Bitcoin is one of the most important human innovations of the last hundred years. And while the mainstream headlines may focus primarily on the fluctuating price of a coin, the investment case is actually very strong. Particularly when considered in the context of portfolio diversification.
But what is Bitcoin and how does it work?
Bitcoin was conceived around the time of the Great Financial Crisis (2007-2009), a time where mismanagement and outright fraud nearly ground the global financial system to a halt. An anonymous person, or group of persons, using the pseudonym ‘Satoshi Nakamoto’ released a document into the world known as “The Bitcoin Whitepaper” which outlined a new way of thinking about money and finance. It outlined a system where individuals could move money without an intermediary like a traditional bank or financial institution. The key to such a system, the paper suggested, was how bitcoin solves what is known as “the double spend problem”.
The Double Spend Problem
In an online world, we see copies of digital assets in abundance. Consider a simple PDF document that lives on a website, free for anyone to view and download. One could also download this PDF to their local computer and send a copy to anyone in their contact list. While that’s great for sharing information, it’s not great as a means to transfer money. For money to have value and to be used online, there needs to be a way to ensure that when you move $1 you aren’t leaving another version of that dollar behind, still to be spent.
Right now, large, centralized intermediaries like traditional banks, PayPal, and the payment processing networks of Visa and MasterCard handle the majority of online cash transfers with their own infrastructure. But Bitcoin solves the double spend problem through an innovative structure known as blockchain technology.
As an asset class, bitcoin has outperformed all others over the last 10 years
What is Blockchain?
While traditional intermediaries have their own ledgers to keep track of transactions, blockchain technology has what’s known as a distributed ledger. Anyone can take a look at the blockchain ledger to see when and where each coin, or fractions of coins, have changed hands. This ensures that instead of a single third-party verifying all transactions, you have many people in the network cross-validating the accuracy of the ledger.
Blockchain technology is incredibly important, not only for creating trust for digital cash transactions, but for any asset or process that requires scarcity and accurate accounting. A perfect use case would be for elections. A vote has scarcity. One person has exactly one vote to spend. But instead of relying on any one company or entity to ensure that any individual’s vote isn’t cast multiple times or for the wrong candidate, bitcoin’s blockchain can accomplish the same goal. Think of it like having thousands of independent scrutineers involved in the process instead of just one.
Why is it called the Blockchain?
The bitcoin network includes tens of thousands of “nodes”. These all store independent copies of the bitcoin ledger (the blockchain). Every so often, roughly every 10 minutes, the transactions in the bitcoin network are batched together into what’s called a “block”. That block is then broadcast to all the different nodes in the network. Some of those nodes are special, they’re called “miners” and they perform a very important function on the network: they verify and secure the network. They do this by using very large computing power to validate whether the transactions in a given block are true and accurate. If a given miner is the first to do that, they are rewarded with new bitcoins. This new block becomes part of the verified ledger which will continue to grow over time as new blocks are added to the chain.
What gives Bitcoin value?
Bitcoin is similar to the concept of “digital gold”. Gold is mined and is scarce. So is bitcoin. Only 21 million coins will ever be mined (18.5 million coins have been mined as of December, 2020). While it was easy to mine coins in the early days of bitcoin, it gets harder over time because the number of coins rewarded to miners who verify the blockchain over time gets “halved” on a regular schedule. This ensures that the stock and flow characteristics that give value to gold will exist in bitcoin. The stock to flow ratio measures how much of an asset exists and how much is being added to that stock. Right now, it would take 50 years at current production rates of bitcoin to match the current stock. That stock to flow ratio (50:1) is basically the same as gold right now. But while gold is harder to mine, it’s not fixed in it’s ultimate quantity. Bitcoin is.
How does Bitcoin fit into an investment portfolio?
Many investors hold exposure to gold in their portfolio as an inflation hedge or as a low-correlating asset to manage risk. With bitcoin fitting that bill too, diversifying one’s store of value positions from just gold, to gold and bitcoin has built a case for bitcoin exposure as a fundamental portfolio building block.
If gold is 5% of a portfolio, splitting that into one part gold, one part bitcoin may be appealing. While bitcoin has been very volatile, that’s not necessarily a bad thing for a portfolio in small doses. Volatility works in both directions. As an asset class, bitcoin has outperformed all others over the last 10 years, with the notable exception of 2 years, reflecting this volatility. But bitcoin’s impressive performance also underscores bitcoin’s ability to add alpha, or enhanced returns, to a portfolio over the long term.
Coupled with a disciplined rebalancing strategy, a small allocation to low-correlated, while volatile, assets like bitcoin has the potential to improve a portfolio’s returns while actually reducing overall portfolio risk.