Undoubtedly you have heard about the new form of money known as digital or “crypto” currencies.
It is a fascinating new development in the financial world and it has caught a huge amount of attention on Wall Street as people try to capitalize on it. To define it, a “crypto” or digital currency (DC), is a form of “money” represented by digital data, or a data file, that can be used for the payment of goods and services online. A couple of the more popular cryptos include Bitcoin and Ethereum, but there are in the neighborhood of 4,500 private cryptocurrencies now identified.
There are a lot of big time players on Wall Street looking to capitalize on the current digital currency craze. They do this in several ways, for example “mining” and acquiring the DCs (or “tokens”); trading in the stocks of companies that purport to mine, use, or own DCs; or trading DC futures. We’ve gotten numerous questions from clients about DCs and “investing” in them. This begs the question: are DCs such as bitcoin truly an investment?
To answer this, let’s first define an “investment.” In my view, an investment involves the process of analyzing and placing money into a vehicle or instrument that one believes has a high probability of providing gain, or a positive return on capital (ROC), based on a definable and predictable source of return such as income (i.e. rent or dividends) or price appreciation based on future earnings. In other words, to be an “investment,” there needs to be a “fundamental” basis for the placement of funds. The “instrument” could be things that are expected to generate a positive ROC such as a bank CD, a high quality stock or bond, real estate, a mutual fund, etc.
So let’s turn to cryptocurrency. Is it an “investment?”
Based on the above definition of an investment, we think not. Crypto does not have definable “cash flow” such as earnings or dividends. Its price is extremely volatile making it a poor store of value. The key to trading or owning crypto is its perceived scarcity value. Many players in the crypto space believe a DC such as bitcoin will only increase in value due to their limited quantity (21 million produced) and increasing number and value of transactions using DCs. While this may be the case, it needs to be understood that the DC is only the medium for transactions; it is not providing the characteristics of an investment.
Trading in crypto is then really more a form of speculation, in my view, which is purely guessing on the future price of something based on non-fundamental factors, such as emotion or fear of missing out. As we do for all our clients’ investments, we believe the best approach for achieving positive ROC is accomplished through investing in diversified holdings of quality stocks and bonds that offer a rational basis for ownership based on sound financial fundamentals.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.