What Do I Need To Know About Bitcoin?
Chief Investment Officer Jared Kizer and Tim Maurer break down cryptocurrency, Bitcoin, blockchain and all of the currencies that seem to be getting so much attention in the investment landscape. Learn how they differ from a traditional centrally managed currency and how they may play a part in an investment plan.
Hello, it’s Tim Maurer, back with another episode of Ask Buckingham, a video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders.
Today’s question will be answered by Jared Kizer, Chief Investment Officer of Buckingham Wealth Partners. And talk about bringing clarity, Jared, this is the topic, it seems, of the day, where clarity is the most needed. That is cryptocurrency, Bitcoin, blockchain, all these things that seem to be getting so much attention in the investment landscape. Let’s start with one of the questions we received, “What is a cryptocurrency and what makes it different from traditional currency?”
So yeah, a lot of different ways that you could go with that question. As you mentioned, a lot of interest in it. It is, at some level, a fairly complicated concept to understand. I think to really, really understand everything that we’re going to talk about today, you almost need a computer science background, but we’ll try to keep it financially oriented.
So when I think about a cryptocurrency, I think the simplest way… First thing to understand is that, historically, money has been lots of different things, from… You go way, way back to obviously precious metals, to cattle, to… Money has a very, very interesting history.
So cryptocurrency is kind of the latest extension of that, if it holds, which is basically currency that is fully digital and protected with cryptography. Basically, so very secure in terms of how it’s constructed, and different also, in the sense that it’s not centrally managed, as most of us are used to today. Effectively government currencies, for better or for worse, are centrally managed currencies and most cryptocurrencies are not. They’re kind of decentralized in a meaningful way, as we see with Bitcoin. But I think cryptocurrency, at it’s highest level, is just a fully digitized currency.
Okay. So it’s only worth what people think it’s worth, but let’s talk about traditional currency and maybe its history for just a second more, Jared. Because someone could make the same argument about the U.S. dollar today. There was a time where every single dollar was attached to a certain amount of gold, and that is no longer the case. Can you talk a little bit about that gold standard and fiat currency in general and how the U.S. dollar is different from cryptocurrency?
Yeah, so that area in and of itself, there’s a lot of history there. A lot of controversy on the [inaudible 00:02:50] for, “Should we still be on it? Should we not be on it?” But you’re right, we’re certainly not on it anymore. If you look at the late 1800s into the 1900s, basically, a lot of currencies were on a gold standard and you basically saw that unravel right around World War I, where you had a transitionary period into, basically, where currencies were, what are known as fiat currencies, which basically means by law, dictated by law. These are the currencies that taxes and other things are going to be paid in. And that you have that transition, basically, happen in the 20th century there.
Cryptocurrency, I think, you’ll hear people talk about, and I think this is a reasonable way to think about it, as digital gold, being one of the reasons that there was a gold standard, is that gold production doesn’t decline or increase by a significant amount each year. One of the things that you’re always worried about with currencies is the currency depreciating over time. And that linkage to gold basically ensured, at some level, that it was very hard for the outstanding supply of currency to increase a lot, one way or the other.
So Bitcoin, for example, has that kind of feature directly, directly built in. In the sense that there’s going to be a certain amount of Bitcoin that exists over time and it appears that there’s really no way for anyone to overturn the amount of Bitcoin that’s going to be outstanding. So a lot of people, you’ll hear, that are in this world, will refer to it as kind of a digital gold, in the sense that it’s something that’s applied, that can’t be changed in a significant way over time.
Interesting. So one of the words that we hear in association with Bitcoin and cryptocurrency a lot is blockchain. What role does blockchain play in the creation and the maintenance of cryptocurrency?
So that term may be one of the simplest things, fortunately, to understand here. A blockchain is basically just a ledger of transactions that are built out over time. So you can think about the blockchain as it would relate to Bitcoin, is just a very, very large set of data that’s telling you over time, recording all the transactions of Bitcoin that have happened over time.
So for example, one of the two of us owns Bitcoin. If we were to transfer it to someone, if it’s a legitimate transfer, that’s going to be reported in the blockchain. So think about that blockchain, is simply a ledger of transactions that is kept over time and should be very, very accurate, in the sense of not being able to be manipulated with false or fraudulent transactions over time, but really nothing more than a transaction ledger.
So it’s a security feature, really, within cryptocurrency, to a degree?
Right. Yeah. If you read a good bit on this topic, one of the things that was not able to be solved for, historically, with a digital currency, was how do you prevent people from being able to fraudulently spend.
Basically, being able to spend the same unit of currency twice. How do you keep that from being able to happen? Obviously, you can only spend something once, you can’t expand or transfer it multiple times. So the blockchain is, in its truest sentence, is meant to be a way to try to keep that from happening over time. That’s the single biggest reason that something didn’t develop before the late 2000s, was this, basically, security question of, for any currency, how do you keep people from being able to spend it twice? Essentially, so the blockchain is, in its correct or pure form, supposed to prevent that from being able to happen overtime.
