Dealing with Bitcoin FUD

If you are like me and have devoted a significant portfolio allocation to Bitcoin, it's relatively easy to fall prey to the "FUD" or Fear, Uncertainty and Doubt that is often spread by the media directed at Bitcoin.  It comes and goes in waves and usually peaks after a big run-up in the price of Bitcoin.  As a long term investor, it's important to do your own research, your own thinking and stick to your strategy - whatever works best for you.  I have found that Bitcoin requires a significant amount of research to understand how it works, but having done that research I still learn more every day and I continue to be committed to having a "nonzero" position in it.  

Here are some of the most common types of Bitcoin FUD:

• Governments will "outlaw" 

• It's a "bubble"

• It's a Ponzi scheme

• Something better will come along

• There's nothing of tangible value (unlike gold or silver)

• It will crash 90% 

• It is used for illicit / criminal activity

Whenever something is new, it's difficult for most people to see the potential.  This could be said of many inventions in the past, such as electricity or the automobile or more recently, the internet.  I recently watched a video clip of Bill Gates on the David Letterman show in 1995 explaining the internet and what it does and Letterman was cracking lots of jokes about it.  I believe the current status of Bitcoin is much like the early internet days and you have similar camps of believers and naysayers, both are equally convinced they are "right." 

When you think about Bitcoin, its most obvious use case is as a commodity similar to gold, where it can be used as a store of value.  In fact, that's exactly what Bitcoin was engineered to be:  programmatically safe, sound money that cannot be debased.  Where Bitcoin is superior to gold is in how it can be stored and transferred digitally at very low cost compared to gold.  Indeed, it is impractical to store and transfer large amounts of physical gold.  Bitcoin is already recognized in the United States as a commodity and many investors believe that as long as the government is able to maintain regulatory control over Bitcoin and get their tax revenue from the sale of Bitcoin (approving Bitcoin Exchange Traded Funds in the US will go a long way toward these objectives), Bitcoin should have a path forward in the US.  

Banning Bitcoin would be silly and a few countries that have tried like India and Nigeria have had to walk that back because ultimately it puts your country at a disadvantage to the rest of the world that is adopting Bitcoin.  It's also practically very difficult to do with a decentralized digital asset.  Also, with a $1Trillion market cap, an outright ban on Bitcoin would be an unconstitutional taking of property and would be extremely unpopular.  There is a whole industry and ecosystem growing up around Bitcoin and that means jobs, many of which we can't even conceive of today.  That's important for economic growth and governments will hopefully soon realize that is the case.  

The more intriguing use case for Bitcoin is the concept of using it as a "base layer" of a new digital decentralized financial network.  Many people are familiar with Etherium, another digital currency that supports "smart contracts" using blockchain technology and that allows for all sorts of financial innovation.  However, the Etherium protocol, although popular, is still a work in progress technically while Bitcoin is essentially a completed project.  What I have learned recently is that there are entrepreneurs who are developing similar smart contract protocols that can work on top of the Bitcoin network, leveraging its large computing base and extremely strong security.  An example of this is Stacks.co.  This next generation of financial technology can bring the best of both worlds together allowing for low cost, rapid and secure "smart" financial transactions without the need for an intermediary and leveraging the Bitcoin protocol for settlement and payment.  I think this is probably the most compelling use case for Bitcoin and one that could dwarf the demand driven by investors and corporate treasuries as an alternative asset.  

Ray Dalio, an investor I have a lot of respect for, created a stir last week by suggesting that it's probable that Bitcoin could be outlawed in the US and other countries (indeed, as noted above that has already been happening).  While that is indeed a possibility (gold ownership was outlawed in the US for many years), I think this only happens if Bitcoin becomes a threat to the demand for US Treasury debt.  The government needs to be able to issue a lot of Treasury debt to fund operations and ongoing stimulus programs and the Federal Reserve doesn't want to be the only one buying all those bonds for obvious reasons (i.e. monetary inflation through monetization of the debt).  I think that only happens in a hyperinflationary scenario in the US, which seems very unlikely.  The Federal Reserve, even if they are late to the game, cannot allow inflation to get out of hand although they can let it "run hot" for a while which should do plenty of damage to cash and bond holdings.  Stocks, especially cyclicals, will continue to see a boost in this environment since investors have no other good investment alternatives (gold and silver have done nothing, which is why investor demand for Bitcoin as an alternative asset class has been so strong).  

Also, as Cathy Wood, another great investor I follow says, there are very powerful deflationary forces at work in the world today due to technological innovations.  Indeed, you really don't have strong inflation without wage inflation and until the unemployment rate is extremely low, you won't see wage pressures.  My own observation from the COVID19 pandemic and recession is that many of the jobs that were lost may never come back since companies have rapidly accelerated adoption of technology to replace labor, which means that wage inflation may have a tough time taking hold.  If we see any signs of deflation, investors will run right back into Treasuries, which was what we saw during the Great Recession and also more recently last year and whenever an economic downturn happens.  That would solve the Treasury demand problem and many investors (as they have been until very recently) might still be willing to accept zero or slightly negative real rates of return in exchange for "safety."

The volatility of Bitcoin is expected to settle down as it gains adoption and over the long haul, should approach a more "normal" rate of appreciation commensurate with inflation.  In the meantime, the network effect will be a major driver of the price of Bitcoin, since greater use as an alternative investment, more use cases and a fixed supply will continue to drive the price up.  The nature of the network effect is that there is a massive advantage to the first mover (in this case Bitcoin, which is the first global monetary network) and the only way you are disrupted is if something comes out that is 10x better.  While that's a possibility, the first-mover advantage is huge as we have seen with the likes of Amazon, Google, Facebook, Netflix, and Apple.  If you are going to own Bitcoin, you have to be willing to hold regardless of the price action, whether up or down, with a time horizon of at least 10 years I believe.  Bitcoin will continue to be volatile in the near term, that much is certain. 

A Ponzi scheme usually has a sponsor who is making money at the top by taking in investments, keeping most of the money for personal use or funding the occasional redemption and paying out a small amount to investors as a "return."  Bernie Madoff was running such a scheme - the largest in US history - and was able to do it for years by showing great results to his investors, and it all fell apart when the stock market crashed during the Great Recession.  The Ponzi falls apart when new investors stop coming in and the operator is unable to pay interest or redemptions to existing investors.  Based on this definition, Bitcoin can't be labelled a Ponzi scheme because as a decentralized platform there is no central sponsor who is enriching themselves at the expense of new investors and there's certainly no faking the price of Bitcoin since it is actively quoted and traded 24 hours a day, 7 days a week.

As far as criminal activity, ironically Bitcoin is probably the worst way for criminals to transact because the blockchain is open and everyone can see it.  This actually makes it easier for law enforcement to "follow the money."  Historically dollars (especially paper bank notes in suitcases) have been used for way more illegal activity than Bitcoin has.

In conclusion, while there is plenty of FUD out there, when you look at the facts there's not much reason to be concerned if you have a long-term buy and hold approach to Bitcoin.  Your percentage allocation should be in accordance with your comfort level and I certainly am not recommending going "all in," as some have done.  It still makes sense to have a diversified portfolio consistent with a strong Financial Fortress, since not all assets are always "working" at the same time.  The outlook for cash and bonds with ongoing monetary and fiscal stimulus not just in the US but globally, suggests that a higher allocation to alternatives such as Bitcoin make sense in the current environment.  

I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2021.  To see all my books on investing and leadership, click here. 

Stay safe, healthy and positive.