Bitcoin has been taking over the headlines of late, so it’s no surprise the most frequent question our client services team fields from clients and prospects is whether we intend to incorporate Bitcoin into our investment management service. As proponents of financial innovation and believers in the power of software, we are excited about Bitcoin. But as investors evaluating appropriate long-term strategies for our clients, our current answer to our clients on Bitcoin is no.
Is Bitcoin an Investment?
The primary reason is Bitcoin does not meet the objective criteria we use to evaluate investments. According to my investment idol Howard Marks, an asset must have intrinsic value to be considered an investment, and the only way for an asset to have intrinsic value is if it has a cash flow that can be evaluated. An investor can then make a determination of the risk and timing of the asset’s cash flows to determine its value. Everything we invest in at Wealthfront on behalf of our clients has intrinsic value, as well as a long performance history through market cycles.
By this definition, Bitcoin is not an investment. As an innovation, we believe Bitcoin may prove very useful over time as a payment network and a software platform. Some people around the world may also treat it as a store of value. But, as an asset today, it is primarily a speculation.
This language may ruffle some feathers with Bitcoin advocates, but calling Bitcoin a speculation is not meant as a negative comment, nor is it meant to imply Bitcoin will not have value. A speculation is simply an asset with no intrinsic value. Its value is based on the price a buyer is willing to pay for it, which is based on what that buyer believes others will pay for it. Gold is a great example of a speculation, not an investment. Gold primarily has value because people think it does; while gold has some decorative and industrial use, the majority of its market value comes from subjective belief. So it’s almost impossible to say what it should be worth.
Since speculations are based on belief and not on an expectation of future cash flows, we have no objective, evidence-based reason to assume they will produce a positive return at a given price level. Further, there have been few (and I mean very few) people in the world who have made money consistently over the long term buying and selling gold. For this reason, we do not recommend including speculations in a long-term oriented, diversified investment portfolio.
Too Soon to Tell
Bitcoin’s creator envisioned Bitcoin as a form of money with a mathematically fixed supply and the ability to enable decentralized, peer-to-peer payments. With these characteristics, Bitcoin is different from currencies like the US Dollar that are issued by governments or payment networks like PayPal or Visa that are run by companies. Bitcoin, the asset associated with this system, is akin to gold, but with advantages (perfectly scarce, more portable, immediately verifiable, etc.) and much broader potential applications (programmability, the ability to use Bitcoin and/or similar systems like Ethereum to build decentralized services and infrastructure). In its ambitions as a technology and financial platform, I think Bitcoin has noble and exciting goals that I hope are achieved.
But my optimism about Bitcoin’s ultimate success does not make it appropriate for Wealthfront portfolios today. Investing in Bitcoin does not fit with our promise of only implementing academically peer reviewed and long-term investment practices. We view it as our job to provide our clients with rigorous, time-tested investment strategies based on hard data and evidence, not our assessment of a new technology or market sentiment around any asset, let alone a speculative one.
There is some early work underway to try to articulate frameworks for valuing Bitcoin and other cryptoassets. Cryptoassets provide access to decentralized applications (for example, payments in Bitcoin’s case), and therefore should have some utility value. We have seen recent attempts at valuation that, for instance, apply the Quantity Theory of Money from economics, arguing the price level of a cryptoasset should increase in relation to its supply, velocity, and the amount of economic activity occurring in the system to which the cryptoasset is attached. This work makes for interesting reading for our investment research team, but is too nascent and unproven to meet our standards for rigor. And the history of Bitcoin and other cryptoassets is so short that any efforts to provide inputs for new pricing models are, at best, educated guesses.
It can be easy to lose sight of what’s appropriate when you see people making money on anything overnight. I lived through this in the Internet bubble in the late 1990s. Seeing so many friends and colleagues gain and then lose money gave me a tangible feeling for the value of disciplined, long-term investing and diversification. Rapid gains can be exciting, but as a general rule they do not last. Even the world’s best professional investors admit humility when faced with trying to understand the direction of asset classes in any given period of time. As Howard Marks has said in response to people asking him to predict market movements: “wait a minute while I ask my taxi driver.” Any time an asset in your portfolio appreciates rapidly, you should consider diversifying and/or rebalancing. Bitcoin, which has risen nearly 2,000% in less than a year, certainly fits the bill. As you might imagine, we would be happy to help people with gains in Bitcoin and Ethereum diversify their exposure!
Our Chief Investment Officer Burt Malkiel is famous for having been the first person to prove the merits of index investing over choosing individual stocks. When asked if he owns any stocks he usually responds “yes, and I also like to go to the horse track.” In other words he views attempting to outperform the market through security or asset class selection as entertainment. He also believes people are more likely to stick with boring diversified index investing (that has been proven to be the best way to invest over the long term) if they allow themselves to have “fun” with a small amount of money. That’s why our advice regarding investing in Bitcoin is the same as the advice we would give on investing in individual stocks, angel deals, real estate and just about any other asset with which you are not professionally involved: If you’re going to buy it, try to limit it to an amount you are willing to completely lose, which we typically define as 10% or less of your liquid net worth. That way if it doesn’t work out you won’t be devastated financially. And if it does, then you get to own some bragging rights.
I have no better view than anyone else of what Bitcoin might be worth in the future. It could be worth twice its current price. But, given what we know today and the data available to us, it could also be worth half. Bubble activity brings a lot of talent and technological advancement, but also attracts a lot of fraudsters, charlatans, and hacks. So make sure you are deeply educated about any decisions you make before you act. Bitcoin, Ethereum and other cryptoassets are fascinating technological experiments that Wealthfront will continue to monitor closely to see what happens over time.
Nothing in this communication should be construed as an offer, recommendation, or solicitation to buy or sell any security. Wealthfront’s financial advisory and planning services, provided to investors who become clients pursuant to a written agreement, are designed to aid our clients in preparing for their financial futures and allow them to personalize their assumptions for their portfolios. Additionally, Wealthfront and its affiliates do not provide tax advice and investors are encouraged to consult with their personal tax advisors.
All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Wealthfront and its affiliates rely on information from various sources believed to be reliable, including clients and third parties, but cannot guarantee the accuracy and completeness of that information.