The following article is part of a series of guest posts by Ben Lakoff. Mr. Lakoff is an entrepreneur and finance professional. He has a wide area of expertise including raising capital, corporate finance, investing, and start-up strategy. The content of this post is not intended as legal, investment, or tax etc. advice and is intended for educational purposes only. You can read more articles by Mr. Lakoff here.
Bitcoin: an Alternative Asset for Diversified Portfolio Management
The spotlight is on Bitcoin for diversified portfolio management in 2019, with analysts seeing more and more institutional investment entering or showing interest in the crypto markets. This could be in part because it was recently revealed that the multi-billion dollar endowments of Yale, Harvard, Stanford, and MIT have all invested in cryptocurrencies, and specifically bitcoin, to diversify their portfolio. Analyst speculation has it that the herd mentality of institutions will trigger a chain reaction, bringing even more institutional investors into the crypto-space.
But why all the attention now? And especially after the unexpectedly bearish market of late-2018?
To answer these questions, let’s trace Bitcoin from the beginning, its inception, to present day and modern portfolio management strategies.
Bitcoin, Explained
Let’s keep this simple. Bitcoin (BTC) is a digital currency, distributed and used electronically. Because bitcoin operates on a decentralized peer-to-peer ("P2P") network, there is no single institution in control. The total supply of bitcoin can never be increased as the network has permanently limited the number of bitcoin that can be created to 21 million. This means that bitcoin is not an inflationary currency.
Where did bitcoin come from?
Bitcoin was first introduced to the world by an anonymous programmer (or a group of programmers) as an open-source software. While its creation is attributed to an alias known to the world as Satoshi Nakamoto, a lot of controversy remains around his/her/their identity. There has been a lot of speculation and rumor, but to this day there is no concrete evidence to link Satoshi to any one person. Estimates are that Satoshi owns around 1 million bitcoin, which as of the time of writing (May 2019) would be worth approximately $8.7 billion USD.
In mid-2010, “Satoshi” disappeared entirely and passed Bitcoin over to a few prominent members of the BTC community, naming Gavin Andersen as lead developer. It was also around this time when, on 22 May, bitcoin was used in its first purchase, proving the nascent cryptocurrency’s potential as a means of payment.
So who controls bitcoin now?
After Satoshi detached himself from the project, Gavin Andersen, the newly appointed lead developer, focused on further decentralization. He wanted Bitcoin to continue autonomously and independent from any particular corporation or government, even if, in his own words, he “would get hit by a bus”. In theory, the developers would only be working for their users. While the development team could decide what new features to implement, it was the users who would decide whether or not to run a particular version of the Bitcoin software.
For many, the main advantage to Bitcoin was its independence from world governments, banks, and corporations. Its intention was to put the user-base in control, and likewise make it so that no single entity could interfere with BTC transactions, impose additional transaction fees, reverse payments, or freeze people’s funds.
And it was also transparent thanks to its distributed public ledger, the blockchain.
How does it work?
The blockchain is a shared public ledger. Think of it like a bank ledger that anybody can view. It contains every transaction ever processed on the network, with digital “records” of transactions being combined into a “chain” of “blocks.” With it being a public ledger, any mistakes or attempts at fraud can be easily detected and then corrected by anybody. This public ledger protects the network particularly against the "double-spend problem' to guarantee there will be no counterfeit or fraudulent BTC transactions.
Users have their own BTC wallets, and these validate every transaction. Digital signatures secure each, with signatures corresponding to the sending addresses.
The verification process utilizes a “proof-of-work” consensus mechanism and “mining” to create every block of the ledger. Mining verifies every transaction, using computer processing time to protect the network from various attack vectors.
Characteristics
A decentralized network
For Satoshi, Bitcoin had to be independent from any governing authorities. Along this backdrop, he/she/they designed the network so that every individual, business, or even machine involved in the verification/mining process became part of the massive network. This means that even if one part of the network experiences problems, the digital currency will keep moving.
Pseudonymous transactions
Often confused as an “anonymous network” and criticized by regulatory authorities for its potential to facilitate nefarious and criminal activity, the truth about Bitcoin is that it’s really a pseudonymous network. While users do not need to connect their wallet to any identifying information, they usually do when buying, selling, or trading their BTC. Given, it can be difficult to reveal the identity of wallet-users, but it is not impossible. There are government agencies and chain analysis firms the world over, actively unmasking users over time. What is more, if you did want to reveal your identity and transaction history, it’s as simple as sharing your wallet address.
Transparency and Auditability
The network stores every single transaction on a public ledger. If your BTC wallet address were ever identified or made public, carefully studying the blockchain’s ledger could reveal how much money you hold in your wallet, and what transactions you’ve made. It is possible for users to remain largely anonymous, but only if they take extra measures to do so. This requires the use of special wallets, or using multiple BTC addresses for transactions. But again, as chain analysis firms advance, this anonymity cannot be guaranteed forever.
Immutability
The public ledger is, for the most part, immutable and unchanging. Because of the network’s proof-of-work protocol, it is nearly impossible to change the ledger without it being easily noticed and repaired. This means that after you send bitcoin, there is no way to get that bitcoin back without the recipient sending your BTC back to you directly. The reception of the payment is guaranteed, so nobody can scam you by claiming they never got the money. When it’s sent, it is sent.
