If messages into Betterment tell us anything, it’s that, right now, cryptocurrencies like Bitcoin and Ethereum are hot. Many investors want our advice on which cryptocurrencies to invest in, how to think about diversification, and how to get the biggest bang for their buck.
As with any emerging investment vehicle, the truth is, there’s just not great data at this point to support sound, responsible advice for investing in a single cryptocurrency. It’s a bit like providing recommendations on individual stocks that we can feel sure are in your best interest. If you have specific reasons to be invested in an individual holding, such as stock from an employer, then, by all means, we’re interested in helping you navigate your way through it. But otherwise, Betterment—and likely most advisors—would be hard pressed to proactively move a person’s investments toward any single holding.
Still, it’s a reasonable question: What’s the right approach to take if you believe in the potential future value of cryptocurrency? Can we use existing investing principles to find a place for cryptocurrencies in a portfolio?
Prices today are driven by speculation.
The underlying problem any investor should understand about cryptocurrencies, like Bitcoin, Ethereum and others, is that it’s extremely challenging to assess the risks and potential payoffs. Traditionally, a financial asset is valued by assessing its potential to generate cash flows in the future. But cryptocurrencies have no cash flows. Traditional currencies can be partially valued by assessing a country’s debt, governmental stability, and other economic factors. Again cryptocurrencies have no immediate parallel. In the absence of reliable valuations, prices can become unmoored from their true economic value.
Sure, there are underlying operations that shape cryptocurrency—such as the process of mining and investment needed to do so—however, at present, most of the price appreciation appears to be driven by speculative buying.
Without a solid anchor in fundamental valuation, making good investment choices becomes difficult. After all, successful investing involves two parts: selecting the right asset and buying it at the right price.
Can we learn from other speculative markets?
There are several speculative markets that might be worth drawing a comparison to. For instance, in the late 1990s, Internet stock values rose with little relationship to conventional valuations. Some financial writers look at that time period as one we should learn from today with the speculation on Bitcoin.
The problem for skeptics is that in any bubble argument, there are numerous counterexamples of how innovation can and will drive value—and perhaps cryptocurrency is just that: the future of trusted exchange, where markets place greater trust in a decentralized ledger than a federal currency.
The other problem for skeptics is that prices can continue to rise for substantially long periods of time.
From our perspective, there’s not a lot to conclude about cryptocurrency yet. Cryptocurrencies have yet to prove themselves as a means for mass global exchange or as a digital store of value. The promise of this nascent technology is exciting, but also risky.
How to Scratch Your Crypto-Itch Responsibly
What investors can do today is to follow sound behavioral advice for investing responsibly in a particularly speculative holding. You can think of it like early-stage “angel” investing in a start-up company. When most angel investors invest in a business, they hope the business will be successful, but there are innumerable factors that make success difficult. They have to be fairly comfortable with a high chance of value loss. With a highly speculative asset like cryptocurrency, we suggest thinking of a potential investment the same way. While the ultimate payoff of a cryptocurrency investment is unknown, a conservative approach would suggest the investment to be worth very little, with some small chance of a large payout. Like being an early investor in a company, you can’t fully expect to make money given that there are many reasons a business might not succeed, but there is also some chance you might do well.
Perhaps the most important part of this framing is that an investor shouldn’t wager more than she would feel comfortable losing on such an investment.
As with most money-making activities, taxes apply.
We’d be remiss if we didn’t mention the most obvious thing that many cryptocurrency investors don’t consider enough: the role that taxes play. The IRS has issued guidance that virtual currencies should be treated as property, which means that if Bitcoin and other cryptocurrencies are held for investing purposes, profits and losses will be treated as capital gains and losses.
That’s just one more thing to consider before rushing to scratch the itch on the cryptocurrency market.