Discover why investing in Bitcoin or Gold is a trend in 2021.foto:
Most asset classes have some degree of controversy.
Investors will debate endlessly regarding whether a stock is overvalued, whether bond yields make sense for the current environment, to what extent oil will be used two decades in the future, and so forth.
But few asset classes are quite as controversial as gold, bitcoin, and other alternative monies. Some people literally put every penny they have into them and trust nothing else, while other people can’t possibly see why they hold any value at all.
Others like me simply incorporate them into parts of a portfolio mix.
Since they are not cashflow-producing businesses or industrial commodities with analyzable supply and demand balances, the bull/bear gap is unusually wide when it comes to valuing things like gold or bitcoin, not just in terms of price but in terms of the very purpose for their existence as investable assets. Some people love them and will happily dollar cost average into 50% price crashes, while others dismiss them as yellow rocks and magical internet money and maintain zero position in the assets under any context.
And yet, it was illegal for Americans to own gold for about 40 years, from the mid-1930s to the mid-1970s. In some places today, it’s illegal to own bitcoin. Governments sometimes find them to be dangerous. How could something so useless, also be so dangerous? Useless things rarely get banned, and instead can be safely ignored as they work their way towards oblivion over time.
This article attempts to shed light on their popularity. So, rather than focusing on specific price forecasts in this article, I’ll be analyzing the reasons behind their use. If you’ve never held gold or bitcoin and don’t quite get what all the fuss is about, consider this your Rosetta Stone to understand why many people do value them.
From there, we can then determine in what economic environments their price is likely to go up or go down from an investment perspective, to see how they can be useful in the context of a diversified portfolio.
There are remarkably few financial assets in the world that you can hold for a long time without trusting a centralized counterparty to hold it for you.
The vast majority of assets, like stocks and bonds and cash accounts, are held by financial institutions on your behalf or rely on centralized databases listing you as an asset owner.
Real estate is the biggest asset class that you self-custody (in a manner of speaking), but it’s not portable or liquid or fungible.
Collectibles are often a self-custodied form of asset, but they’re not very fungible or liquid, meaning that each individual unit has various quirks such as date, condition, or type that make it hard to exchange for other goods or services. The same is true for gems.
That leaves physical cash, precious metals, and cryptocurrencies as the only asset classes that can be self-custodied and traded with others without a trusted/centralized third party, while also being sufficiently liquid, fungible, and portable. In other words, they are among a small number of money-like bearer assets.
If you think about it, it’s actually really hard to invent a money-like asset that derives value from itself. If you and me want to exchange fungible value in any arbitrary amount without a third party, online or offline, there are remarkably few ways to do it. Usually we don’t particularly want to do that so it’s not a problem (we’re fine with a third-party involved, like a credit card transaction), but if we think about how we would do that if we wanted to, there are surprisingly few options.
Just about any mechanism that we can exchange value with, in a way that is liquid and fungible, requires processing/verification by a centralized third party, and that third party can spy on the transaction or block the transaction. Physical cash, precious metals, and cryptocurrencies are the exceptions, where they can be both held and transacted with outside of any centralized third party custodian or verifier.
Physical Cash: Pros and Cons
Physical cash depreciates in value over time. Policymakers around the world target a positive inflation rate, often 2% or higher, and the amount of fiat currency in existence grows over time.
The word “fiat” means an authoritative declaration. Fiat currency is just paper or bits of information with no inherent value or supply caps, and thus is not something that usually self-organizes towards usage. It requires the government to mandate its use by force, which means by taxing other asset transactions, making taxes payable only in their government-issued currency, and in some cases implementing capital controls or banning competitor assets to their currency.
An exception to the rule that fiat currencies tend not to self-organize, would be that in various developing countries with particularly weak currencies, dollars or euros are sometimes traded in black markets or out in the open, and are considered a relatively hard form of money compared to the local alternatives.
An example of a developing market currency that historically has issues, is the Egyptian pound. Egyptians saw their cash savings lose half of its value against the dollar or euro practically overnight in November 2016, whether it was held in a bank or not. And that’s a country with 100 million people.
Over the past century, the strongest currencies, like the Swiss franc and US dollar, lost over 95% of their value. The average currency lost more than that, like around 98-99%. The worst currencies lost 100% of their value.
Even in a less extreme and more recent environment, the dollar lost about 40% of its value against official consumer price inflation since the year 2000.
The only way to counteract that is to hold cash with a bank to earn interest, and thus involve a counterparty. In particularly inflationary decades, the interest often isn’t enough to keep up with inflation. This chart shows T-bill interest rates minus the official CPI inflation rate since the 1930s; whenever it’s below zero it means T-bills (and by extension bank cash accounts that generally have similar rates) aren’t keeping up with inflation even when earning a yield.
And for longer-term savings instruments, here is a chart of the inflation-adjusted forward annualized rate of return of buying 10-year Treasury notes that year and holding them to maturity. You can see the three decades where bondholders got massacred, because the underlying dollars were devalued. During those times, anyone who bought Treasuries and held to maturity received annualized real returns of as low as -4% or -5% during the full duration of the note.
So, cash is useful as a medium of exchange and less-so as a store of value. It’s something we hold as working capital that we can usually expect to be reasonably stable a few years out (at least in developed countries), but not something that can be considered a long-term store of value outside of the financial system, and sometimes not even within the financial system.
Plus, the current iteration of fiat-only currencies is actually only about five decades old, as it became the norm in 1971. It’s a surprisingly recent system even though we take it for granted today.
