We’ve recently gotten some questions about investing in Bitcoin and other cryptocurrencies, so I want to take this chance to talk about them. To avoid burying the lede, let me just say this up front: they really aren’t viable investment options.
First, let’s look at what cryptocurrencies are, and then we’ll dig into why they probably aren’t a good investment.
What Are Cryptocurrencies?
Cryptocurrencies are decentralized digital mediums of exchange. In other words, electronic currencies. There are several interesting features of cryptocurrencies, but I want to focus on two: they are decentralized, and this is still the wild west for cryptocurrencies.
Because cryptocurrencies are designed to be decentralized, there’s no central authority that controls the money supply, or really anything about them. There’s no cryptocurrency Federal Reserve pulling levers behind the curtain. In fact, it’s pretty much the opposite. The monetary policy of each cryptocurrency is baked into the specific design of the cryptocurrency.
Cryptocurrencies are still very new. The first major cryptocurrency was Bitcoin, which launched in 2009. New ones have been popping up like mushrooms ever since. Some of them are all but exact copies of existing cryptocurrencies, some are jokes (2014’s Coinye West, for instance), some are just strange (PotCoin, which was designed to facilitate buying and selling marijuana, notably sponsored Dennis Rodman’s recent trip to North Korea), and some have real technological developments that meaningfully add to the ecosystem.
But while all this activity moves cryptocurrencies forward from a technological standpoint, it also means a lot is still up in the air. We have no clue which of the hundreds of active cryptocurrencies (and all that have not yet been created) the market will settle on.
Like most technology, this is likely a winner-take-all type of situation. You don’t want to bet on the wrong one or it will be about as useful as your HD-DVD collection.
But What Are They Like as Investments?
As an investment, cryptocurrencies fall somewhere between a currency and a commodity. In their ideal world, they would act like a (reasonably) traditional currency – though we aren’t quite there yet. On the other hand, for tax purposes, the IRS has said they are property, which fits pretty well.
They are something you can buy and sell, but they don’t produce any value in and of themselves. In other words, they’re a commodity. In fact, there’s research out there that suggests Bitcoin acts very similar to both gold and silver.
Cryptocurrencies as Commodities
I’ve talked about commodities before. They aren’t great investment options. Because they don’t produce value themselves, they end up with inflation-like, long-run returns with massive amounts of volatility thrown in for fun.
Because cryptocurrencies are global in nature, their inflation would likely end up following the global inflation rate. This means it would be an even noisier inflation hedge for US investors. Also, cryptocurrencies don’t have the practical commercial and industrial applications of most commodities.
I can do something with a barrel of oil or an ounce of gold. That’s not as easy to do with Bitcoin.
Cryptocurrencies as Currency
If we look at them from the standpoint of a currency, the story doesn’t change all that much. First, let’s back up and think about a regular currency as an investment.
Let’s say you think the Indian economy is about to take off. Would you turn around and go buy a whole bunch of Rupees? No, you would likely go buy Indian stocks. You want to participate in the economy, not the foreign exchange markets.
Currency prices, just like other market prices, incorporate all the available information, but there are no reliable long-term risk premiums on offer, so the returns are just noise. That’s not what you want in your portfolio.
It’s the same thing with cryptocurrencies. They are just a medium of exchange. They are trying to be a currency (with some new bells and whistles), but they are still there to buy and sell other things – and those other things are what create value.
So Should You Invest in Cryptocurrencies?
Putting your money into Bitcoin or other cryptocurrencies is straight up speculation. You’re betting the particular cryptocurrency you bought is going to keep outperforming expectations. Not that they keep getting more popular – the conventional wisdom is that cryptocurrencies will keep getting easier to use, and more and more people will start using them.
This expected growth is already built into the price. When you buy Bitcoin, the bet you’re making is that Bitcoin will do even better than the market expected it to.
Maybe that’s a good bet, maybe it’s not. But either way, that’s not investing.
For more on how to get the most out of your investments, read our eBook, 12 Principles of Intelligent Investors.