27 - Cryptocurrency returns
Disclaimer: This is not investment advice.
The basic concept of investing is to take capital (money) and “put it to work.” Specifically, this means investing in an asset that you believe will increase in value over time. A common question that arises when investing in the crypto industry is: “How do you make money?” The crypto industry offers countless ways to make a return on your investment, and understanding how that return is generated is the first step towards feeling confident in making informed investment decisions. In Cryptocurrency or digital asset?, we learned about the different categories of digital assets. Each category provides an investor with different risks and returns, but there is an argument to be made for why every type of digital asset could have a place in an investment portfolio.
Growth vs stability
We can categorize investing into two buckets: investing for capital appreciation (growth) and investing for stability (stable). Growth investing involves buying assets that expose the investor to the potential upside of an innovative product/service, often known as “disruptors.” Markets like artificial intelligence have yet to be fully quantified; and investing in new companies or technologies is risky because the success of the products that underlie these investments is unproven. Investing for stability, on the other hand, involves acquiring assets that are more certain or predictable. The product/service a company produces has a validated market with a track record of customer demand. Investors in stable industries such as consumer goods often believe that the businesses will grow at a slower, yet stable rate.
The primary difference between these two types of investments is the way in which an investor is obtaining a return on their investment. The expectation for a growth investment is that the money invested will obtain a return through a potentially significant increase in asset value by capturing market share of an emerging industry. The result is that growth companies are able to accrue value but require that an investor sell out of the investment to capture it. On the other hand, the expectation of return from a stable investment is driven by cash flow. Investors in stable businesses know that the companies they are investing in have businesses that do not require major investments to acquire market share like those of growth companies. Stable companies already have market share, and therefore are more likely to distribute cash as a dividend to their investors.
Cryptocurrency as an investment
For anyone reading this piece, stocks are most likely a major part of your investment portfolio. Shares of stock are valuable because they represent ownership in a value-creation machine, i.e. a company. As that company captures more share of a market and presumably the profits created by that market, the equity value (stock price) of that company should increase. Contrastingly, when investing in a digital asset, you are not buying the ownership in a company but rather in the right to transact on a network. Cryptocurrencies, which were the first type of digital asset created, are used to pay what are essentially “communication fees” between participants operating on a blockchain. If you want your transaction to be processed, you must pay a miner to do so. The value of cryptocurrencies is in their ability to obtain a transaction space in the latest block.
Crypto, as I am sure any reader could have guessed, falls into the growth category of investments because the value of blockchain based communication is still uncertain. If you are investing in a crypto currency, you are of the belief that the related blockchain is going to have an increase in usage which would mean an increase in demand for that particular cryptocurrency and a subsequent increase in price. The key here is that there is actual demand for the use of a blockchain network which leads to the question: why would someone use a particular blockchain? We can look at BTC as an example.
Bitcoin as an investment
There are many ways bitcoin investors believe that the technology is useful and therefore valuable. Four of the most popular** arguments as to how BTC could have long term value are as a….
Global settlement system
Global currency
Alternative to gold
Government free asset
The first argument is that the open and secure nature, coupled with low transaction costs, makes the Bitcoin network a compelling network on which to conduct large transactions. Transactions on the network cost somewhere between $1-2 regardless of how many BTC you are sending. Anyone can send billions around the world in minutes at a fraction of the cost it would take to move that amount in the traditional financial system. Even if a small amount of the global monetary exchange happened on the bitcoin blockchain, it would result in a massive boon for the price of BTC. The price could increase due to an increased demand for the asset not only to pay transaction fees but also as a place for companies to hold wealth. In, But… why? we discussed the idea that BTC is “sound money.” The second argument focuses on bitcoin’s embodiment of this concept. Sound money is the concept that the item being used as money (ie. a medium of exchange, unit of account, or store of value) has a limited supply that cannot be increased. Historically, sound money has been used to describe gold because its supply is perceived to be limited and constrained. Gold is clunky and hard to transport, so we moved to paper government-issued currencies. Unfortunately, government currencies are far from scarce and frequently subject to manipulation. Bitcoin’s being scarce, outside government manipulation, and accessible by anyone with an internet connection could eventually propel it to the preferred global currency.
Instead of replacing money, the third argument is the belief that bitcoin could replace gold in investors' portfolios. Even though gold is no longer used as a form of currency, it is still valued as an investment. The idea behind investing in gold is that it protects the investor’s capital from inflation and geopolitical uncertainty. The validity of these beliefs has been questioned in recent years due to gold's lackluster performance in circumstances where it should theoretically thrive. Despite its shortcomings, demand for gold remains by investors who want an asset with qualities gold is believed to have. Bitcoin’s autonomy from centralized governments and limited supply makes it a potential option for investors interested in insulating a portfolio against government turmoil and inflation.
The final argument touches on BTC's autonomous and borderless nature. In the third argument, we highlighted BTC’s being useful for investors as an alternative to gold. In order to be an investor, you need to live in a developed nation because investing requires you to put off gratification today for the promise of more gratification tomorrow. The argument for BTC as a replacement for gold would therefore be driven by people living in developed countries. Based on its design, BTC could also be demanded by less developed nations as a tool for citizens of those nations to avoid the fallout from political unrest. A great example of this is the Russian invasion of Ukraine which has had a severe financial impact on both countries. Ukrainians were cut off from much of their wealth by Russian attacks on infrastructure; and the people of Russia were effectively ousted from the global financial system thanks to economic sanctions. BTC’s being outside the reach of governments and accessible anywhere with an internet connection could be used by anyone after fleeing their respective countries.
Takeaways
Investing is a complicated process that involves risk analysis and an understanding of desired outcomes. When looking at investments, investors decide if the risk they are taking is worth the reward. Stable investments provide investors with less risk and uncertainty but lower returns. Growth investments often have more risk and uncertainty but increased returns. The arguments for investing in a cryptocurrency like BTC are compelling but are still unproven. If the history of investing has taught us anything though, it is that significant uncertainty can often lead to significant reward.
** Ark investments does a great job of articulating these arguments in their piece Bitcoin as an investment in 2020.