THE FUTURE FOCUSSED PORTFOLIO – PART V:
INVESTING IN BITCOIN – THE ADVISER’S GUIDE TO CLIENT CONVERSATIONS
Maybe you’re curious about Bitcoin, maybe you are grossly opposed to it.
Either way, your clients are likely asking about it.
As someone who has spent many years learning about Bitcoin and Web 3.0, I can confidently say, we are entering a stage where it is a necessity for investors to have exposure to Bitcoin.
The size of the allocation is debatable, but keep in mind: not taking a position in Bitcoin, is in fact taking a position – a strong one. I liken this to insurance; a concept advisers know all too well. Bitcoin is no longer just a speculative edge case asset with ‘no fundamentals’, it is coming of age and as a trusted adviser it’s imperative that when your clients ask (and they will ask) that you understand how to navigate their questions.
So as a guide, here is your five-minute introduction, to put you in a position to comfortably talk about Bitcoin.
IGNORE THE TECHNOLOGY
The first point is to ignore the tech. Yes, while the technology is important in enabling the Bitcoin network, it is only that, an enabler, and it muddies the waters. The value proposition is what makes Bitcoin valuable (Figure 1, below). Too many people focus on the Blockchain and write Bitcoin off as generation 1 tech that will be superseded by more efficient technology, missing completely the sustainable value proposition that makes it what it is.
Bitcoin’s true value lies in the asset.
Figure 1: The Bitcoin Map
MONEY IS HARD
Money is an invention. Created by humans to solve the ‘Double coincidence of wants’ (an economic phenomenon where two parties each hold an item that the other wants). Money has been and can be anything, there are just consequences of using certain forms of money over others. History is littered with examples of money that in hindsight have been devastating to a society to use, Aggry beads in Africa in the 16th century for one.
So, what makes good money?
Humans have over the last 5,000 years used gold as a reliable form of money. The reason? Gold solves three key necessities of money:
The last point is arguably the most important. And while many of you will think of perishable goods here, what it means is that gold has the ability to carry value over time, to store wealth over time. Because creating new units of gold is hard. We measure this hardness, by a metric known as the stock-to-flow ratio (Figure 2, below). It is clear why gold has become the monetary standard over history, followed by silver.
Figure 2: Stock-to-flow ratios gold and silver vs. Commodities
Existing stock versus yearly flows
MONEY SERVES THE PEOPLE
Gold however has become increasingly impractical as money, as society has become more mobile and technological advancements have occurred. Moving gold from one destination to another became risky and burdensome, and the simple solution was to create paper certificates that were more portable and divisible, and still linked to the monetary value that underpinned it.
While attractive this came to have two unintended consequences. Firstly, the role of silver as a more divisible currency severely diminished, causing an extreme devaluation of silver that has not since recovered from the late 1800’s.
The silver to gold ratio has remained relatively low throughout history. The Roman Empire pegged the ratio at 12:1, and this ratio remained relatively stable until paper currency became more widely adopted (Figure 3, below). The lesson? Money serves the people, and if money stops playing its role the monetary premium dissolves.
Figure 3: Gold/silver ratio through history
The second unintended consequence was the eventual shift away from the monetary asset itself. The banks that were storing gold eventually began issuing more paper certificates then they had gold, underpinning it (why not create money if you can?). At the risk of oversimplifying, over time these banks turned into central banks, and we eventually created state-issued certificates that had some backing to gold but were not redeemable for gold. This is fiat currency.
Fiat currencies have lost more than 95% of their purchasing power in comparison to hard money (gold) since the 1930s (Figure 4, below). The incentive for governments to print money in times of crisis is too strong, and the increase of money into the global economy eventually forces hard assets to reprice to a devalued fiat currency.
Figure 4: All Major Currencies Have Depreciated Relative to Gold
The ability to create (print) money for state-funded projects is not necessarily bad, there have been many government-funded projects throughout history that have helped increase the quality of living for a society. The problem is when the money being created is not well allocated, and inflation starts impacting lives in a negative way – when the money stops serving the people.
