“Speculation is only a word for covering the making of money out of the manipulation of prices, instead of supplying goods and services.” – Henry Ford

In the last newsletter, we discussed how people may become enamored of a new-fangled strategy or product. In particular, we discussed SPACs (Special Purpose Acquisition Companies, otherwise known as bank-check vehicles) and high velocity stock trading (relative to investing). We would be remiss if we did not more fully discuss bitcoin and other cryptocurrencies since their prices are not only being bid up but there’s also serious debate about whether they will become legitimate currencies. To answer the question of whether or not we believe these cryptocurrencies deserve a place within an investor’s portfolio, we will borrow from a thoughtful white paper written by Dimensional that perfectly sums up our thoughts as well.

First, what is a cryptocurrency like bitcoin? Simply put, it is a digital currency that, unlike traditional money, involves no paper notes or metal coins; no central bank issues a cryptocurrency, and no regulator or nation state stands behind it. Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet, and currently very few sellers of any sort accept payment for goods or services via a cryptocurrency. Next, let’s look at the roles that stocks, bonds, and cash play in your portfolio to see if a cryptocurrency can play a similar or alternative role.

Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain amount of expected cash in the future. An important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations, thereby growing wealth to enable greater consumption tomorrow.

Holding cash, in contrast to owning stocks or bonds, does not provide an expected stream of future cash flow; one US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies or bitcoins in a digital wallet; you should not expect a positive return from holding cash or a cryptocurrency unless you can predict one of those currencies will appreciate relative to others - and history suggests that short-term currency movements are extremely unpredictable. So why should investors hold cash at all? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies. With this framework in mind, it might be argued that holding a cryptocurrency is like holding cash; it can be used to pay for some goods and services.

Yet most goods and services are not priced in bitcoins or any other cryptocurrency, and as stated before, very few sellers of any sort accept payment of a cryptocurrency for goods or services.

To complicate matters with cryptocurrency, a lot of volatility has occurred in the exchange rates between cryptocurrencies and traditional currencies, and volatility implies uncertainty in the amount of future goods and services that cryptocurrencies can purchase. Adding to the uncertainty is possible future regulation; we have no way of knowing or quantifying what regulation may do a to cryptocurrency’s future supply and demand (much less its existence). This uncertainty, combined with possibly high transaction costs to convert cryptocurrencies into usable currency, suggests that cryptocurrencies fall short as a store of value to manage near-term known expenses; thus, cryptocurrencies are not good alternatives to cash.

With all that being said, none of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins and other cryptocurrencies. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries (although these effects may take some years to emerge). But the “hope” or speculation that a cryptocurrency either becomes a good substitute or alternative for stocks, bonds or cash, or simply appreciates due to supply and demand, does not justify a cryptocurrency’s inclusion within an investment portfolio unless it is only used as a purely speculative investment. In other words, the only way a cryptocurrency currently becomes worth more than what it is worth today is based on the hope or speculation that someone else is willing to buy at a higher price without fundamental justification. If you’re tempted to buy a cryptocurrency such as bitcoin, our advice, with any speculative investment, is to only spend money you are willing to lose. Similar to visiting Las Vegas, we strongly suggest you carve out the money you want to play with – knowing that as much as you might think you know something, the reality is that you will simply either get lucky or unlucky when it comes to speculation.

For our part, we will continue to refrain from recommending products and strategies that we believe are purely speculative. And when someone tells me that it’s different this time, the cynic in me will just nod and smile – hoping we are wrong, knowing that no one knows what the future holds, and believing - as Henry Ford reminded us - that hard work for goods and services is always a better way to make a living.

Thank you so much for your friendship and trust, especially during these crazy covid days, and thanks so much for your referrals – that is truly the kindest compliment! Have a wonderful April!!

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