Why Holding Bitcoin is Pure Speculation

The surging price of bitcoin grabs a lot of attention. But it also raises questions about the nature of money and currency. What gives a currency its value?

The Elements of Money and Currency

Money is a medium of exchange. In a way, money is fiction; everything depends on people believing in its value. If enough people agree, anything can potentially be used as money—people have been known to use seashells, salt, grain, and even giant stone disks. Each of these options have drawbacks, of course. Seashells can weather and break. Grain can rot. Giant stone disks are hard to tote around in your pocket. Coins and paper money help solve these problems.

Currency is any widely-circulating form of money. The dollar, pound, and yen are state currencies. Gold is often considered a currency. Bitcoin, ripple, ethereum, and other alt-coins could also be considered currencies. You can exchange modern currencies in physical form, as you do with cash, or in electronic form, via credit cards, payment apps, or cryptocurrencies.

But what constitutes a useful currency? What attributes do we want for the currency we use every day? First and foremost, you need general acceptance. People must agree to accept the currency as payment. This agreement can come through legal means (when the government declares it legal tender), or through organic means (when people decide on their own, like with bitcoin).

Second, you want price stability. You need a reasonable sense of what your money will buy tomorrow, next month, and next year.

If you have hyperinflation, you have no faith in your currency’s purchasing power. Your incentive is to spend or exchange your currency as fast as possible. Many emerging countries (Yugoslavia, North Korea, Zimbabwe) have experienced currency hyperinflation.

If you have deflation, everyone’s incentive is to hoard the currency. If there is no incentive to spend or invest, economic growth stalls. Along with the Great Depression, the United States saw several deflationary periods in the 19th century such as the panics of 1837 and 1873.

A Real-World Experiment

I recall an interesting story that helps illustrate the difference between useful and ineffective currencies. The podcast Planet Money did an episode called Libertarian Summer Camp about a festival for government skeptics. For a few days, festival-goers were completely self-sufficient—they sold food and beer without licenses, traded goods, and discussed abolishing the IRS. They also engaged in a small-scale economic experiment, conducting daily business using silver and gold instead of the U.S. dollar.

It was clear that as everyday currencies, precious metals have some drawbacks. First, it’s hard to pay in small increments. If you want an omelet for breakfast, you need to measure out little shavings of silver. You need to carry around a scale, and unless you trust everyone you’re doing business with, you may have to test each bit of metal for purity. Paper money and electronic payments like credit cards and cryptocurrencies solve this physical problem.

But there’s another big drawback—the prices are volatile. This month, an omelet might cost 0.22oz of silver, but next month, it could be 30% more. Today it’s one price, but tomorrow, who knows? So how did the libertarians solve the volatility problem? They used their smartphones to look up the price of silver (in dollars, of course).

This is a silly anecdote, but the point is that price stability is extremely important for a useful currency. Because precious metals don’t have price stability, people need a stable reference currency (like USD) to decide what to pay. Not knowing what your money will buy tomorrow is not a good quality in a currency.

Mechanism for Price Stability

For decades, the U.S. dollar has exhibited strong price stability compared to other currencies. If you hold dollars, you aren’t worried about day-to-day volatility in your purchasing power. If you save money for a car, you have faith you’ll be able to afford it when it comes time to buy. You aren’t worried the car will cost $15,000 today, $20,000 tomorrow, and $5,000 a few weeks later.

The dollar’s price stability is aided by the central bank through monetary policy. To combat inflation, the Fed decreases the money supply. To combat deflation, the Fed increases it.

With gold, silver, and bitcoin, there is no central bank. If you distrust the government, the lack of a central bank may be a selling-point. But it doesn’t do much for price stability. If you own ten bitcoins or a pound of gold, what can you expect to buy with them next year? What about tomorrow? The lack of a mechanism for price stability is a major disadvantage. Without price stability, gold and Bitcoin are not effective as modern currencies.

Bitcoin and Source of Value

Bitcoin has no intrinsic value. You can’t eat it, use it to build things, or even look at it. It’s a virtual currency that exists in a virtual space—a decentralized ledger called blockchain. Its price is determined entirely by the market, and there is no government or central bank that can influence it. If people want to exchange bitcoin for $10 each, they can. If they exchange it for $1M each, so be it.