The Pizza Purchase
This is one of those "classic" amusing/incredible stories to come from the early days of bitcoin. Before 2010, hell even as recently as 2016 mostly only techies and hobbyists were aware of bitcoin. The network and the currency got a big "real world" boost though thanks to one, rather complicated pizza order made on the bitcointalk forum. Laszlo Hanyecz, a Florida-based programmer working for the online retail company GoRuck, was just hungry... and he had some bitcoin. So he posted the following message on the forum:
"I'll pay 10,000 bitcoins for a couple of pizzas.. like maybe 2 large ones so I have some left over for the next day. I like having left over pizza to nibble on later. You can make the pizza yourself and bring it to my house or order it for me from a delivery place, but what I'm aiming for is getting food delivered in exchange for bitcoins where I don't have to order or prepare it myself, kind of like ordering a 'breakfast platter' at a hotel or something, they just bring you something to eat and you're happy!"
At the time, 10,000 BTC was worth approximately $30 US. (At the current price of bitcoin that bitcoin would be worth approximately $87 million USD).
Jeremy Sturdivant, also known as “Jercos” on the bitcointalk forum, saw Laszlo’s post and took him up on the offer. After receiving his bitcoin, he called in two large Papa John’s pizzas, and the rest was history. From that day forward, May 22 became known as Bitcoin Pizza Day. There’s now even a Twitter account dedicated solely to the Bitcoin Pizza. You can check it daily for an update on the current value of those two pizzas, commemorating the first real price valuation of the digital currency.
Advantages to the Bitcoin network
There are a number of positive attributes to this network. For ease of reading, however, let’s simplify the list and look at the most noteworthy.
1. It’s independent from governing authorities. Bitcoin as a currency cannot be debased or hyper-inflated because of its limited supply. No entity can increase transaction fees, and there is no intermediary in control of the money.
2. It’s highly portable. It’s digital, meaning you can store massive amounts of money on a device as small as a flash drive, or even stored online. All you need is internet access to view your account, make a payment, or send currency to somebody else.
3. You can choose your transaction fee. There is no commission to an intermediary who facilitates the transaction. Rather, with Bitcoin, you choose your own transaction fee or none at all. If you choose none, however, miners likely won’t validate your transaction. The fee gives them incentive to share their computer processing power. The higher the fee you choose, the quicker the processing time.
4. It reduces the chance of counterfeiting to near-zero. To solve the ‘double-spend’ problem, the Bitcoin network uses enormous amount of computational power. Blockchain technology and BTC’s various consensus algorithms have been designed to counter the all-too-familiar problem of fraudulent transactions in the digital world.
It’s far from perfect though
Let’s now look to the other side of the coin and outline some the network’s most prominent weaknesses:
1. There is no unified consensus on its legality. What is really lacking is a unified definition and framework for bitcoin. But governments around the world can’t come to any agreement. You see bitcoin taxed different from one country to the next. Some countries are embracing it and others are banning its adoption altogether.
2. It still needs further recognition and adoption. Many still perceive cryptocurrencies and blockchain technology as too complex to understand. This makes crypto assets in general seem unapproachable to the masses, and is one of the factors hindering mass adoption. Another is the lack of merchants accepting bitcoin as legal tender. Then you have the legal scrutiny and regulatory uncertainty that comes with issuing and possessing digital assets.
3. You can lose the keys to your wallets. With any cryptocurrency wallet, you and only you are in control of your funds. There is no intermediary to help if you lose your private keys or fall victim to online fishing schemes, trojans, or malicious malware. You are your own bank, and if you don’t protect yourself, you can lose entire wallets.
4. It’s still a volatile emerging asset. Speculation has had a lot to do with the price volatility of bitcoin and other cryptocurrencies. Take the crypto crash of 2018 for example. Bitcoin went from an all-time high of approximately $19,000 USD down nearly 70% of its value just several months later. There were a lot of factors to this, from government scrutiny, standardization, and regulation; to bitcoin trading more like a commodity, with its price inflated by limited supply and increased demand. (Which can only last so long before the bubble bursts.)
How Can Bitcoin Be Used For Portfolio Management?
To find some answers to this question, let’s look back to Yale University. A recent study conducted and published by Yale economist Aleh Tsyvinski and Yukun Liu has examined the risk-return tradeoff of adding cryptocurrencies (in this case: Bitcoin, Ripple, and Ethereum) to a portfolio.
Their paper, “Risks and Returns of Cryptocurrency” observes the behavior of cryptocurrencies as being distinct from traditional stocks, currencies, and precious metals. The results documented high returns but with a lot of volatility. They analyzed their crypto assets by applying the Sharpe Ratio, which measures the performance of an asset by adjusting for its degree of risk.
What they found was that in terms of return versus volatility, the Sharpe Ratio of the cryptocurrencies in their portfolio showed “the return is higher than the risk implied by [their] volatility.”
In addition to this, Tsyvinski and Liu summarized their study in a YalesNews Interview, and stated the following:
“If you as an investor believe that Bitcoin will perform as well as it has historically, then you should hold 6% of your portfolio in Bitcoin. If you believe that it will do half as well, you should hold 4%. In all other circumstances, if you think it will do much worse, then you should still hold 1%.”
This makes a sound case for bitcoin in diversified portfolio management, especially coming from Yale University whose multi-billion dollar endowment invested cryptocurrencies.
The Key Takeaway
Bitcoin has typically shown little to no correlation with the traditional market. And according to the findings of Yale’s Tsyvinski and Liu, this means it can compliment allocation strategies for alternative assets or absolute return.
With the right management, some bitcoin in a portfolio can not only improve a portfolio’s overall performance but also reduce its overall risk.
What it all comes down to is proper portfolio management. It’s important to treat crypto assets as the emerging asset class they are and to not risk more than you can afford to lose. Cryptocurrencies in general are still a hyper-volatile asset class, so you need to manage these assets in your portfolio wisely.
If you are in need of legal counsel in relation to blockchain or cryptocurrency matters check out The Rodman Law Group
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