Money

Should Bitcoin ETFs Change Your Investment Strategy?

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After months of speculation, last week the SEC approved spot Bitcoin ETFs. In the months prior to the approval, Bitcoin reentered the public consciousness. Its price jumped by over 60% in just under three months.

Simultaneously, I’ve been noticing a resurgence in interest in Bitcoin in personal finance circles. SEC approval makes trading Bitcoin more accessible and provides an air of legitimacy. 

So this is a good time to take a step back and reconsider what role, if any, Bitcoin should play in your portfolio.

What is Bitcoin’s Use Case?

The first Bitcoin was mined in January, 2009 acording to Investopedia. It is purported to be an alternative to traditional currencies, designed as a means for anonymous peer-to-peer transactions with no third-party involvement or government regulation.

Another talking point of Bitcoin proponents is that it is a scarce resource, making it a store of value. It was designed with a cap of 21 million Bitcoins able to ever be created. This is in contrast to fiat currencies created by governments. They constantly expand the money supply, making money less valuable over time.

Bitcoin’s massive price volatility makes its usefulness for transacting challenging at best. Its primary use to date has been as investment/speculation by people who buy it with hopes that it will go up in value.

What Is Bitcoin’s Role in Your Portfolio?

The approval of spot Bitcoin ETFs makes this asset easier to own and trade. This should add a layer of security for those who are interested in Bitcoin, but concerned with fraud which has been rampant in the cryptocurrency space.

ETFs will add convenience, making storing and trading Bitcoin easier. Stories about people losing millions of dollars because they lost a hard drive or password should become less prevalent, or at least become a preventable occurrence.

The approval of Bitcoin ETFs has revived excitement in this cryptocurrency. That enthusiasm seemed to be waning after Bitcoin lost nearly 74% of its value in a year between November 2021 and November 2022.

Does any of this mean you should own these ETFs? Consider what purpose Bitcoin would serve in your portfolio.

Going Up?

There is an idea that these ETFs will draw in many new investors. New demand will increase the value of Bitcoin competing for this limited resource.

This is possible. However, there are reasons it may not come to fruition.

Having Bitcoin ETFs regulated should decrease fraud risk associated with owning this asset. The risk of losing access to your assets because you lose a password or hard drive can be eliminated.

However, a point pounded home in William Bernstein’s The Four Pillars Investing is that risk and reward are inextricably linked. Making Bitcoin less risky could decrease its upside potential.

One of the key features of Bitcoin was operating outside of the traditional financial system and avoiding regulation. Regulation will undoubtedly make Bitcoin more attractive to some. Simultaneously, it may drive away some of the most ardent supporters. Time will tell what the net impact will be.

Finally, I’ve seen social media posts highlight Bitcoin’s past outsized returns as a reason to invest. Bitcoin’s value grew at an annualized rate of nearly 85% over the past 8 years, despite multiple 50+% drawdowns along the way. Is anything approaching this rate possible?

Some people who get a lot of attention in financial press think so. It seems highly unlikely to me that anything approaching this rate of growth is sustainable.

Think of anything that starts small and grows exponentially: the most successful businesses, the spread of a novel disease, or the followers of popular social media influencers. In any of these cases, early rapid growth is possible. When you start small, there is much room to grow.

But at some point, there aren’t many more towns that don’t have a Walmart, people who haven’t either died or developed immunity to a particular virus, or people who want to watch your YouTube videos. There is less capacity for growth and rates slow, stops completely, or even reverse.

Diversification

Another proposed role I’ve seen for adding Bitcoin to an investment portfolio is to provide diversification to traditional stock and bond assets. Proponents argue Bitcoin’s true scarcity will provide a store of value. People will rush to it in times of panic and crisis as they traditionally have to gold.

This theory was tested in 2022. The S&P 500 dropped 18%. The US aggregate bond market ended down 13%. Inflation was high. If ever there was a time for Bitcoin to provide a diversification benefit to a traditional asset allocation, this was it.

Instead the price of Bitcoin fell 63% in 2022. If we measure from the top of the drop in November 2021, the drop was even larger, nearly 75%.

