Cryptocurrencies like Bitcoin, Ethereum, and dozens of others are certainly a compelling idea. I believe they will be a game-changer and business disrupter in ways we don’t yet understand. They will change how people exchange money, how they send it to each other, how they store it, and how they shop. They’ll even impact the monetary and fiscal policies of governments. Yep, cryptocurrencies are here to stay. But, goddammit, that doesn’t make them a good investment! They are a currency, not an investment. The skyrocketing values of cryptocurrencies make the temptation strong. But here’s why average investors should avoid cryptocurrencies:
In the last year, the value of a Bitcoin is up 614% – even after recently crashing due to China’s new regulations. Ethereum is up even more – over 2,000% in just a year! YUM! No doubt, those are some compelling increases. Soooo tempting!
And they’ve attracted hordes of speculators, driving up the prices further. Who knows? If you let it roll on cryptocurrencies, maybe you too can quit your day job within just a few short months! (Don’t)
Here’s the Bitcoin price for the last year from CoinDesk:
A Cryptocurrency Is Not An Asset
Here’s the fundamental problem: a cryptocurrency is not an asset, it’s a currency. There is no underlying asset that creates growth or value. There is no income, and no future promise to pay. It is therefore not an investment. There is only speculation, hope, and desire.
Any company stock, or even the S&P 500, derives its value because there is an underlying asset – a company. The company employs hundreds or thousands of employees who are doing their very best every day to make money – for you, the shareholder. The stock is working for you. If the company makes money, that directly gives value to the stock. Stock prices rise over time because companies continue to find ways to make more money than they did in the past.
Real estate investments are similar. Houses have value because they can generate rental income, and house prices rise over time because rents rise. Even government bonds derive value thanks to a future income stream – a promise to pay. These are all wonderful investments for main street investors. They are all virtually guaranteed to make money, if you diversify properly and give them enough time.
But not cryptocurrencies. Cryptocurrencies, like all currencies, are merely a way to store and exchange value. They are a horrible investment because they are not an investment. For this reason, main street investors should avoid cryptocurrencies.
Cryptocurrencies are a horrible investment because they are not an investment
The only reason someone might invest in cryptocurrencies is because she believes their price will rise in the future. But, since there is no underlying asset working to push the price up, the price can only rise if a greater fool comes along. In other words, if you invest in cryptocurrencies, you are betting that someone else will want to pay more for the same thing in the future. I call this pure speculation. “Gambling” is another word that comes to mind.
The Trust Factor
Like any currency, cryptocurrencies have value because people believe they have value. But there are about a gazillion reasons people might stop having faith in one cryptocurrency or another. Hacking, regulations, and even out-right fraud can turn trust into fear in two shakes of a lamb’s tail. And because cryptocurrencies have no underlying asset, this thin faith is all they have.
Worse Than Gold
I like to compare cryptocurrencies to gold, because they share a lot in common. Neither is an investment because there is no underlying asset, and no income stream. Neither can be expected to earn money over time. But sometimes they do. And thanks to their wild price fluctuations, an investor with good timing can make a lot of money on them.
One reason people invest in gold is because it is not correlated with stocks, bonds, or real estate. Gold can bring some diversification to a portfolio – which is generally a good thing. When stocks go down, gold often goes up.
People also invest in gold because they believe gold will retain value in the face of a complete economic meltdown. I am not convinced that it will, but gold bugs believe that gold is a safe-haven. Perhaps it is.
Like gold, cryptocurrencies can also bring some diversification to a portfolio. But cryptocurrencies certainly are not going to offer a safe-haven in the event of global thermonuclear war! Good luck using your Bitcoin when all the lights go out! In my book, that makes cryptocurrencies worse than gold as an investment.
Diversification may be the only good reason to invest in gold or in cryptocurrencies. But I would never recommend putting more than 5-10% of a portfolio in either – simply because they are not real investments.
The vast majority of any main street investor’s portfolio should be in well-diversified index funds, high-rated bonds, and/or real estate. These are the bread and butter of a good portfolio that will grow and endure. Unfortunately, these investments can also be quite boring. Some people just want more excitement, or more risk.
For bored investors, I recommend having just a bit of “play money”: a small slice of a portfolio that an investor plays with, however she wants. No more than 5-10% of a portfolio. The idea is that if you gamble and lose your play money, you’ll still have at least 90% of your portfolio intact.
Play money can be put in something speculative, such as risky individual stocks, options, P2P lending, venture capital, gold, or, I suppose, cryptocurrencies.
Despite the juicy returns in recent years, main street investors should avoid cryptocurrencies, simply because they have no underlying asset and are not an investment. They cannot be expected to earn money over time – unless you get lucky by finding a greater fool. They are pure speculation, and their prices rely solely on trust and faith. But, if an investor has an itch to scratch and wants to gamble with a little play money that she doesn’t mind losing, then I say go for it!