Bitcoin 101: Is It A Viable Portfolio Option?
By Brady Redington, CFP®
Over the last decade the popularity of cryptocurrencies like Bitcoin, Ethereum, and others have gained momentum and popularity among techies and investors. And with prices reaching all-time highs, cryptocurrency has gained a lot of traction in the news and it is one of the most common things we get asked about by our clients today. For the purpose of this discussion, we will focus solely on bitcoin.
Bitcoin is a virtual currency that uses a cryptographic encryption system to facilitate secure transfers and storage. It is not printed by a central bank like traditional currency, rather it is mined – a process where high-powered computers use an open-source mathematical formula to produce bitcoins. The biggest difference between bitcoin and fiat (traditional) currency is that it is decentralized – meaning that there is no central entity that prints money, like the central bank does. New bitcoins are created in the mining process – and there is a ceiling of 21 million bitcoins (which has not been currently reached) at which time no new bitcoin will be able to be mined. With a cap on the amount of bitcoin that can be created – this means that once the 21 million figure is reached – inflation in the cryptocurrency is not able to exist as no new money will be allowed to enter the decentralized system.
From a tax perspective – bitcoin is treated more like an investment asset than a currency. The sale or use of bitcoin is considered a taxable event that will trigger capital gains taxes similar to any other investment asset. Therefore, any gain in value above the original purchase price of the bitcoin will be taxed at capital gains rates. For example, if you had $100 in cash that you have held in your wallet for a few months and then used that $100 dollar bill to pay for groceries – you obviously would not need to report this transaction as a taxable event to the IRS, whereas with bitcoin you would.
When clients come to us and ask if they should be investing in bitcoin, my simplified answer is: it depends. Bitcoin as an investment is what we consider ‘high risk’ because it is extremely volatile. Although bitcoin has had an extraordinary run up to this point, past performance is no indication of future results. Investment experts have both bullish and bearish opinions on bitcoin and to date, a consensus has not been reached. One of the biggest cases against bitcoin as a long term investment is the likelihood that the government bans the use of the currency if it reaches a certain level of success. On the flip side, we are starting to see widespread adoption of cryptocurrency in the market; Tesla announced that they purchased $1.5 billion in bitcoin and they now accept it as payment for their cars. Wall Street and investment companies are receiving increased pressure and demand to offer more cryptocurrency related investment options and list bitcoin as a legitimate asset class. If and when that happens is yet to be determined.
The figure above showcases bitcoin’s average annual returns compared to more traditional asset classes and indexes and I have included it as a case both for and against investing in bitcoin. If you look closely, you can see that every year since 2011 bitcoin has either been the single worst or single best performing asset class – and not only by a small margin but to a very extreme degree. This should help put into perspective the amount of risk and volatility you should expect if you decide to hold bitcoin in your portfolio.
If you make the decision to invest in bitcoin – do it with money you are prepared and willing to lose. If you are investing dollars that are meant to provide an income in retirement or you have a short-term need for those funds, you should not be investing in bitcoin. There are plenty of investment options and your individual risk tolerance will determine your strategy. Until the price of bitcoin can stabilize and its volatility is reduced, I would proceed with caution.
Any opinions are those of Brady Redington CFP ® and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Past performance does not guarantee future results. Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP®, Certified Financial Planner™, CFP® (with plaque design), and CFP® (with flame design) in the U.S., which it authorizes use of by individuals who successfully complete CFP Board's initial and ongoing certification requirements. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The prominent underlying risk of using bitcoin as a medium of exchange is that it is not authorized or regulated by any central bank. Bitcoin issuers are not registered with the SEC, and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment, and a potential total loss of their investment. Securities that have been classified as Bitcoin-related cannot be purchased or deposited in Raymond James client accounts.