Cryptocurrency has become a fashionable asset over the past few years. However, many people don’t truly understand it. In fact, I recently had a business owner call me to ask if they should go “all in” on cryptocurrency. Hence, the title of this entry. Now, I told this owner not to place 100% of their money into cryptocurrency (“all in”), but that doesn’t mean it can’t have a place in your investment portfolio. With today’s entry, I’m going to try to explain an extraordinarily complex subject in financially simple terms. So, get comfy. There’s a lot to unpack here.
Follow Along With The Financially Simple Podcast!
Before I go any further, I want to make it absolutely clear that this is not advice. The purpose of this entry is to educate and provide a basic understanding of cryptocurrencies. Past performance is not indicative of future results, and any assertion to the contrary is a federal offense. You should always speak to a qualified financial advisor and/or conduct your own due diligence before making any investment decisions.
Now that that’s out of the way, I also want to clarify that I am explaining a very complex subject in an overly simplified manner. Because of this, I am leaving out some of the details. This isn’t done to mislead or misinform, but rather to make the material simple enough that you can leave with a basic understanding of the subject. My hope is that this will prompt you to feel a little more confident about researching this asset and making an informed decision about how or if crypto might fit into your investment strategy.
I know you’re ready to get into the meat of today’s topic. But before we can start exploring cryptocurrency, you need to understand the blockchain. What is it? How does it work? Essentially, you can think of blockchain as a ledger. Think about your checkbook. Yes, I know. I’m showing my age, and many of you under 30 years of age are thinking, “I think I saw one of those in a museum once.” But in my personal checkbook ledger, I could keep an accurate account of every check that I’ve written. Likewise, every debit and credit is accounted for in my ledger.
However, only I have access to this ledger. Each entry in my ledger is like a link in a chain. I can look at this ledger and see check number 1895 is followed by 1896, 1897, and so on. I could change a number or two somewhere in my ledger, and nobody would be the wiser. Blockchain works in a similar way but with a few differences. It’s like a ledger. Each block holds specific information, and the blocks are “chained” together.
The major difference between my check ledger and blockchain is that blockchain is duplicated and distributed across the entire network of computer systems participating in the blockchain. It makes it much more difficult for a hacker to change information without it becoming immediately apparent. To change one block of information without it being noticed, a hacker would need to change every block in the chain across the entire ecosystem. In a nutshell, blockchain is a digital ledger system designed to keep the records authentic. As a result, many corporations such as Visa, Ford, Shell, Pfizer, etc., use the technology. They use it because it keeps the transference of money and information digitally protected.
Now that you understand blockchain, we can look at cryptocurrency. A cryptocurrency is a form of payment that can be exchanged for goods and services online. Now, a lot of companies have actually begun creating their own currencies. These are called tokens, and they’re meant to be used specifically for the goods and services that the issuing company provides. Oftentimes, these are utilizing the blockchain.
This isn’t an entirely new concept, folks. There’s a particular pizza chain that’s been doing this for years. I loved this place when I was a kid. As an adult? Not so much. Of course, I’m referring to Chuck E. Cheese. If you’re not familiar with this concept, it’s a pizza place with a great big arcade and an animatronic band that plays kid-friendly versions of pop songs. Anyway, I can walk into Chuck E. Cheese, give them money, and receive a cup full of tokens. In my family, we like to use the tokens to play skeeball. And let me tell you, friends, I show no mercy when it comes to skeeball. I destroy my kids and strut around like Muhammad Ali after a prizefighter.
According to CoinMarketCap.com, a market research site, there are more than 6,700 different cryptocurrencies being publicly traded. Now, you might think there’s not a lot of money involved in the trading of cryptocurrency. However, there is currently around 1.6 trillion dollars worth of bitcoins being traded. I need to make a quick distinction here. When I say “bitcoins,” that is not the same as saying “Bitcoin.” Bitcoin is a specific brand of cryptocurrency. On the other hand, bitcoins is a generic term for digital currencies.
