price in the last year[7] almost certainly contains a mania factor, driven by the underlying monetary and interest rate environment described earlier. We know from history that manias don’t last. Thus, an investor would be wise to consider whether they can stomach a large decline in Bitcoin’s price at some point. 

From a longer-term perspective, Bitcoin could lead cryptocurrencies into becoming a viable asset class. But there are more open questions than answers at this point. There is no credible way to fundamentally value Bitcoin, especially given its price volatility. Also, given the remarkable pace of disruptive change, and the number of emerging competitors, the odds are probably against investing solely in one digital currency as a long-term investment holding.

We will continue to analyze the long-term investment merits of digital currencies and broader blockchain technology. At this time, however, we consider Bitcoin a speculative investment.

Dave Donabedian, CFA is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.