Does Cryptocurrency have a place in my investment portfolio?

It’s pretty unbelievable the number of times I have been asked this question since folks knew I was writing a personal finance blog. My answer to them has always been – I don’t know enough about it to give an opinion. But they have continued to push me to offer an opinion. The reality was that I had done a fair amount of reading and listening to podcasts on Bitcoin and the blockchain technology and did have an opinion. My conclusion was that while I think there is a lot of promise for the underlying blockchain technology, Bitcoin as an investment flew in the face of all the principles I talk about in my blog. But I just was not comfortable propagating that opinion publicly yet. 

However, recently I had a pretty vigorous debate with a close friend of mine on Bitcoin/cryptos (she used to be a currency trader so I should have known better than to engage in this debate with her :)). I found myself vehemently defending my position and explaining why I thought Bitcoin was not a good investment. I won’t go into the details of the debate or my arguments but after the debate I found myself reflecting and asking myself – Am I being too stuck to my position and not being open minded to listening to the opposing viewpoint? I have always prided myself in being fairly objective – what if in this case, I was subject to confirmation bias and only reading/listening to material that confirmed my own theories/biases?  So I decided to go down this path and do a bit of a thought experiment where I said I am going to look for material that confirms the opposite – that Bitcoin is the next thing since sliced bread. I focused on Bitcoin but I know there are differences between the different crypto currencies. But the ultimate framework and thought process I wish to present in this article will be the same irrespective of the crypto currency. 

After a few weeks of doing some more focused research, there were not a lot of new things I had learnt. But what was interesting to me was listening/reading to a number of fairly rational minded and intelligent people who were pretty gung ho about Bitcoin. I listened to their arguments intently and appreciated some of the points that the true believers were propagating a bit better. So what are my conclusions and my recommendations? As my readers know, I never tell people what to do. I only focus on how to think through these decisions. So that’s what this article will do today. In case you are wondering – did I change my mind about Bitcoin? Not really – after I stepped back, I realized the fundamental concerns and questions I had still remained but I also had developed a better appreciation for the opposing viewpoint. My view is a bit more nuanced now. So here is a bit of a framework on answering the question as to whether Bitcoin has a place in your investment portfolio. This thinking applies to any investment you are making so in a way I am going back to basics here.

Thinking in bets – probabilistic thinking

I am a big fan of the book ‘Thinking in Bets’ by Annie Duke. Annie Duke was an international champion poker player and some of the principles she outlined in her book will be permanently etched in my mind. It’s a fantastic read and I strongly recommend it. But the fundamental principle she talks about is what I want to start with. When we think about any investment, we need to engage in some level of probabilistic outcome thinking. If that was a mouthful, it simply means asking yourself what are the possible outcomes of a decision/investment and what is a probability of each of those outcomes. That sounds very quantitative but you can make a qualitative estimate of probability based on history/research etc. So what does this mean practically? 

If I invest in Bitcoin, will my investment grow or drop in the short, medium and long term? That’s the fundamental question we need to start with. I think it’s fairly safe to say in the short run, Bitcoin is extremely volatile. At the time of writing this article in Jun 2021, Bitcoin valuation has dropped a whopping 30% – 40% from its high earlier this year. And at the high earlier this year, bitcoin had almost tripled in value from the beginning of the year! We have seen that play out in the past as well. So my opinion is that in the short run, Bitcoin has a high probability of both going up and going down and as a result, if I am investing money for the short run, I will definitely not be putting any money in Bitcoin. I think this argument is fairly valid for all other crypto currencies too. As a side note, this volatility is also probably a strong reason to think that Bitcoin is not going to be a replacement for fiat currency anytime soon, and possibly never. 

So what about the medium to long term? This is where I was fascinated to listen to all the different view points ranging from how Bitcoin is the true hedge against inflation (you have CEOs like Michael Saylor of Microstrategy who genuinely believe this and have added billions of $ of Bitcoin to their balance sheet) to at the other end who say Bitcoin has no underlying value and can very much go down to zero. I am not going to use this article to get into an intellectual debate on these points. But here is my own layman conclusion (lots of people will disagree but the purpose of this article is not to debate my opinion but to offer a framework for thinking) – my opinion is that based on everything I have read, while there is a lot of upside for Bitcoin in the medium to long term (the believers believe 1 Bitcoin can go upto $100K to $1M or more), but there is also a lot of downside risk to Bitcoin – there are a variety of reasons for all this which I am not going into here. Often, we look at history to project the future. We do this with other asset classes like Stocks and real estate. So if we look at the relatively short history of Bitcoin (Bitcoin was launched in 2009), you will see the trend is upward. So then why can’t we, based on the history, conclude Bitcoin will always go up? Well, the answer is simply to make a reasonable judgment, the history is too short. Stocks, bonds and real estate in comparison have decades of history through different economic cycles to make some reasonable long term projections. So then in the case of Bitcoin, the future projection has to be very much based on your expectation of what can be possible. From where I sit and the limited capacity of my brain, I see an equal probability of upside and downside in the long run. You can and should make your own judgment.

Your question then could be – by that logic, we can never invest reasonably in anything with limited history? How on earth do you answer to the folks who did invest in Bitcoin in the early days and are now multi-millionaires? So many of us missed that. So that brings me to the next principle in my framework which was probably a more important learning through my recent reflections. 

Investing in bets

I listened to this podcast between Julia Galef, an author and podcaster and Vitalik Buterin, the co-founder of Ethereum. Vitalik is a smart 27 year old programmer-entrepreneur and I was amazed at how he has so much clarity in thinking at such a young age. The basic point he made was you can invest in different bets with small probability but high impact. What that means is –  in its infancy, most new ideas have extremely low probability for success. But for the few that do succeed, they have a huge impact. A good example of this is a company like Amazon. Jeff Bezos when he went out to start Amazon, found that there was generally a less than 10% probability of tech businesses surviving. He considered himself smarter than the rest but still gave it only a 30% probability of success. He decided to do it anyway and we all know how Amazon turned out. But Vitalik’s point was that of thinking like an angel investor – invest in different things you research and believe in but know that very few will actually pan out. So what does that mean practically for us and specifically in this conversation about investing in crypto? Well, the argument goes that if you had invested a mere $100 in buying a few bitcoins back in Feb 2011 when the value of 1BTC was $1, well you would be a multi millionaire now. But how on earth was one to know Bitcoin was going to be anything big back in 2011? Well, that’s why you have to have an angel investor mentality IF you want to invest in bets. You simply invest in multiple bets assuming at least one of them will pan out in a big way. Of course, nothing stops anyone from investing in Bitcoin today especially IF you believe this is going to grow another 10X in value. But to buy a few bitcoin today is going to be a more significant portion of your wealth for most people. So my point is that if you are someone who really likes the idea of investing in bets and doesn’t want to be a boring investor like me and invest only in traditional asset classes, you need to consider setting aside a portion of money to do this each year. Which brings me to my final point today. 

Invest in bets by thinking of the worst case scenario

Invest only as much in these moon shot bets as much as you are comfortable losing your entire investment. Someone who invested $100 back in 2011 in Bitcoin would not have felt the pinch of losing the entire investment. Someone who invests in buying a lot of bitcoin today will have a lot more to lose. So IF you want to invest in bets, set aside a small chunk of your overall net worth to invest in these different bets with the hope that something might pan out. But my advice to you is to assume you will lose 100% of this investment. That’s the worst case scenario. If that happens and it does not financially ruin you, then you are Ok. So is there a magic number or % of money you can invest? Well this is up to you – it’s the amount you are willing to lose completely. For some rational investors, they consider that % to be anywhere from 1% – 5% of their overall net worth. I had originally invested a token amount of $100 earlier this year in Bitcoin just to learn more about it. After my recent reflections, I decided to up that to $1000. While losing $1000 would not be fun, it will not ruin us financially. I intend to keep that investment for at least the next 10 years and not withdraw it if retains any value. Btw I did that based on the thinking I laid out in this article. 

So what if you are someone who truly believes in Bitcoin and wants to invest a significant portion of your net worth – much more than 1% – 5%? Well that goes back to my original point – probabilistic thinking. If after all the research you have done, you strongly believe in the upside of Bitcoin and that outweighs the downside risks, then go ahead and do it – but do it with your eyes wide open. Rational investors will also weigh the risks so assuming you are a rational investor, then you need to do that too. A good investment portfolio is well balanced for risk.

Final concluding thoughts

So should you invest in crypto? It’s up to you really. But whatever you invest in, spend the time to understand it and research it. Don’t invest in it because Elon Musk tweeted about it. Invest in it because you believe in it or at least feel there is some promise to this. Understand both the upsides and downsides. If all this feels like too much work then know that investing is generally hard work – if all you want to do is click a button and invest, then stick to broad market index funds. Don’t succumb to FOMO (fear of missing out) and invest without understanding something.  

I want to extend a special thanks to my friend who engaged in that debate with me and got me to reflect more on this and inspired this article. My learning from that debate was well summarized by what Vitalik Buterin said in his recent podcast interview “I have always been a rationalist. So the good rationalist values not being over confident, of not being overly dismissive of tribes you disagree with, of trying to see the best arguments from both sides..”

Thank you for reading and I wish you success in your financial journey. 

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.