Okay. Now, I think we’re hearing once every couple of weeks, something about a new high and it’s these fascinating, almost imaginary numbers, like $50,000 for one Bitcoin. Why has Bitcoin risen so much from its inception in the late 2000s?
So that’s a hard one to answer and you know the financial world as well as I do, there’s no way, over any period, to know this is exactly the reason that it did what it did, even though we’ve got lots of people trying to convince us that they do know the exact reasons why it’s done what it’s done.
I have no doubt that part of what we’ve seen over the last six months, because the price appreciation has been so substantial over even the last six to eight, nine months, there’s got to be some speculative component to that. We’re all humans, when something starts moving down or moving up by a lot, there’s certainly going to be some portion of the investor community that’s going to be jumping on and trying to follow that trend. So there’s some component of it, but it’s speculative.
That said, you’re trying to be balanced in view, I think you do have to give credit to something that, at one point in time and 10, 12 years ago, was basically not anything other than an idea, to now, whether it’s 50,000, 40,000 or 30,000, or who knows what it’ll be next week, there’s still a meaningful value assigned to it, relative to the dollar. So I don’t think… I’m certainly not in the camp that says, “Well, this is entirely a speculative thing.” Maybe it will prove to be that, but I think you have to be skeptical of that, of coming down on that side of the equation at this point too, just because it has, over a pretty long period of time, been meaningfully valued relative to the dollar.
My best guess as to why is that true is kind of everything that we’ve talked about up to now, it does appear to be fairly secure in a reasonable sense. It does seem that the community believes that there won’t be an infinite supply of Bitcoin over time. So I think it is in the process of emerging into something that is a true store of value.
Again, now, I’ll repeat what I said just a minute ago. At another month, it could be down by past the level of volatility that we’ve seen. But I think that there’s certainly a good chance that a lot of what we’re seeing is an emergence of a digital currency and cannot be purely chalked up to, “Oh, this is just pure speculation.”
Well, I appreciate the respect, almost, that you’re giving it, as an investment, as an entity out there in which people could find some value. And indeed, as an investor at all, when you see the story of the rise of this thing, it makes you want to get a piece of the action. So could an allocation to Bitcoin makes sense for me or any other investor?
I’m in the camp at this point that I think it can make sense to a very limited degree for some people. I think I caveat, again, that with some people, because it is going to likely be more volatile than anything else that you would ever contemplate considering as part of your allocation. And that can be problematic for a lot of folks, not to fall into the behavioral traps around something like that, to either get too pessimistic or too optimistic. So I think it can make sense and in a relatively small slice of a portfolio, but very, very small. And I think there are folks that would argue against that, but I’m in the camp that thinks that if you want to have a relatively small allocation here, that could make sense, but you’ve got to be prepared that this is something that could collapse. And there is a tremendous amount of volatility here. So I don’t think you want to get carried away at this point either with it.
For example, when I think about what are the risks that could absolutely show up and I think are one of the reasons we’re seeing such big amounts of volatility, huge amounts of volatility, we don’t know, could something emerge that’s even better than Bitcoin, in terms of its structural features, that’s similar, but perceived to be better? That would obviously be detrimental. We don’t know what the regulatory environment is going to look like as time marches on here and how that might impact cryptocurrencies in general.
So you can definitely see the arguments against, but if somebody said, “Hey, it’s appealing to me. I’m willing to have a small portion allocated.” Certainly, don’t think that’s the end of the world, in terms of… I think that’s a reasonable perspective.
A rousing endorsement, it might not be the end of the world. I get it though. And I also want to agree with you, that when your curiosity is peaked to such a substantial degree, a balanced, understandable portion could absolutely make sense.
However, how in the world would you even do it these days? Do you have to muster up $50,000 to get one Bitcoin, or do you anticipate seeing mutual funds, or exchange traded funds in the near term future that people could utilize for investing in Bitcoin or other cryptocurrencies?
Yeah, so reading the tea leaves here on the kind of the mutual fund ETF landscape, from the folks that we interact with, it does seem like they all believe that is likely just a matter of time at this point. Meaning, they all seem pretty… That people that really, really know this space, seem confidant that at some point, we will see a registered vehicle, a form of an ETF or a traditional mutual fund. And maybe in advance of that, we’ll see mutual funds that do other things, allocating a small slice to Bitcoin. So it does seem like folks believe that will happen at some point.
Here, that said, it’s still, even those folks think it’s about probably 12 to 24 months off. So that still seems pretty distant. And of course, lots of ways that could go off the rails from a regulatory perspective, but does seem, at some point, that would be a direction that folks could go from an allocation perspective. And I think one that would make sense because it’s always comforting to know that you’ve got some kind of registered structure that you’re investing in, particularly if this is something, as an investor, a space that you don’t pretend to know really, really well. So I do hope that happens at some point down the road.
