I have been meaning to write this one for a while, but with the events of this week, I can’t think of a more perfect time. Up until this year, the financial services industry has largely ignored Bitcoin and the rest of the cryptocurrency craze. However, with Bitcoin up 20x since the beginning of the year and futures contracts trading on several exchanges, it is time to pay attention. (If you know nothing about Bitcoin, watch THIS and come back). This is not an article about what cryptocurrencies are, but about what role they might play within an investor’s overall portfolio. This article is entirely speculative, intended to flesh out ideas about what MIGHT happen, and as such should not be used to make investment decisions.
Cryptos are an asset class. A lot of people in my industry would like to argue that, but that’s because the financial industry is slow to change and change is scary. What can’t be argued, though, is that cryptos are here to stay. With the momentum that the trend has accumulated, both in price and adoption, advisors and their clients need to start thinking about how it might affect the rest of the portfolio. What are the correlations between cryptos and the other asset classes? What is the intercorrelation between individual cryptos? Most importantly, what is the fundamental driver behind prices?
That last question is the big, ugly elephant in the room. We know that earnings and growth are the fundamental driver behind equities, we know interest rates and inflation (along with credit risk and other factors) influence fixed income, and we know consumption drives commodities. So far, sentiment is the only thing that drives prices of cryptocurrencies, which was precisely the driver behind Tulip Mania, the Nifty Fifty, and the Tech Bubble, and if you know enough about history, you know those didn’t end well. I suspect something similar will happen with cryptos, but make no predictions about how or when.
It’s not all doom and gloom, though. Fiat currencies have been used as hedges or outright investments for centuries, and cryptos could have similar use. While hedging with traditional currencies comes with all the political and economic risks associated with that particular country, cryptos would be free of that risk (unless other countries start creating their own currencies like Venezuela is doing). However, cryptos are likely to encounter all sorts of cyber security and counterparty risk, so they may not make as attractive a hedge as many may believe.
I think crypto’s biggest opportunity for disruption is it’s potential to disintermediate the investment banking industry, allowing companies to go public and raise capital without the major expenses involved in hiring an investment bank to do so. We have seen this already with “ICOs” (short for initial coin offering), but there is little to no transparency about company financials or operations like there is with public stock offerings. If this issue can be solved, there are BIG implications for public markets. This also means that small, otherwise unknown companies can raise capital from a global investor marketplace without the need for investment banks or stock exchanges, and the coins can be directly distributed and redistributed between investors. We are a long way off from this, but the potential is exciting, to say the least.
For the time being, I make no recommendations on cryptocurrencies. At this point, they are purely speculative investments (fancy way to say gambling) and investors should not allocate more than they are willing to lose.
This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at firstname.lastname@example.org.