A SHIFT TO AUSTRIAN ECONOMICS
Moving back to gold is certainly a solution, and maybe it is part of the solution, but gold in today’s digital economy will face an even tougher challenge than it did in the early 19th Century.
Bitcoin takes the hard monetary properties of gold and improves on them in a digital format.
Bitcoin provides a potential pathway for society to move away from the risks of fiat-based money without compromising on the digital nature of today’s financial system. As with Aggry beads and silver, the importance of a new form of money cannot be understated. If society was to shift away from Keynesian economics to Austrian economics (Hard money) the impact on the global financial system would be severe.
Imagine a market based, deflationary system for money, where our key store of value or cash does not devalue, it is completely at odds with the current financial system.
Read that again. It is important.
Most of the global financial system today is built around the idea that money inflates, and that investors must allocate capital to outpace inflation. (I’m sure many of you would understand this from adjusting your Xtools+ assumptions up for increased inflation. You’ve adjusted them up, right?)
But if investors didn’t have to step outside cash to maintain their purchasing power the ramifications would be extraordinary, as the need for financial services would simply diminish. Australian investors in particular would be greatly exposed with 25% of the ASX comprising financial services.
BITCOIN: NOT ALLOCATING IS NOT INSURING
In investing we work on probabilities. No one can be certain, it is why we diversify our portfolios across assets, it is why we take out insurance. Bitcoin is very much in the same camp. Bitcoin has proven to be resilient in its early years, and today, every metric of Bitcoin speaks to a story of growing adoption. We’re seeing uptake across developing countries; companies are storing Bitcoin on their balance sheets; governments are introducing it as legal tender, and asset management firms are starting to allocate to Bitcoin.
Of course, allocating to Bitcoin isn’t just about exposure to the upside, it is about protecting from the downside in the existing portfolio. It is about protecting from a transition in monetary policy, that could be severe to many investors heavily exposed to the current monetary system. Bitcoin is not a perfect store of value today. But as Bitcoin matures it will move from a risk-on asset to a risk-off asset, the volatility will lower and the confusion about it acting like a store of value will fall away (Figure 5, below).
Figure 5: The monetary policy journey
Allocating to Bitcoin is about recognising the path that Bitcoin is on and the probability of failure or success. We believe that the case for failure in many advisers’ minds is heavily overstated, meaning their clients are currently uninsured.
BEYOND HARD MONEY
While this is only an introduction to Bitcoin, it would be incomplete without touching on some of the innovation that is occurring in the Bitcoin protocol, which is adding value to Bitcoin beyond the monetary asset.
The Lightning Network is a key development that is enabling Bitcoin to scale to billions of users. The idea of buying coffee with Bitcoin was laughable just a few years ago but the Lightning Network is enabling just that with effectively free transactions. This same innovation is being utilised by Strike to send money internationally, for close to free as well. Strike enables these free USD transfers by using the lightning network in the background. This means the payment rail for international money transfers could be changing too.
Taproot is another recent innovation that is also helping to solve scalability but in a different way. Taproot has the potential to open up much more complex transactions on Bitcoin as well and allow the network to more easily upgrade in the future.
Both these innovations are still relatively early, and it would be hard to put too much weight on their value – but the point is that Bitcoin is continuously developing and the utility of the Bitcoin network will only increase.
BITCOIN AND CLIENTS
Talking to clients about Bitcoin can be daunting, some know it all and for others, it’s just ‘all over their head’. It is polarizing, to say the least.
But, it doesn’t have to be.
Bitcoin is less about technology and more about money, how money should be governed and the cost of inflation over time. Like politics, there will be very strong opposing views.
As an adviser, protecting your client’s portfolio for future outcomes is what is important here, it is not what you believe ‘should happen’ it is what is ‘likely to happen’. As usual, education is the key. Put aside the hype, so that you can have these important conversations and not be caught out.
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