Some supporters see cryptocurrency as the currency of the future. As such, they rush out to buy as much as they can before they presumably increase in value. Others view it as a means of seizing control from the central banks. Still, others value cryptocurrencies because they like the technology behind them, i.e., blockchain. Because it works so well at keeping data secure, I’d like to see it utilized in future election cycles. Finally, there are some who like crypto just because they’re increasing in value. They have no interest in its long-term application or acceptance.
Although these currencies may increase in value, many investors still see them as speculations rather than real investments. What do I mean by that? Well, “real investments” are things you can quantify into fundamental and technical analyses. The reason that so many investors feel this way is that, like real currencies, cryptocurrencies don’t generate cash flow. Therefore, in order for you to profit, someone has to pay more for the currency than you did.
This strategy—purchasing something that doesn’t generate cash flow but may increase in value—is known as “the greater fool” theory. Despite the name, it’s not suggesting that the person who invests in cryptocurrency is a fool. No. There are many ways someone could “buy low and sell high.” But, in a well-managed business, value is increased by growing the profitability and cash flow of the operation. Cryptocurrencies don’t currently generate cash flow.
So, if you see bitcoins as the currency of the future, allow me to point out a major difference between them and other currencies. Stability. There are some who would argue that because crypto lacks stability, it is a speculative investment. I agree with that statement. However, there are others who believe that the instability indicates it will stabilize at a much higher price point. We don’t know that right now.
I’m a big fan of Warren Buffett. I believe what he did, when he did it, is incredible and will go down in history. When it comes to cryptocurrency, he said this, “It’s a very effective way of transmitting money, and you can do it anonymously and all that. A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?” The obvious answer is no. Just because something can transmit money doesn’t mean it’s valuable.
Another one of his statements that I wholeheartedly agree with is, “When people are greedy, be fearful. And when people are fearful, be greedy.” In fact, I agree with this statement so much, I had it printed on canvas, and it now hangs in our main conference room so that our clients see it whenever they meet with us. You see, there is a time and place for everything. But, at this time, I view investing in cryptocurrency as speculative, and investing in speculative investments should only be conducted after deep research and understanding of the topic.
Unfortunately, that’s not what’s happening. So many people are buying into something they don’t understand, and it costs them millions of dollars. Not long ago, I read an article about how many early investors can’t access their “wallets” because they’ve forgotten their authentication key. Essentially, this is a code that was assigned when they made their initial investments in cryptocurrency. So, there are millions of bitcoins that will never be realized because investors didn’t understand how it worked.
Whenever you begin investing, I firmly believe you should come to the table with an investment philosophy. Right now, you’re probably saying, “Justin, my investment philosophy is to make money!” I get that. But you’ve got to have something more than that. You need something that will protect you from your emotions. In my company, we generate an Investment Policy Statement (IPS) for every client. It basically tells them what “guardrails” we’re going to use to prevent emotion from entering into their investment equation.
My investment philosophy has been displayed on our website for over a decade. At this point, I’m pretty set in my ways, and it isn’t likely that I’ll change many things any time soon. I believe the markets are efficient. Likewise, I believe in Modern Portfolio Theory. The key insight of the theory is that an asset’s risk and return should not be assessed by itself but by how it contributes to a portfolio’s overall risk and return. Additionally, I believe in the Three-Factor Model created by Eugene Fama and his University of Chicago colleague, Kenneth French.
The three-factor model combines the market factor (stocks vs. fixed income), the size factor (small-cap over large-cap stocks), and the value factor (high book-to-market over low book-to-market stocks). Similarly, I believe that target band rebalancing (daily or weekly rebalancing of positions that break through the 20% variance) yields more desirable returns over time. I believe these things because the research shows them to be true. All of this is building to answer the question, “Should we invest in cryptocurrencies?” But first, you have to understand that you can’t be swayed by hype if you utilize quantifiable research and predictive outcomes. Wall Street and Main Street love to hype.
As business owners, we need a less risky asset class for long-term funds. You see, most business owners have 80% of their net worth tied to their businesses. That’s a huge risk. Much more so than investing in a small, mid, or large-cap corporation on the stock market. Because we’re often behind the 8-ball, when it comes to diversification, we try to take our dollars and deploy them to some speculative investment. We think that it will be the home run we need.