Speculation vs. Investment

The introduction of spot Bitcoin ETFs decreases some risks and increases convenience of holding and trading this asset. At the end of the day, the Bitcoin that backs these new ETFs remains a purely speculative play.

If Bitcoin prices go up, you can make money. If they go down, you can lose money.

David Stein provides a framework for differentiating speculation from investment. Speculation has no cash flows. There is disagreement about whether the price will go up or down. Making a profit requires you to be correct in predicting the direction of its future price. This is in contrast to an investment, defined by having cash flows and a positive expected return.

Bitcoin is still a relatively new technology. No one knows what, if any, long term role it will play in society, finance, and investment portfolios.

Before allocating any of your investment portfolio to this, or any, speculative investment, it’s  important to ask yourself two questions.

What if you’re wrong?

Choosing to purchase a speculative investment means you think its value is going to go up. But by our definition of a speculation, it may not.

As with any investment, you should have a plan for controlling risk. One way of accomplishing this is limiting how much of your portfolio you allocate to Bitcoin ETFs. If you silo this speculation off from the rest of your portfolio, then you can’t lose more than that initial purchase.

I became interested in Bitcoin several years ago, attracted by the idea of having a small allocation to an extremely volatile asset. If it is not highly correlated to other assets, which remains to be seen over time, the rebalancing effect could substantially boost portfolio returns. 

I ultimately decided not to allocate any money to Bitcoin due to the inconvenience of holding and trading Bitcoin directly. This is a more feasible strategy with the convenience of trading ETFs.

However, this approach requires purchasing more of the asset when it goes down. This is in contrast to the risk management idea of siloing the investment. 

How do you determine when and for how long to follow your rebalancing plan that requires buying more Bitcoin if prices drop? How do you know if and when to stop throwing good money after bad and admit your initial speculation was wrong if you take this approach?

These are important questions to figure out before purchasing these speculative investments. They aren’t easy questions to answer.

If you don’t understand why I wrote those last two sentences, I challenge you to read Annie Duke’s Quit: The Power of Knowing When to Walk Away. It is a fascinating look at our mental and behavioral biases, particularly when it requires admitting we were wrong and changing course.

What if you’re right?

Being wrong is what most people worry about. There is an equally important question before making a speculative purchase.

What if you’re right….at least initially? I encourage anyone thinking about buying Bitcoin to take a look at this chart tracking its historical prices.

You could have purchased Bitcoin in late 2020 or early 2021 when it had a massive price run-up similar to what it is experiencing today. Seeing your money double or triple in a couple months would certainly qualify as “being right”…. Until it wasn’t when Bitcoin dropped by over 50% in just a few months by mid-2021.

Many people again felt “right” when buying along the ascent to new highs in the second half of 2021. Bitcoin again more than doubled in price in just a few months. Hopefully you wouldn’t have gotten too excited about being right about any of your purchases along that run up in prices. Bitcoin experienced a one year 74% drop in price between November ‘21 and November ‘22. 

Maybe the current run up in prices will last longer and go even higher than previous highs, spurred by new demand for these ETFs. Maybe there won’t be another huge crash in prices. BUT maybe they’ll never reach old highs. Or will crash to even lower lows.

The problem is no one knows. This is the nature of speculation.

If you feel the euphoria of initially being right for a few months or a few years, will you stay to your original hypothesis, risk management strategies, and investment plan? Or will you be seduced by “being right” and ignore the fact that you may have just gotten lucky?

My Personal Take

I don’t know how to set reasonable expectations related to future Bitcoin prices, don’t have good answers to the questions I posed related to risk management, and don’t need to add the complexity and risk of adding this asset class to my investment portfolio to achieve my financial goals.

For those reasons, I’ve felt comfortable remaining on the sideline with regards to cryptocurrencies. The new Bitcoin ETFs do not change that.

I would love to hear how you are thinking about these developments. Will these new Bitcoin ETFs change your investment plans and strategies? Let’s talk about it in the comments.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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