“There is nothing so disturbing to one’s well being and judgment as see a friend get rich.”
Economic historian Charles Kindleberger said this in 2005, and it has perhaps never been more relevant than over the past 12 months. The values of cryptocurrencies – Bitcoin, Ethereum, Ripple, among others – have experienced explosive growth, enriching early investors and leading many to question whether it’s worth making a late-stage investment.
In June 2017, Bitcoin was valued at $2,500. By late December 2017, it reached a record high of $17,000. There is no economic rationale to explain this growth. Instead, we must rely on Kindleberger’s premise. Following the same financial trajectory as early investors is inherently appealing. But cryptocurrency exists in an extremely volatile marketplace, and all signs indicate we’re in the midst of a Bitcoin bubble.
Prudent investors should understand the dynamics of cryptocurrencies and how Bitcoin stacks up against traditional investment strategies.
Why it’s a bubble
A bubble occurs when the price of an asset is driven well beyond what it’s actually worth. It tempts investors by continually climbing, but doesn’t have the market fundamentals to support it – so the bubble eventually bursts and leaves many investors with significant losses.
Source: BCA Research, www.bcaresearch.com
As this chart from BCA Research displays, investor enthusiasm has driven up the price of Bitcoin at an extremely fast rate, tracking against BCA’s Mania Index.
Bubbles are especially vulnerable to market news that sways sentiment. In early January, it was reported that Chinese authorities would be clamping down on domestic access to central cryptocurrencies. This news, along with indications that other countries may follow suit, set the price of Bitcoin back $5,000 in two days. Though it bounced back later in the week, investors are now paying close attention to how global politics may affect accessibility to – and the value of – cryptocurrencies.
Why it’s a sideshow
The Bitcoin bubble is unlike bubbles in recent memory, and this insight is key to understanding how the effects of a crash would impact global economics. The easy answer: it won’t.
Let’s look at the housing debt bubble as an example. It was made possible because low interest rates and loose loan terms made the market irresistible for buyers. As mortgage lenders gained traction, they sold loans and derivative products to big banks – where those loans sat on balance sheets until housing prices finally came crashing down. The housing market was so entwined with the financial system that the collapse reverberated across the global economy. It led to billions of dollars in bailouts, new regulations and hardship for so many families.
When the Bitcoin bubble does burst, the losses will only be experienced by participants in the exchange and those whose jobs or businesses rely on the cryptocurrency. That’s because Bitcoin is not tethered to bank balance sheets. It is isolated from the U.S. economy, and therefore investor portfolios will remain unharmed in the event of a collapse.
Why it’s a risk
At Wescott, we believe the best investment decisions are made by considering client goals, first. We look for investments that tend to perform well in growth and momentum-driven markets, as well as those that protect on the downside. We look for investments that are opportunistic and can take advantage of undervalued areas of the market, including those poised for long-term future growth regardless of market conditions. We build diversified portfolios that reflect each client’s risk tolerance.
As such, we don’t believe Bitcoin can play a meaningful role in a financial plan. It does not provide any clarity about its future expected returns and instead threatens to lead investors down a path of chasing today’s big winners. Moreover, investors cannot currently custody Bitcoin with any financial institution, and the cryptocurrency is vulnerable to both hacking and severe swings in value.
However, we know that interest in cryptocurrencies will undoubtedly continue even after the Bitcoin bubble bursts. Plus, Bitcoin is just one of nearly 1,400 coins or tokens currently trading, and the exchanges may continue to evolve. Wescott’s investment management team will continue to monitor the space to assess the risks and opportunities for our clients.