How Bitcoin Works: Part 3 - Trading in Cryptocurrency

published by:
March 30, 2021
How Bitcoin Works

How Bitcoin Works: Part 3 - Trading in Cryptocurrency

We covered a lot of ground in part 1 and part 2 of this three-part series on cryptocurrency. You may or may not be interested in using cryptocurrency as a means of exchange. But what about trading in it, directly or in fund form? If you’re considering that possibility, know that, at this point:

·        Cryptocurrency is a highly risky holding: For every cryptocurrency success story you read, there are plenty of other tales of woe. 

·        Cryptocurrency is not an investment; it’s a speculative venture: Bottom line, cryptocurrency doesn’t fit into our principles of evidence-based investing … at least not yet.

Remember the Risks 

All the transactional risks we covered in part 2 can also impact cryptocurrency traders. To recap, these include:

·        Potential loss or theft of an underlying cryptocurrency you’re holding

·        Loss of equilibrium between a cryptocurrency’s supply and demand

·        Governmental regulation hobbling a cryptocurrency’s growth potential

·        The massive energy consumption required to mine cryptocurrency

That’s a lot of potential buzzkill for your happily-ever-after holdings. These and other risks have translated into a highly volatile ride for cryptocurrency traders. This is one reason you might want to think twice before piling your life’s savings into them.

Then again, every investment carries some risk. Without risk, there’d be no expected return. That’s why we also need to address an essential difference between evidence-based investing vs. speculative ventures. It has to do with how we evaluate future expected returns.

Setting Expectations

What’s a bitcoin worth? A dollar? $100? $1 million? The answer to that has been one of the most volatile bouncing balls the market has seen since tulip mania in the 1600s. As described in this Wall Street Journal piece, bitcoin was trading for around $7,000 per coin in early 2020; as of February 20, 2021, the price topped $55,000. By the time you’re reading this piece, there’s not much stopping it from being worth far more than that, or far less.

The problem is, there’s no way to establish meaningful expectations either way. In his column, “Bitcoin & Its Risks,” financial author Larry Swedroe summarized how market valuations typically occur:

“With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With bitcoin, none of the preceding analysis is possible. Bitcoin is purely speculation.”

Here are several others weighing in on the matter:

“Bitcoin’s fundamental value is zero. … It’s almost all speculative.”

—   Steve Hanke, Professor of Applied Economics, Johns Hopkins University

“[Bitcoin] is not a vehicle for investment, not a store of value, and not an inflation hedge. BTC is not a capital asset: it does not generate cash flows derived from economic returns on capital. Its extreme volatility invalidates claims of a reliable store of value and calls into question any inflation-hedging properties.”

— Alex Pickard, Vice President of Research, Research Affiliates

“Bitcoin depends on the faith of investors and nothing more. It could equally well go to zero tomorrow if 10% of investors sold.”

— Eswar Prasad, Trade Policy Professor, Cornell University

“You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

— Alan Greenspan, former Federal Reserve Chair

Investing vs. Speculating

In other words, we’re not saying it’s impossible to profit from trading in cryptocurrencies. But the attempt more closely resembles a game of chance than an investment. In contrast, evidence-based investing enables us to create a unified portfolio we can manage according to YOUR individual goals and risk tolerances. Evidence-based investing calls for the ability to:

·        Estimate an asset’s expected return, based on relatively well-established fundamentals

·        Factor in how different asset classes interact with one another within your total portfolio

·        Provide a sensible structure for embracing a long-term, buy, hold, and rebalance strategy  

Cryptocurrency doesn’t yet synch well with these parameters. It does have a price, but it can’t be effectively valued for planning purposes.

Venturing Forward 

All this said, what if you are still interested in trading in cryptocurrency for fun or potential profit? If so, here are vital tips to consider:

(1)  Treat it like an entertaining trip to the casino. Don’t venture any more than you can readily afford to lose!

(2)  Use only “fun money” outside the investments you need to fund your essential lifestyle.

(3)  If you do strike it rich, regularly remove a good chunk of the gains off the table to invest in your managed portfolio. That way, if a bubble bursts, you won’t lose everything you’ve “won.” (Also, set aside enough to pay any taxes you may have incurred.)

Making Sense of Cryptocurrency

This wraps our three-part series on cryptocurrency. We hope it’s helped you put this headline-grabbing subject in proper context. What other questions can we answer for you? Whether cryptocurrencies mature into mainstream transactional tools or they eventually wither on the vine, we remain available to assist you in managing your total wealth in whatever form it takes.

Have questions about your personal financial situation? Please contact us to discuss.

Are your retirement funds in alignment with your Risk Number? Are your investments keeping you up at night? Find your Risk Number® now!

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At RCS Financial Planning, our mission is clear and straightforward: to provide personalized wealth planning and investment advice that minimizes our clients' financial concerns and maximizes their long-term peace of mind.. We firmly believe that a true financial partner shows you how to make the best choices for your future by always focusing on your needs first. And our fee-only service model ensures there is no conflict of interest.

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