And technically, cash does rely on a trusted/centralized third party (the government). It’s just that the trusted/centralized third party doesn’t need to be present for transactions to occur, and doesn’t need to hold it for you. As a bearer asset, cash can be self-custodied and exchanged with other people offline, with no direct counterparty.
Precious Metals: Pros and Cons
Gold and silver are the longest-running fungible stores of value, stretching back thousands of years on multiple continents.
Since gold is nearly chemically indestructible and can be re-melted and re-forged any number of times, it basically lasts forever. Unlike industrial commodities that are regularly consumed, gold has a high stock-to-flow ratio, meaning that its supply/demand characteristics are more like a currency than a commodity. Since it is extremely malleable, it is easy to work into standardized coins or bars. And it’s shiny and resistant to most forms of degradation, which makes it ideal for jewelry.
There was a History Channel documentary a while back called “Life After People” that visualized what would happen to the cities and stuff we left behind if humans suddenly vanished. It basically tracks the decay process until everything we built turns to ruins, crumbling and rusting away. One of the few things that would last hundreds of thousands of years without changing, would be our vaulted gold. The gold vault stored under the New York Fed, for example, would be filled with water and long-buried, but the gold bars would be the same after a bit of cleaning.
It’s hard to find big and accessible earth deposits of it, and it requires processing many tons of rock to get a tiny amount of gold, so only about 1.5%-2.0% gold is dug up each year as a percentage of the current amount that is estimated to exist above-ground. Gold has a 1.5%-2.0% average annual monetary inflation rate, in other words. This has historically been about the same rate as world population growth, so the amount of gold per capita has been pretty consistent over time.
A 1-ounce gold coin could buy you a top-notch outfit a century ago, and can buy you a top-notch outfit today. No more, no less. Based on estimates by the World Gold Council, there is only around one ounce of above-ground gold per person in the world.
If you stick physical cash somewhere and come back to it decades later, it will have lost most of its purchasing power. In contrast, if you stick physical gold somewhere and come back to it decades later, chances are it will have retained most or all of its purchasing power, unless you bought right at the top of a rare gold bubble like in 1980 or 2011.
However, in any given 5-year or 10-year period, it could easily lose or gain 25%+ of its purchasing power. Additionally, gold is subject to taxes when sold, and in the physical market is usually bought at a premium to spot and sold at a discount to spot, since the middlemen need to earn a profit to make a liquid market. So, it’s not great for everyday use, unless countries decide to peg their currencies to it. It’s best used as a long-term store of value. There are debit cards that can be linked to gold accounts to make it a medium of exchange, but that introduces a trusted/centralized counterparty.
Plus, it’s risky to hold a lot of gold in self-custody due to the risk of theft. Vaulting services can safely hold larger amounts of gold, but this ironically centralizes it, and over the past century, most countries went through one or more periods of gold confiscation where vaulted gold was taken from the owner. There are very few jurisdictions in the world where someone could have vaulted gold with a third party a century ago and successfully passed it to their grandchildren, for example.
Silver and platinum are similar to gold as self-custodied stores of value, but they are more of a hybrid between currencies and commodities, and as such have lower stock-to-flow ratios and more volatility. Platinum also tends to have less liquidity and bigger frictional costs when physically bought and sold.
Overall, gold is a better long-term self-custodied asset than cash. Many wealthy people retain a small amount of it for disaster insurance.
Cryptocurrencies: Pros and Cons
In 2008, Satoshi Nakamoto put together a number of existing technologies, with his own innovations added to the mix, to create the concept of digital scarcity. There were a number of predecessors that solved parts of the problem, but this was the first one that put enough pieces together to become a big success.
Bitcoin is an open source decentralized public ledger, with a built-in incentive mechanism for miners across the distributed network to verify transactions in exchange for fees and block subsidies, where people use a set of public and private keys to transact without a centralized third party. There are also thousands of nodes, that anyone with a normal computer and internet connection can run, to verify the network and push back against various types of miner collusion.
Kind of like fiat currencies, each individual bitcoin or fraction of a bitcoin has no industrial use outside of the potential payment and store of value properties that it has. Bitcoin is just a ledger, keeping track of values assigned to different addresses, and your private key entitles you to control the coins associated with that address. There are deeper technical nuances like UTXOs, but that’s the basic idea.
You can self-custody your private key on paper, on a hardware wallet, stamped on a titanium plate, or memorized in your head with a seed phrase. You can even split your key into several parts and hold each part in different ways in different locations.
However, unlike fiat currencies, there is no central authority that can change the Bitcoin network’s monetary policy, issue more bitcoin, block transactions, or take bitcoin from an address.
Bitcoin is digitally native, unlike gold and cash. Gold and cash can only be transacted with offline, unless they are willing to rely on a trusted/centralized third party (at which point they lose the property of being self-custodied and censorship-resistant). Bitcoin can do that online and across borders. It’s a digitally-native money-like bearer asset.
That’s why it’s so polarizing. At first glance, Bitcoin and other cryptocurrencies seem silly and without intrinsic use. But when you go down the list of attributes and compare bitcoin to fiat currencies, it is better in most ways other than volatility. It has no industrial use, but the simple concept of a wide network effect of uncensorable transactions wrapped around its strict monetary policy with no leader, makes it an interesting form of global internet money that has rapidly grown in value since inception. It reached 100 million users faster than the internet or smartphone usage did, and became the fastest asset in history to touch a $1 trillion USD market capitalization from inception.
In short, either gold, bitcoin or stocks are a risk to invest and to take, but do not be misinformed about it!