Blockchain, the distributed database bitcoin uses, is a useful payment system. It is anonymous, secure, and fast. To use blockchain for payments, you can convert dollars to bitcoin. The seller can instantly convert it back. Payment companies like Coinbase and Stripe already do this. There is no need to hold the bitcoin for more than a few seconds, so you can avoid the volatility risk.

Coinbase promotes avoiding bitcoin volatility.

Many people confuse bitcoin (the currency) with blockchain (the database). Because blockchain is a great payment system, people say, bitcoin must be valuable. But what imbues bitcoin with a specific value? Why should we assume $10, $100, or $1M is “correct”?

Some people claim it’s supply and demand—because bitcoin has a finite supply, the price of bitcoin will simply increase with demand. But if we can use bitcoin for payments without holding it for more than an instant, where is the stable source of demand? Demand comes from people wanting to hold bitcoin, not just use it for payments.

Another concern is the growing number of “altcoins.” Here is a list of the top 100 cryptocurrencies, by market cap. The higher the market price of bitcoin goes, the greater the incentive to create and trade alternatives.

Why Hold Bitcoin Long Term?

For months, I’ve been asking cryptocurrency fans for answers to this question. What are the benefits of holding bitcoin, besides speculation? I hear plenty of good reasons for the merits of blockchain, but never the merits of bitcoin as a currency. As far as I can tell, the only reason to hold bitcoin for any length of time is the belief that its price will rise.

This is absolutely fine, if you want to speculate. If you think bitcoin will trade for $1M in five years, it might make sense to own some. But I wouldn’t bet the farm. It’s an asset with no intrinsic value, no physical form, and no mechanism for price stability. Blockchain gets well-deserved hype, but this does not mean Bitcoin has any predictable value. Maybe bitcoin will trade for $1M someday, but not for any reason other than human behavior.


Postscript

My inspiration for writing this piece was a concerning post last week from someone I’ve known a long time:

Late May Links

I’m working on a piece about Bitcoin, money, and the necessary qualities of an effective currency. But for now, here are some gems from the past few weeks:

Josh Brown on the inanity of cheering on a crash (“throwing spaghetti against the wall”).

Why Monish Pabrai regrets selling Ferrari.

Shane Parrish on seeking out disconfirming evidence.

Ben Carlson on barriers to entry in the investment business.

Robert St. George on information intensity in equity investing.

Why Drawdowns Matter: A Visual Demonstration

Common knowledge in investment circles is that drawdowns are bad. But are they always bad? Are there times when they’re especially bad?

Let’s explore these questions by looking at stocks and bonds. From 2001-2016, the S&P 500 returned +133% and the Barclays US Agg. Bond Index returned +112%. In this time period, the cumulative returns of stocks and bonds were fairly close, but the return patterns were very different.

The chart below shows the growth of a $100,000 investment in these two indices. As you can see, stocks had significant drawdowns during the period while bonds were less volatile. If you simply bought and held for the 16-year period, you would receive a +133% return in stocks and +112% return in bonds. Your account balance would have ended about 10% higher investing in stocks than bonds.

The next chart shows the same initial investment of $100,000, but this time let’s assume you deposit/buy an additional $500 per month. You will notice that under this scenario, stocks worked a little bit better—your ending balance would have been 25% higher investing in stocks than bonds.

The third chart shows the same initial investment of $100,000, but let’s assume you sell/withdraw $500 per month. You will notice that under this scenario, bonds did much, much better—your ending balance would have been 154% higher investing in bonds than stocks.

The three scenarios above illustrate the drastically different outcomes that are possible when investing in the same two indices. The only difference between each scenario is the assumption that you made deposits or withdrawals along the way.

What it means:

The three scenarios above demonstrate the importance of drawdowns depending on your situation.

1) If you make no trades, the return pattern doesn’t matter—the only thing that matters is your return. Of course, this is not how most people invest.

2) If you’re depositing on a regular basis (e.g., a young person with a 401(k)), big stock market drawdowns shouldn’t scare you. In fact, drawdowns help you, because they allow you to buy more shares at a lower price.

3) If you’re withdrawing on a regular basis (e.g., a retiree), drawdowns matter a lot. If you sell during a drawdown, you have to sell a larger quantity of shares to get the same dollar proceeds.

This is not a comment on the behavioral effects of volatility. These scenarios assume you can stick to a regular plan.

The above simply demonstrates  how much return patterns matter depending on the investor’s situation. Drawdowns are not always bad, and can be beneficial to someone  with a long time horizon who is dollar-cost averaging. But drawdowns are absolute killers if you’re making regular withdrawals.


