In March, we published a couple of articles that covered a lot of ground on cryptocurrency in general and the challenges and opportunities that exist for those hoping to earn, store, and spend their bitcoin or similar cryptoassets. Now with all of the previous knowledge from the past two articles, you may or may not be interested in using cryptocurrency as a means of exchange. But what about trading in it, directly or in fund form? If you’re considering that possibility, know that, at this point:
- Cryptocurrency is a highly risky holding: For every cryptocurrency success story you read, there are plenty of other tales of woe.
- Cryptocurrency is not an investment; it’s a speculative venture: Bottom line, cryptocurrency doesn’t fit into our principles of evidence-based investing … at least not yet.
Remember the Risks
All the transactional risks we covered in part 2 can also impact cryptocurrency traders. To recap, these include:
- Potential loss or theft of an underlying cryptocurrency you’re holding
- Loss of equilibrium between a cryptocurrency’s supply and demand
- Governmental regulation hobbling a cryptocurrency’s growth potential
- The massive energy consumption required to mine cryptocurrency
That’s a lot of potential buzzkill for your happily-ever-after holdings. These and other risks have translated into an extremely volatile ride for cryptocurrency traders, and one reason you might want to think twice before piling your life’s savings into them.
Then again, every investment carries some risk. Without risk, there’d be no expected
return. That’s why we also need to address an important difference between evidence-based investing vs. speculative ventures. It has to do with how we evaluate future expected returns.
What’s a bitcoin worth? A dollar? $100? $1 million? The answer to that has been one of the most volatile bouncing balls the market has seen since tulip mania in the 1600s. As described in this Wall Street Journal piece, bitcoin was trading for around $7,000 per coin in early 2020; as of February 20, 2021, the price topped $55,000. By the time you’re reading this piece, there’s not much stopping it from being worth far more than that … or far less.
The problem is, there’s really no way to establish meaningful expectations either way. In his ETF.com column, “Bitcoin & Its Risks,” financial author Larry Swedroe summarized how market valuations typically occur:
“With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With bitcoin, none of the preceding analysis is possible. Bitcoin is purely speculation.”
Investing vs. Speculating
In other words, we’re not saying it’s impossible to profit from trading in cryptocurrencies. But the attempt more closely resembles a game of chance than an investment. In contrast, evidence-based investing enables us to create a unified portfolio we can manage according to YOUR individual goals and risk tolerances. Evidence-based investing calls for the ability to:
- Estimate an asset’s expected return, based on relatively well-established fundamentals
- Factor in how different asset classes interact with one another within your total portfolio
- Provide a sensible structure for embracing a long-term, buy, hold, and rebalance strategy
Cryptocurrency simply doesn’t yet sync well with these parameters. It does have a price, but it can’t be effectively valued for planning purposes.
All this said, what if you are still interested in trading in cryptocurrency, for fun or potential profit? If so, here are key tips to consider:
- Treat it like an entertaining trip to the casino. Don’t venture any more than you can readily afford to lose!
- Use only “fun money,” outside the investments you need to fund your essential lifestyle.
- If you do strike it rich, regularly remove a good chunk of the gains off the table to invest in your managed portfolio. That way, if a bubble bursts, you won’t lose everything you’ve “won.” (Also set aside enough to pay any taxes you may have incurred.)