A Beginners Guide to Cryptocurrencies

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Questions such as “What do you think of cryptocurrencies?” or “Should I buy Bitcoin?” are becoming increasingly common amongst investors in 2021.  While we currently do not participate in cryptocurrency investing as a firm, there is still value in understanding and tracking this segment of the market.  We thought a high-level overview of our thoughts and insights may be useful to quench your own curiosity thirst.

The Black and White

Cryptocurrencies are typically not tied to a bank or government and were created to ideally become replacements for paper money.  Bitcoin, introduced in 2009, was the world’s first cryptocurrency and is probably the most well-known.  Although the units are referred to as “coins”, Federal Reserve Chair Jerome Powell has said the central bank prefers to call crypto coins “crypto assets,” because their volatility undermines their ability to store value, which is a basic function of a currency.  Currently, Bitcoin’s share of the overall crypto market value is about 42%, down from roughly 70% at the start of the year.

Where do these come from if there is no underlying tangible asset?  Bitcoins are created by users who “mine” them by lending computing power to verify other users’ transactions. They receive Bitcoins in exchange for the use of computing power.  Once mined, the “coins” (units) can be bought and sold on exchanges and can be used as a currency, as some businesses take Bitcoin as payment.  Currently, some financial institutions allow it in their clients’ portfolios, but overall mainstream acceptance is still limited.

What is the Hype with Cryptocurrencies?

The appeal to cryptocurrencies is easy to understand.  They are a digital store of value but viewed to be more liquid and mobile, all while ideally hedging against inflation and providing growth, which traditional currencies do not.  The value is based on the same premise as gold, diamonds, or even stock… It is only worth what someone is willing to pay for it.  The more these survive and thrive, the more reputable they become and thus the value increases (but not without extreme volatility).

The past performance is also very appealing. Over the past 10 years, Bitcoin was the best performing asset class and has beaten all other asset classes by at least a factor of 10.  While keeping in mind that this instrument is only 12 years old, the performance, no matter how volatile, is still noteworthy.

Why are Cryptocurrencies so Unpredictable and Volatile?

There’s no predicting what the future holds for an asset class that’s still in its infancy.  In investment management we often use past returns and previous market trends to estimate future performance.  Experts look for patterns and signals that may give insight to how today’s markets will react to current events and within cycles.  One of the major issues with crypto which causes hesitation for professional investors is the lack of “history” of cryptocurrency.  We do not have 100 years of market cycles and movements to analyze to help predict how this investment option will react.

There are some factors that will affect cryptocurrencies in a similar manner as the traditional stock market.  For example, Bitcoin was no exception to the ‘dash for cash’ at the height of the Covid-19 crisis in March of 2020, where it dropped more than 50%. However, it rebounded just as we saw in the stock market.

Is Cryptocurrency a “Safe” Investment?

Cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. But the safety aspect depends on the investor’s definition of what ‘safe’ is.  This is typically based on the investment’s price volatility and the maximum drawdown, which is the maximum decline from the peak point to a pullback low.  Regarding volatility, Bitcoin is 5 times more volatile than gold and 10 times more volatile than the S&P 500.  In March of 2020, when the equity market fell 26%, Bitcoin fell nearly 60%.  And as we witnessed in following months as the market rebounded, Crypto saw even more exaggerated bounce-backs, with Bitcoin increasing 1,428% over the following 12 months.

It is important to note that there is also a complete loss of principal risk associated with this new investment category.  There is nothing tangible backing its value and there is a risk associated with the style in which the asset is digitally held.  Cryptocurrencies hold the promise of making it easier to transfer funds directly between two parties, without the need for a trusted third party like a bank or credit card company.  They must be stored in a digital wallet, either online through an exchange like Coinbase, or offline on a hard drive using specialized software, leaving vulnerability to being hacked.

More regulation of the cryptocurrency space is needed to help institutional investors become more comfortable with these digital assets.  This is a controversial opinion, especially among those who got into crypto investing early.  But the reality is, if cryptocurrencies are going to become more widely accepted as both a form of currency and a valid investment option, it must be more regulated. Now when we say there are hopes for increased regulations it does not mean that the desire is for “Big Brother” to step in and limit activity and gains, but more so to provide clarity and assurance to potential investors in this market that is commonly viewed as the “wild west” of investing. With regulatory involvement would also come more opportunities for investors.  If the SEC gets more heavily involved, there would be wide availability of ETFs and mutual funds, more access to a variety of the currencies, and accountability of the institutions that hold the funds.

Cryptocurrencies, such as Bitcoin, were historically ignored by large financial institutions.  This is now changing.  As more platforms offer these investment options (either directly or as an EFT/mutual fund) and institutional investors get more involved in investing (hedge funds, investment firms, tech companies, etc.), we will begin to see the future of the sector unveiled.  And as these stabilizing forces come into play, we will be closely following from the sidelines, keeping our client base apprise of any new, realistic investment opportunities. If you have any further questions about how Voisard selects our investment assets, please feel to reach out to a team member.  As always, we are happy to be here as a resource.

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