Postscript (Into the Weeds)

I often see discussions of the negative effects of volatility. For example, this Michael Batnick post makes the valuable point that “outsized volatility is a drag on returns.” It shows how a portfolio can erode over time if it experiences alternating gains and losses.

The below chart shows what happens over time to a dollar if it experiences alternating gains and losses of +10%/-10%, and +20%/-20%:

But here’s the thing: volatility is not what causes the value to drop. The reason is that a gain of 10% is not equivalent to a loss of 10%.

If you lose 20%, you need a 25% return to get back to zero. So -20% is equivalent to +25%.

To find the equivalent loss for a gain of 10%, we can use the formula 1/(1+r)-1, which in this case is about -9.09%. This is because single-period returns are compounding, not additive.

In other words, a single-period return of 10% is actually equivalent to a loss of 9.09%. You could alternate returns of +10% and -9.09% forever and never fall below your original dollar.

A portfolio can experience equivalent gains and losses forever, but the trick here is that +10% is not equivalent to -10%, and +20% is not equivalent to -20%.

 

Bad Incentives and Portfolio Managers as Salesmen

This is part one in a series about how active management could be better. This is my perspective alone. Of course, the dynamics I describe do not apply to all managers. In a prior piece, I explained how active managers could theoretically outperform their benchmarks; now we arrive at the question: why don’t they?

Part One: Bad Incentives and Portfolio Managers as Salesmen

Incentives are powerful. They unconsciously motivate everything we do. Even with the best intentions, the wrong incentives will keep pushing us to do the wrong thing. “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it,” says Charlie Munger.

Across vast swaths of the money management business, the incentives are broken, causing a vicious cycle that erodes returns. I will describe how this dynamic plays out.

There is a giant pool of portfolio managers (PMs) trying to build a track record. In such a large field of PMs, some will have periods of strong performance. Some perform well due to talent, others due to luck.

For a PM who shows good short-term performance, the incentive is to sell based on that performance. It’s hard to resist because the PM gets most of his income from a percentage fee on assets. The more the PM wants that new vacation house, the less he cares about his strategy’s fit for prospective clients. The prime directive is to grow AUM and ask questions later. He might employ a sales team whose bonus is tied to short-term inflows. Because the sales team has no long-term incentive, they will be eager to please. With these incentives, every prospective client seems like a perfect fit for the strategy.

Second prize is a set of steak knives.
Due to the laws of probability, the strategy does not outperform forever. Now that the PM has built a sizable AUM, his incentives shift to retaining assets. When performance lags, there is enormous pressure from clients to defend every quarterly return. The PM may say “some periods of underperformance should be expected in this strategy,” but that’s not how he pitched it when times were good. Clients are upset. The PM becomes myopic, short-term focused. There is pressure to hug the benchmark. It becomes harder and harder to stick to the strategy that gave him success in the first place.

It doesn’t help that many large clients want active managers to hug the benchmark. Many prefer closet indexers. Many consultants rank PMs using “optimization formulas” that heavily penalize managers for deviating from their benchmark. In my opinion, this is an area where the industry has lost its mind. If you don’t want deviation from the benchmark, don’t hire active managers—buy an index fund. If you just want less deviation from the benchmark, allocate less to active management!

Most equity managers don’t believe they can outperform every single year, much less every month. Not everyone is Renaissance Technologies. Most PMs have long-term investment strategies; they expect to have good years and bad years.

But misaligned incentives create a bad dynamic: when performance is good, the incentive is to sell fast, grow AUM, and ask questions later. This creates a poorly-fitted client base of impatient investors with unrealistic expectations. When performance lags, PMs feel pressure to become defensive or hug the benchmark, forgetting what brought them success in the first place.

What can be done about the problem of incentives?

Underlying almost every problem with active management is an uncomfortable fact: there is still more of it than we need. Too many PMs try to grow AUM without making sure clients are a good fit. Too many clients hire active managers without understanding the strategy. They develop unrealistic expectations and don’t stick with the strategy long-term. For many investors, indexing is a better approach. Encouraging more investors to use index funds will improve active management.

The other problem affecting PMs and their clients is a culture of impatience and desire to get rich. For most of us, active management shouldn’t be about getting rich quickly; it should be about getting rich eventually. Active managers should charge lower base fees (fees based on a percentage of AUM). When possible, they should use long-term performance fees and invest more of their own personal savings in their strategies. Aligning these incentives places the PM’s primary focus on long-term returns, not month-to-month AUM.