Simply put, diversification is holding investments that will react differently to the same market or economic event. In other words, a well-diversified portfolio offers balanced growth and mitigated risk by spreading across multiple asset types and classes. I often revert to lessons that my father taught me—and I’ve since passed to my own children—about not keeping all of your eggs in one basket.
Although it’s a common phrase, its origins come from the practical agrarian application. You see, I learned not to keep all of my eggs in one basket—and thereby, diversification—from collecting eggs with my father. I thought I could get done with my chores faster if I just filled the egg basket to the brim and ran home. Unfortunately, I tripped over the hose, and the eggs went flying. Diversification protects your portfolio from disaster when you trip on the hose with one of your egg baskets.
Nobel Laureate Harry Markowitz, once described diversification as “the only free lunch in investing.” What he meant was that, by diversifying, investors could receive the benefit of reduced risk without diminishing their returns. With that in mind, let’s take a look at 7 basic asset classes and how they can be further diversified.
These are common stocks listed with the various United States Securities exchanges, such as the New York Stock Exchange. Within the market, there are a variety of equities, and, ideally, you want to have some of each in your portfolio. These can be further broken down into large, mid, and small-cap companies and may be categorized as growth or value stocks. Depending on their individual type, they may have varying risk/return ratios and return at different rates.
Cash and cash equivalents are great assets. However, they are subject to inflation, so you may not want to rely too heavily on them. You can diversify cash and cash equivalents in three forms: U.S. currency, foreign currency, and crypto–currency.
Essentially, these allow you to loan money to the bond issuer—typically, the U.S. government or a corporation—and they pay interest over the bond’s life. Like the rest of the asset classes, bonds ( a.k.a. fixed income) come in a variety of flavors, ranging from general obligation bonds to municipality or even U.S. Treasury bonds. Each one responds differently to various market phenomena.
These are literally anything that someone is willing to pay a price for. Commodities are any goods that are readily tradable or sellable for the exchange of currency or goods. There really aren’t any limits to the ways that this asset class can be diversified.
Essentially, these assets are the opposite of U.S. equities. This is because they are traded or exchanged on the international markets. However, they come in the same varieties (large, mid, and small-cap/value and growth) and will have various risk/return ratios. Additionally, the global market asset class can add an extraordinary amount of diversification to your portfolio.
Real Estate may be one of the most popular asset classes available. This is because real estate is a ‘hard asset,’ meaning that, many times, you can own tangible or physical property, unlike stocks and bonds. Additionally, real estate is a very diverse asset class. You can invest in anything from commercial and residential properties to mining, timber, and farmland.
Just as International markets are to U.S. equities; International fixed income is like domestic fixed income. This asset class focuses on the international markets. International fixed income offers further diversification through non-US governments and general obligation bonds on non-US companies.
I believe cryptocurrency could have a position as part of a well-diversified portfolio. In fact, I currently own cryptocurrency. It’s part of my overall investment portfolio and is in alignment with my risk score and IPS. Likewise, it aligns with my overall financial plan. However, this is not what I’ve seen recently. What I’ve seen recently is similar to what we saw with real estate. Investors are taking everything and going “all in” with cryptocurrency. In my opinion, going “all in” on ANY single asset is unwise.
Look, I know this is a lot to digest and I challenge you not to go at this alone. This is highly complicated. I don’t even manage my own money. Why? Because I’m emotionally attached to it. If you’re honest, you’ll understand that the same is true for you. If you’re still unclear on blockchain/cryptocurrency, contact a good financial advisor. Don’t go for one that is trying to sell you junk. Instead, find an advisor who works to build a true plan that helps you reach your goals. Perhaps cryptocurrency should be a part of your plan. But use sound judgment before making that decision.
Friends, life is hard but life is good. Trying to navigate the wild world of cryptocurrency can be frustrating, but it doesn’t have to be. By speaking with a knowledgeable financial advisor and conducting your own due diligence, you can make deciding whether to invest in crypto, at least, financially simple.
We realize that this is a highly complex subject and that you may have further questions. If so, reach out to us. The team at Financially Simple is here to help.