By Allen Wastler
Allen Wastler is a former financial journalist with over 30-years of experience, including time at CNBC, CNN, and Knight-Ridder Newspapers.
Posted on Feb 1, 2022
A new investment category has emerged in the investing world over recent years: cryptocurrency. It started out as a financial experiment for digital enthusiasts and outfits with a penchant for new and untested investments. But now banks, investment companies, and other established financial institutions are beginning to add cryptocurrency to their asset base.
Should an average investor follow suit?
Probably not. Most experts advise that only knowledgeable, sophisticated investors with an appreciation for speculation and a high tolerance for risk should consider cryptocurrencies in their portfolio. And, even then, only in a limited way.
“For some, a small allocation, less than 2 percent, may be fine if you are concerned about a hedge for future dollar weakness,” said Daken Vanderburg, head of investments for wealth management at MassMutual. “But cryptocurrencies are not for the faint of heart. They are appropriate only for those who clearly understand the risks and can tolerate the volatility.”
Indeed, the risks are significant. They include:
- Obsolescence
- Extreme volatility
- Indeterminate value
- Hacking
- No cash flow
Understanding risk
Like all investment decisions, the first place to start is understanding and recognizing your own tolerance for risk. This is comprised of a number of factors, including age, income/savings level, lifestyle, investing knowledge, and personal comfort level with risk.
Your risk tolerance lies at the heart of determining your asset allocation — how much money in your savings portfolio is in relatively risky investments versus relatively safer investments.
For most retail investors, this comes down to balancing a combination of stocks and bonds. Both types of investments can offer cash flow over time through dividend or interest payments. But they differ in risk.
Stocks, as a general category of investment, tend to be more volatile than bonds but provide a higher level of return over time. Bonds, by contrast, tend to be more stable but generally provide a lower level of return.
So, when an investor is younger and near the beginning of their working years, it might make sense to have more stocks in a portfolio, because there is time to recover from any short-term losses. And as an investor ages, they shift more holdings into bonds to protect against losses as they move into retirement.
Beyond a basic stocks/bonds mix, some investors add additional types of investments, such as holdings based on commodities or currencies. They can either do this directly or through mutual funds or exchange-traded funds. These types of investments are generally riskier and don’t have an expected cash flow. So, some investors also look for vehicles with guaranteed value over time, like permanent life insurance and annuities, to help mitigate overall risk.
Why would investors put riskier investments into their portfolio? Typically, some investors put riskier investments in their portfolio in hopes of garnering bigger returns. Also, some may have a “fear of missing out” on a popular form of investment. And, if they have the wherewithal, it may pay off for them in the long run. On the other hand, they may incur losses.
In the end, each investor has a different level of risk tolerance.
Cryptocurrency obsolescence risk
Cryptocurrency essentially uses encrypted computer files as a form of payment. Transactions are verified and records maintained by decentralized networks using blockchain technology, so no government or single entity stands behind the cryptocurrency.
There are a variety of cryptocurrencies in existence — many thousands by some estimates. Two of the more well-known are Bitcoin and Ethereum. But there is obsolescence risk as there is no guarantee that any of these cryptocurrencies will stand the test of time.
“It’s a significant risk that is different than other investment vehicles,” said Vanderburg. “No one, for example, knows whether Bitcoin is going to be around in 10 years — or 6 months.”
Cryptocurrency volatility
Nevertheless, although cryptocurrency is barely more than a decade old, many professional investors have seized upon it, touting its inflation resistance, transparency, and freedom from government control or influence. On the other hand, cryptocurrency has also been criticized for its volatility and use as a medium for illegal activities.
It’s the volatility that any potential investor should be wary of. Since 2011, Bitcoin has been roughly nine times more volatile than the S&P 500 (a leading stock market index) and roughly 30 times more volatile than bonds, according to one analysis.
That has led many leading financial and investment pundits to advise against it as a retail investment.
For example, in a 2018 TV interview, the renowned multibillionaire investor Warren Buffett said he would never have cryptocurrencies as an investment, adding “I can say with almost certainty that they will come to a bad ending.”
Cryptocurrency value risk
Nevertheless, cryptocurrencies continue to gain speculative interest and make gains in recent years as a result.
The chart below shows the change in value of $100,000 entirely invested in either of the two most well-known cryptocurrencies — Bitcoin or Ethereum — or the S&P 500 Index.1
This chart shows recent gains. But it also shows volatility and deep loss of value for certain periods. Compare that with the historical performance of the S&P 500 in the chart below.2
This chart illustrates steady gains, albeit with some ups and downs, in the stock market for roughly a hundred years.3
And notably, the S&P is having one of the best returns lately in its almost 97-year history. In fact, with dividends reinvested from February 2018 till September 2021, the S&P 500 (as shown in the charts) returned a whopping 74.63 percent. In the last rolling 12 months, it did almost 30 percent, and this after the latest “mini-correction” at the outset of the pandemic.
How does that overall growth come about? Stocks represent ownership in companies that produce goods and control property and means of production — assets. And as those assets produce more, they represent more value.
Similarly, other mainstream investments — bonds, commodities, real estate — have underlying asset value. And currencies, which can fluctuate, are reflective of the value assigned to a particular country’s government policy and economy.
Cryptocurrencies have no such underlying asset base or value. They are simply a means of exchange and a subject of speculation.
“Cryptocurrencies are remarkable innovations, but they are not assets,” said Vanderburg. “They have seen rapid adoption and significant increases in market value in a very short period, but there is no structural reason to believe they will increase as equities, bonds, and real estate have done historically. At best, beyond basic speculation, they can be a small hedge against fluctuations in other mediums of exchange, like currencies. But I wouldn’t advise a large holding for an individual investor.”
Cryptocurrency hacking risk
As a digitally based form of financial value, cryptocurrencies can obviously be the target of hackers. And already a number of cyberattacks have taken place at various cryptocurrency platforms. And, unlike banks, accounts on those platforms are not covered by the Federal Deposit Insurance Corp.
That kind of hacking is not a risk with stock and bond investments, which typically make up an average investor’s portfolio.
No cash flow for crypto
Additionally, cryptocurrencies provide no cash flow. Many companies, however, issue regular dividends to stockholders. And bond owners typically receive interest payments on their holdings. And real estate investments can also provide a steady stream of income.
“Cryptocurrency simply doesn’t provide any expected cash flow, whereas bonds, equities, and real estate do,” observed Vanderburg.
Conclusion
Access to cryptocurrencies is still somewhat limited, although more and more financial trading platforms and exchanges are offering various investment products.
But before choosing to invest in cryptocurrency and deciding on a platform, probably the wisest course of action would be to consult a financial professional and carefully consider your financial goals beforehand.
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1 Source: Bloomberg as of December 31, 2021. Past performance is not indicative of future results. Inception date for calculations is first common based on Bloomberg data feeds (2/8/2018) and the graph is portrayed in log-base 10 scale (exponential growth base factor 10).
2 Source: FRED and Bloomberg as of September 30, 2021.
3 An investment cannot be made directly into an index. The S&P 500 Index pays dividends, Cryptocurrencies do not. Dividends reflect past performance and there is no guarantee that they will continue to be paid.
