bitcoin investment: Does bitcoin belong in your investment portfolio?
Let's be clear from the outset. I love FinTech and I am fascinated by innovation around any financial products. So it goes without saying, I am really interested in bitcoins.
In the last two years, there has been a lot of hype around bitcoins. We've all heard about it shooting from US$120 to US$1,120 between Sep and Nov 2013. Then the subsequent "crash". Now trading at around US$220 - US$250.
I've recently been diving into bitcoins and the underlying technology. I keep wondering if bitcoins can be, should be, an asset class for investment purposes. Does bitcoin investment make sense. Should bitcoin be considered as investment at all?
In analysing it's short history, it is hard to see them as a strong asset class in a diversified investment portfolio. There is too much volatility / risk, and they show a pretty strong correlation to the Aussie stock market. Both of these factors make them less than ideal candidate for Gen-Y growth portfolios.
Is bitcoin an Asset Class?
bitcoin is like a commodity that you can trade - like currency or Gold. According to Coin Cadence, there are A$4.31B of bitcoins floating around bitcoin exchanges. Daily trade is roughly A$33M worth, with average transaction size of A$150 per trade.
Despite the low volume of trading, there are lots of bitcoin exchanges around the world. From CoinBase and Kraken in the US, to CoinFloor and Coin Corner in the UK, to Bitfinex in Hong Kong, to our Aussie favourite CoinJar from Melbourne. Buying and selling bitcoin is quite simple.
In May 2015, bitcoin took a big step as an asset class, with the New York Stock Exchange creating a bitcoin Index. To me, this demonstrates some level of recognition and legitimacy as an investment asset.
We are even seeing companies creating bitcoin ETFs. They work in similar way to Gold ETFs. Even the famous Facebook villains - Winklevoss brothers, are starting a bitcoin ETF.
Interesting reading: What are ETFs?
Does it work in a diversified investment portfolio?
I was only able to get data on bitcoins from July 2010. This short duration is not ideal for investment analysis. But it is all that we have. In the 5 years to May 2015, bitcoin jumped from US$0.09 to US$237 (26 May 2015). If you owned a bitcoin from 10 July 2010 and held it through thick and thin, you’d be looking at a massive gain of 276,505% - yep, 2,766 times your money.
But … there is a massive but. bitcoin price has been jumping up and down like a yo-yo. It has a much higher volatility (risk) than other asset classes. In finance terms, it had a Coefficient of Variation of 1.41. This compared to 0.11 for the Aussie stock market and 0.09 for the Aussie government bond market. Read more about what Coefficient of Variation means here. For our purposes, we can say that bitcoin investment is orders of magnitude more risky than the stock and bond markets.
By itself, a high risk asset doesn’t make it a bad inclusion into a diversified portfolio. However, bitcoin also shows a good degree of positive correlation to the Aussie stock market. In the past 5 years, bitcoin had a correlation of 0.69 with the stock market. This means when the stock market goes up by $1.00, bitcoins will go up by $0.69.
This positive correlation make them a bad asset class for diversification purposes. This is especially true for Gen-Y portfolios that are usually Aussie stock heavy.
Investing and Risks
In the current form, bitcoin is probably more suitable as a currency to pay for goods and services, transferring money overseas and speculative trading. If you want to get and use bitcoins for these purposes, it is pretty easy to get yourself setup with a bitcoin wallet like CoinJar.
If you are considering bitcoin as an investment class, you should consider a few things:
- they have very high price volatility;
- there has been instances of bitcoin exchanges going out of business and lost of investor money. Most famous case being Mt Gox going bankrupt and customers lost US$450M;
- there is a very high bid/ask spread when you buy and sell bitcoins