If someone came up to you and offered to convert your cash to a handful of chocolate coins, would you accept them as legitimate currency even though their real-world buying power is severely limited?
The world of crypto and other NFTs (non-fungible tokens) is similar in that you probably won't be able to use them as regular currency anytime soon, and, much like chocolate coins, there's no governing body to validate their worth beyond the people trying to sell them to you.
There's a rule in investment that always holds true: Past performance is not a guarantee of future results. That's why your investment portfolio should always be diverse, to help protect against one area falling.
Crypto investors may think they're on to something amazing, but if all their money is going into that one area they run a real risk of losing it – by the nature of its volatility, or even just by virtue of forgetting their own password.
In its relatively short existence, bitcoin has proved extraordinarily volatile, sometimes gaining or losing more than 40 per cent in price in a month or two.
Any asset subject to such sharp swings may be catnip for traders but of limited value either as a reliable medium of exchange (to replace cash) or as a risk-reducing or inflation-hedging asset in a diversified portfolio (to replace bonds).
Assessing the merits of bitcoin as an investment can be problematic. Adding it to a portfolio could mean paring back the allocation to investments such as stocks, property, or fixed income.
The owner of stocks or real estate generally expects to receive future income from dividends or rent, even though the size and timing of the payoff may be uncertain.
A bondholder generally expects to receive interest payments as well as the return of principal. In contrast, holding bitcoin is like holding gold as an investment.
Even if bitcoin or gold are held for decades, the owner may never receive more bitcoin or gold, and unlike stocks and bonds, it is not clear that bitcoin offers investors positive expected returns.
Putting aside squabbles over the future value of bitcoin or other cryptocurrencies, there are other issues investors should consider:
A lack of authority
Bitcoin is not backed by an issuing authority and exists only as computer code, generally kept in a so-called "digital wallet", accessible through a password chosen by the user.
Many of us have forgotten or misplaced computer passwords from time to time and have had to contact the sponsor to restore access. No such avenue is available to holders of bitcoin. After a limited number of password attempts, a user can permanently lose access.
Since there is no central authority responsible for bitcoin, there is no recourse for the forgetful owner: a recent New York Times article profiled the holder of more than $200 million worth of bitcoin that he can't retrieve. His anguish is apparently not unusual—a prominent cryptocurrency consulting firm estimates that 20 per cent of all outstanding bitcoin represents stranded assets unavailable to their rightful owners.
Mt Gox, a Tokyo-based bitcoin exchange launched in 2010, was at one time the world's largest bitcoin intermediary, handling over one million accounts in 239 countries and more than 90 per cent of global bitcoin transactions in 2013. It suspended trading and filed for bankruptcy in February 2014, announcing that hundreds of thousands of bitcoins had been lost and likely stolen.
Concern from overseas
The UK Financial Conduct Authority cited a number of concerns as it prohibited the sale of "cryptoasset" investment products to retail investors last year. Among them were the inherent nature of the underlying assets, which have no reliable basis for valuation; the presence of market abuse and financial crimes in cryptoasset trading; extreme price volatility; an inadequate understanding by retail consumers of cryptoassets; and the lack of a clear investment need for investment products referencing them.
The financial services industry has a long tradition of innovation, and cryptocurrency and the technology surrounding it may someday prove to be a historic breakthrough. For those who enjoy the thrill of speculation (which is essentially taking a gamble), trading bitcoin may hold appeal.
If you're looking to grow or protect your wealth, you are much better off following philosophies which subscribe to scientific, evidence-based practices. If you're questioning your current approach or want to get into investing but you're stuck on where to start, get in touch with a trusted fiduciary to discuss your options.
And if you're really looking to invest in some alternative currency this Easter … you're probably better sticking to the chocolate variety.
Nick Stewart is a Financial Adviser and CEO at Stewart Group, a Hawke's Bay and Wellington-based CEFEX certified financial planning and advisory firm. This article was created in conjunction with Dimensional Fund Advisors.
The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz