(Dan Kemp, Morningstar Managed Portfolios)
It is well known that the key to successful investing is the ability to focus on the long term, buying assets that collectively boost your purchasing power (or fund your lifestyle) and ultimately help you achieve your goals. Whether we’re talking about traditional assets such as stocks or bonds—or new-age alternatives such as crypto—it is always worth reiterating why we invest. Under this lens, we can start to unpack the rise in popularity for cryptocurrencies. The primary question I’d ask is what role is it expected to play in a person’s portfolio? Is it a return generator or a diversifier?
As a return generator. We can’t argue with the recent incredible gains, but the challenge for enthusiasts of cryptocurrencies remains a function of value. Specifically, there are no intrinsic cashflows and therefore no reliable way of estimating its fair value or return potential. Of course, this is true for other holdings such as gold too, often creating speculative movements and big swings in prices like we’re seeing today. In such a scenario, enthusiasts usually rely on supply and demand as their primary justification for inclusion. However, it is important to remember that equilibrium can only be reached (at a price above zero) if supply is limited. While this may be the case for individual cryptocurrencies, the group as a whole continues to experience massive supply growth with over 14,350 cryptos currently being tracked by Coinmarketcap.com—as of November 17th, 2021—thereby creating portfolio vulnerabilities for investment managers. Like anything, crypto’s popularity might continue to rise higher for a while, but it unfortunately doesn’t meet the valuation standards for inclusion in our multi-asset portfolios as return generators.
As an inflation hedge or other diversifier. Here, the case for crypto inclusion is perhaps more nuanced. For example, crypto is often branded as an alternative if our modern monetary system (including fiat currency) is destabilized, which potentially has merit. Linked to this, it is also thought to offer inflation protection, which is also a worthwhile pursuit. However, we don’t have nearly enough evidence to support this view and hence must expect a wide range of potential outcomes from crypto assets. As investment managers, we build portfolios to be robust in a wide range of market environments. Consequently, when adding diversifying assets to portfolios, we want to ensure that they will deliver in the scenario for which they have been selected. We simply don’t have enough evidence to support holdings in crypto as diversifiers against market stress. Said another way, as stewards of capital, it would be paradoxical to add an ultra-high–risk holding to reduce total portfolio risk.
While crypto doesn’t meet our standards, we are cognizant that some investors will decide that crypto does meet their criteria. But for those that decide to pursue crypto as “fun money” or a “side bet”, please be aware that you are vulnerable to an ‘escalation of commitment’, a psychological phenomenon researched by Prof. Barry Staw and characterised as disappointment reinforcing rather than undermining a prior belief. This has been typically witnessed in religious cults focused on the end of the world. However, it is equally apparent in more mundane settings such as wealth management, especially when an asset has a short track record.
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