Yeah, for sure. Well, I think it’s the opportunity that kind of magnetizes investors to cryptocurrency because they hear the stories of these huge swings in the upward direction. But let’s talk about what might be the most important factor here, and that is the risk. What are the risks associated with investing in Bitcoin right now, or any other cryptocurrency for that matter?
So there are a number, so I’ll talk about a few that I’ve mentioned already. I think you’ve certainly got one, that could something else emerge that’s perceived to be better by the community. Seems like folks, again, somewhat dismissed that with the scale that Bitcoin has achieved at this point. A lot of folks would say, “Don’t necessarily see that as a big risk because this has already, obviously, become popularized at some level, kind of a networking type of effect.” But I don’t dismiss that risk. I think that’s certainly something that feels like it could be a risk.
Number two, is I think the most obvious, which is just the pure levels of volatility that we’re seeing. I mean, it is way, way beyond anything else that somebody has or considers an investible asset. I mean, we saw February and March in the stock markets. That’s like every day in Bitcoin, those levels of volatility. So of course, that can go in the negative direction in a big, big way. So I think pure price volatility. And that’s one thing that’s a little bit puzzling to people that think a lot about it, surely, there would be some point where the volatility would decrease, but we haven’t arrived at that point yet. So that’s number two to me.
And three, I think of as behavioral related risks that we touched on a little bit earlier, getting we’re all human. No matter how robotic we might try to be, we’re all humans. So I think it’s easy to fall prey either to pessimism, if you see it decline a lot, or getting carried away with the size of an allocation, if it does increase a lot from here. So I think of that as a risk as well.
And then the last one to me, that jumps to mind is the regulatory dynamics. We have no idea how the central banking system and the regulatory authorities are going to respond to this. There’s going to be some level of response at some point, will that be embracing cryptocurrencies? Will that be trying to shut the space down at some level? So who knows where that is going to go and what impact that would have on the cryptocurrency marketplace broadly. So that would be the last one that comes to mind.
So I think there are certainly very, very substantial risks there.
It’s always important to balance the risk and the opportunity. And I think it’s especially important to acknowledge, as investors, our perceived response to the risk part. Because oftentimes, that is what ends up driving behavior. We need to envision how we would respond to that volatility in order to be sure we can deal with it. And Jared finally, it seems as though Bitcoin, cryptocurrency in general is one of those types of investments that forces us to draw a line between speculation and investing, and the line begins to become somewhat hazy. How would you recommend investors discern the difference between a genuine investment and a speculation?
Yep. So when I think of investing, and lots of directions you could go here. When I think of investing, I think of you’re investing in things that, yes, in theory, there’s some kind of world out there where they could completely disappear, but that almost seems like fantasy land at some level, at least over the long-term. So that’s what I think about when I think about what is investing, it’s investing in something that, yes, it could decline by a lot and there’s probably something that could happen that would be a really terrible, terrible long-term event for global stock and bond markets. But that’s certainly way, way out there in the left tail, on the risk perspective.
When I think of speculation, I think of things that, “Well, there might be some good cases with something like Bitcoin, in terms of why it might appreciate over time.” But there’s also a meaningful amount of risk of something approaching complete loss. You’ll hear people refer to it as a liquid venture capital. So venture capital is a very, very risky way of investing in equities. I think there’s that speculation component there, that I think is as meaningful. And as you said, the line is a little bit hazy with Bitcoin, which of those two does it fit in? But I think from a pure volatility perspective, you have to think about it as more in that speculation category. In the sense that there probably are some meaningful ways that you could see just a massive, massive decline in the value, that would be hard to imagine at least over the longer term with kind of the more conventional asset classes that people might think of.
The other thing, I think that’s a good point for Bitcoin, that you’ll hear from some of the folks that are counter to it being an investible asset, I think that’s at least worth thinking about for your question here, is it doesn’t throw off any cash flows when your interest rates are low. So I guess, you could almost say that about fixed income at this point, but historically, fixed income equities, there’s some source of either dividends, interest, something that you’re getting paid in the form of cashflow. This is a currency, so you’re basically, you’re thinking about, “Is it going to rise in price or decline in price over time?” There’s not any cash flows that it’s throwing off. So I think that’s another thing to think about here in terms of this investible asset versus kind of a speculation-related question.
Yeah. And I think for me, one of the most important things about speculation is acknowledging that everybody’s crystal ball is cloudy, as our friend Larry Swedroe would say. And when you hear someone, or read someone who seems to think they know exactly what an investment is going to do, that’s when you could probably be most sure not to listen to their advice.
Right. Yeah. And I completely agree with that. And this is a complex space. I think you’ll hear people with opinions that are wildly divergent, over where Bitcoin is going to go. And I think, again, that’s one of the reasons that you see the volatility that you see. That it is really, really hard today to know where it will go from here, even harder than lots of other things that we think about in terms of investing. So yeah, absolutely.
Well, Jared, thank you so much for answering several of the questions we’ve been getting over cryptocurrency. And thank you for tuning into this episode of Ask Buckingham.
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