This post was written by Bob Keane, CFP® – Financial Advisor
I am sure we are like most financial advisors in that we are fielding more calls from clients regarding “investments” in crypto “currency.” I put quotation marks around these words intentionally because cryptocurrencies like Bitcoin, Ethereum, Cardano, and the thousands of other cryptocurrencies have elements of both, yet still defy easy definition.
First let’s dive into some basic definitions (per Merriam-Webster) and see if we can wrap our minds around this:
- Currency: something (such as coins, treasury notes, banknotes) that is in circulation as a medium of exchange
- Investment: the outlay of money for income or profit
So if we follow the basic definitions, digital currencies (or cryptocurrencies) seem to function as both a currency and an investment. I can buy something like Bitcoin for US dollars and can use it to buy goods and services; or I can buy Bitcoin as an investment like a stock or bond and hope it appreciates in the future so I can earn a profit from my investment. There are some unique differences as well.
Crypto vs “Standard” Currencies
One unique difference between crypto and other currencies is that one US Dollar today will likely be one US Dollar tomorrow, buying power may have changed due to inflation or other factors but as a medium of exchange, things are simple. Crypto currencies are valued based on what a buyer would pay for one Bitcoin and what a seller would sell one Bitcoin for, or true supply and demand. One could argue that there are market elements to various currencies that mean one USD today may be worth a different amount of Euros in a day or months’ time, but generally currency price fluctuations are fairly random and more importantly, unpredictable.
Another unique difference between crypto and other currencies is its tax treatment. For now, the IRS considers cryptocurrencies as capital assets, which means it is generally subject to capital gain and loss rules. As an example, assume one buys $500 of Ethereum today and receives 50 Ethereum units – so there is a cost of $10 per unit (these numbers are not reflective of current market prices and have been simplified for this illustration). If that person then uses 50 Ethereum units to buy goods/services one month later when Ethereum is trading at $20 per unit, they will have to report a short-term capital gain of $500 on their current year tax return. Keep in mind that if there was a loss on the using the Ethereum in this case, it may be used to offset capital gains (or up to $3,000 of ordinary income if there are no other capital gains) or if the Ethereum was held longer than one year, our $500 gain above would be a long-term capital gain. To me, it seems like the record-keeping when using cryptocurrencies as a medium of exchange may be problematic from a reporting perspective…
Crypto vs Other Investments
Most clients asking about crypto aren’t planning on using it as a medium of exchange, they are looking for price appreciation, so this seems to put crypto more in an investment bucket, so what might the differences be here?
If we are interested in price appreciation of any asset, we generally consider what the “expected returns” may be over the holding period. The definition of expected return:
- Expected return: expected return is the profit or loss anticipated by an investor using historical rates of return. It is calculated by generating a distribution of returns multiplied by the probability of said returns and totaling the result
Without getting into a statistical discussion of the calculation of expected returns here, a key element is the presence of historical returns. The difficulty with crypto at present is that the asset class doesn’t really have expected returns… In contrast to valuing a company’s stock based on forecasted growth, free cashflow or other metric, the price of cryptocurrency is currently more commodity-like in that it is more a supply/demand pricing model. While supply for crypto is slowly rising, it is limited. In standard supply/demand models, one attempts to consider where additional supply comes from, what the demand looks like and a future price is determined. Volatility in these types of markets generally point to either or both supply issues and demand issues. Our partners at Dimensional Fund Advisors put the issue in succinct terms:
“Regarding future demand for bitcoins, there is a non-zero probability that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand)… All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input to the price of bitcoins today. The price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today”. 1
So given the above discussion, we firmly view cryptocurrency investments as highly speculative, but that doesn’t mean there isn’t a place for it in a client’s well diversified portfolio. Each clients’ tolerance for risk is different and several clients have some risky “side-bets” to provide some additional upside to their portfolio. However, when we include these side-bets in a client’s aggregate portfolio, we ensure that the downside does not effect any portfolio goals such as retirement, education for one’s children, etc.
This was not intended as a primer on everything crypto so please reach out to your financial advisor regarding any further questions regarding cryptocurrency, bitcoins, or blockchain technology in general.