Since I decided to move away from my corporate career to focus more on my business and investments, I am often asked by friends and former colleagues where they should invest their money. My answer always disappoints them.
Investing is less about picking winners and more about risk management. The only task that every investor has is to leverage the power of diversification within their portfolio i.e. identify as many uncorrelated asset classes and allocate a certain amount of capital to each of them, based on their risk appetite.
Not only I am not qualified to provide financial advice but, to a certain extent, nobody really is. It is impossible to predict the future, and our only hope as investors is to spread our bets systematically (think about one stock vs the stock market or one house vs thousands of commercial and residential properties).
Asset classes are not immutable and new ones are created as society evolves. It is of great importance for investors to be keenly aware of new asset classes as their inclusion in a portfolio will increase diversification, thus reducing risk and increasing the portfolio’s overall returns.
The issue with emergent asset classes is that they carry the risk of being just a fad and return losses in the long run. On the other side, precisely because of this risk, investing in an emergent asset class can be very profitable if we are able to enter that market before billions of dollars are poured in by institutional investors.
It is along these lines that investors around the world are looking at Bitcoin and other cryptocurrencies. In particular, many investors are thinking of replacing Gold with Bitcoin in their investment portfolios.
Gold is the oldest asset that survived to our modern times. Naturally scarce, shiny and easy to mould, it has captured people’s imagination across time and generations. Since the inception of the stock and bond markets, it has also proved to be a hedge against the volatility of these assets. At least in historical terms, Gold has shown no clear correlation with stocks and bonds and, in that capacity, it has always been perceived as an asset to include in a properly balanced portfolio.
Bitcoin shares lots of similarities with Gold — an early attempt by Nick Szabo to create a decentralised digital currency was actually called BitGold — as scarcity is digitally enforced by the blockchain and both Bitcoin and Gold are normally not accepted as a general means of payment. In addition, like Gold, Bitcoin derives most of its value by the potential investors see in it, rather than by its underlying functionalities (Gold and Bitcoin are valuable because investors believe they are, not because they satisfy a specific human need).
However, there are also some differences between these two assets that are worth examining from an investor’s perspective.
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The first thing to notice is that the current market capitalisation of Gold ($11 trillion) greatly exceeds the market capitalisation of Bitcoin ($1 Trillion). While this difference is expected given how recently Bitcoin was developed, the difference in market capitalisation matters in terms of liquidity. The larger the market for an asset, the easier it is to buy and sell that asset.
However, the Bitcoin market has grown exponentially in the last few years, so it is not impossible to imagine a future where Bitcoin becomes the largest asset by market capitalisation.
The Lindy Effect
The Lindy effect (also known as Lindy’s Law) is a theorized phenomenon by which the future life expectancy of some non-perishable things, like a technology or an idea, is proportional to their current age. Thus, the Lindy effect suggests that the longer something has survived, the longer remaining life expectancy it has.
The concept is named after Lindy’s delicatessen in New York City, where the concept was informally theorized by comedians who have enjoyed its pastrami sandwich for several decades.
The Lindy effect has phenomenal importance in investing. Time is the great destructor and assets that have maintained their value across time are likely to continue to do so for an equal amount of time. With Gold being traded since the dawn of time, the Lindy effect suggest that it will continue to be traded in the future.
On the other hand, Bitcoin has been around for a limited number of years and there is no guarantee that its popularity will continue over the next few decades. This is, of course, typical for of any emergent asset classes where early adopters can be either highly rewarded or lose most of their money.
The Underlying Value
Gold is not just widely used in the jewellery industry, but it has also acquired prominence in consumer electronics as well as the aerospace industries. In addition, being an extremely stable material and non toxic, it is also used in the healthcare industry. Having secondary uses is extremely important for an asset as it confers a higher-than-zero threshold to our investments and limits our potential losses.
On this topic, Bitcoin fares quite badly as it has no underlying value due to the lack of current secondary uses.
The Effect on the Environment
In recent times Bitcoin has been under attack because of the phenomenal amount of resources needed for the mining process. According to a report by CNBC, the yearly carbon footprint of Bitcoin is comparable to that of New Zealand, which is definitely bad news for our planet and may affect the future viability of our investments.
On the other hand, most Gold has already been extracted but, should the value of Gold surge, it may become economically viable to re-open old mines or to dig deeper or larger ones, thus also increasing the negative environmental impact of our investments.
The Transaction Costs
Every investment suffers transaction costs in the form of a combination of entry fees, ongoing fees and exit fees. Normally, the more a market is developed the lower such costs are due to competition between brokerage firms, economies of scale and technological developments.
Transaction costs are extremely important because they compound over time, eating away larger and larger chunks of our investments.
As of October 2021, it is possible to acquire an exposure to Gold ETF\ETC for as little as 0.15% per year. On the contrary, crypto exchanges charge various fees which are normally 3 to 10 times larger than what a Gold ETF\ETC would charge.
It is likely that crypto exchange fees will be reduced over time in the same way that brokerage commissions plummeted in more developed markets, but this is something to always consider especially for those who enjoy trading more frequently. In addition, under the transaction cost label, it is also worth considering the risk of crypto exchange and crypto wallets being hacked and/or all our Bitcoin being potentially lost forever. A similar risk is extremely low in the case of ETF\ETC due to the different nature of the investment.
Bitcoin, and decentralised digital currencies in general, have been under government scrutiny since their inception. The strong cryptography allows for potentially untraceable payments between potentially anonymous users. Consumers have been lured by enormous returns and several have lost all their money due to extreme volatility or due to fraudulent attempts. Most of all, governments fear their loss of primacy in the currency market if other supra-national currencies are allowed to circulate.
That fear turned into action in China, which has recently banned all cryptocurrencies transactions (China used to account for 60% of the mining efforts on the Bitcoin blockchain). It is not impossible to imagine other regulators around the world to follow suit and to ban or restrict cryptocurrency payments. Similar decisions will of course have an extremely negative effect of our investments.
On the other hand, Gold doesn’t seem to be a target of any regulatory intervention and can be freely bought and sold in its physical form as well as a financial product.
Bitcoin AND Gold?
After researching for this article, I realised that probably the original question was framed incorrectly. Although Gold appears to offer superior investing credentials compared to Bitcoin, it would be a mistake to look at our investment portfolios in terms of “either this or that”.
Replacing our Gold position with an equivalent Bitcoin position may not be answer, but so it is discounting completely one of the greatest inventions of our generation.
Maybe the answer is to consider Bitcoin as a potential source of diversification in our portfolio, subject to the considerations listed above as well as to its high risk profile, which may not appeal to everyone.
Do you have Gold and\or Bitcoin in your investment portfolio? What was your rationale to include or exclude these assets?