Finally, active managers need to focus on setting the right expectations and building trust. Some PMs have been model citizens in this regard. Seth Klarman’s Baupost Group has gone so far as returning money to investors when it doesn’t see enough good investment opportunities. If clients understand an investment strategy and trust it for the long term, the manager won’t need to do backflips every time quarterly performance lags a bit.

Changing these incentives would certainly benefit clients, whose fortunes are on the line. For many PMs, this could mean less money. But the system would be fair—the best active managers could thrive just by implementing their strategy. If they skillfully invest a sizable chunk of their own money, they will earn great returns for themselves. With great returns, they can attract a well-fitted client base and build a solid foundation of trust. It may take a bit longer, but everyone will be better off in the end.

Netflix, Precision, and Stories

We think in terms of stories and analogies. We were born to do it. In SapiensYuval Noah Harari argues that our penchant for telling and believing in stories is the “mysterious glue” that allowed humans to cooperate and dominate the world.

While stories may encourage cooperation, they can sometimes blind us to reason. Daniel Kahneman illustrates how stories can breed fallacies in Thinking: Fast and Slow.

He describes an experiment involving a fictional woman named Linda. In the experiment, Kahneman and his partner Amos Tversky described Linda as a young, single, outspoken, brilliant philosophy major “concerned with issues of discrimination and social justice, [who] also participated in antinuclear demonstrations.”

They then asked people which was more probable:

(1) “Linda is a bank teller.”

(2) “Linda is a bank teller and active in the feminist movement.”

They found that “85% to 90% of undergraduates at several major universities chose the second option, contrary to logic.”

We can be so willing to take a narrative, form a mental picture, and categorize things that we set aside reason.

The same thing can happen when discussing businesses, and few companies are as well discussed as Netflix. In a recent appearance, CNBC guest David Trainer argues that Netflix’s valuation is “disconnected from fundamentals.” He claims that that investors “seem to be unbelievably gullible these days,” and that Netflix is a “story stock.” Trainer mentions profit margins and multiples to suggest that Netflix is hugely overvalued, and explains that investors are falling victim to a false narrative.

But which is the false narrative? Although Trainer derides Netflix as a “story stock,” isn’t he constructing his own story here? He seems to apply a standard valuation framework, compares Netflix to other content creators like Disney, and posits that it’s “a tough business to be in”. He asks, “can you name any businesses in the history of the world that have consistently [sic] created profitable new content?” The framing of that question sounds suspiciously close to a story.

The problem with this way of thinking is that some businesses have predictable economics and some have highly uncertain economics.

In an electric utility, for example, we can be somewhat confident in forecasting future cash flows. We might look at population trends, trends in energy consumption, and the utility’s cost per watt. The industry is highly regulated, so utilities have limited ability to increase margins. Given those constraints, if we try to place a value on XYZ Utility, maybe we’ll say it’s worth $1 billion, or maybe it’s worth $1.2 billion, but it’s definitely not worth $10 billion. With this type of business, we could use multiples or industry comparables and feel pretty good about our estimate of value. It’s a fairly predictable story.

With a business like Netflix, the future is incredibly uncertain. We do not know what its programming content will cost in ten years or how much pricing power it will have. We don’t know what its innovations will be. Trying to use a quantitative approach like discounted cash flow or even comparables to value this type of business is fraught with danger.

So why might Trainer be wrong? Why might the market think Netflix is worth $60 billion?

Consider what the business is, who runs it, and what it could be in ten years. The company is building a massive stream of recurring revenue with sticky subscribers. It has an innovative team. We can see the trends in cable vs. streaming, and we can imagine a future in which Netflix could raise prices without losing many subscribers. A business with almost no need for physical capital has the potential to send additional revenue directly to the bottom line. Netflix might not live up to lofty expectations, but there is something real here. Maybe investors aren’t just being “gullible.”

Sometimes, using a valuation formula or comparables can be dangerous. To quote Seth Klarman, “Any attempt to value businesses with precision will yield values that are precisely inaccurate.” We should be skeptical of any stock that has a sky-high valuation, but we should also be skeptical of valuing a business by formula or by analogy. Valuing a business like Netflix is like looking through fog. If you’re looking through fog for land on the horizon, don’t use a magnifying glass.

Disclosure: I do not currently own shares in Netflix.