How to Invest in Bitcoin

Updated: Jan 22


Bitcoin

As a new asset in a new category of investments it created (digital assets), Bitcoin can be a confusing puzzle for investors wanting to establish its investment characteristics, or looking to add Bitcoin investment to their portfolio.


Although designed as an alternative to central banking during the global financial crises, and for person to person transactions (as opposed to transactions that use a third party such as a bank), Bitcoin has only recently been recognised as an institutional store of value, and is not the best asset for cash style transactions.


But it is still a very important asset - the most important of all digital assets - and there are many ways of viewing what it is -depending on what we want out of it.


Bitcoins historical use-cases are fascinating. Bitcoin was given life as an anarchists protest against centralised authority. With this functionality establishing a significant level of interest and the asset surviving that scrutiny, Bitcoin was then used in libertarian marketplaces to trade products that would not be accepted in mainstream modes of transaction. This helped Bitcoin survive a far more significant level of scrutiny, in which it was eventually found to be a legitimate asset and new asset class.


With each new use-case establishing a foundation for the next, a digital cryptocurrency first used by teenagers to purchase pot online developed investment characteristics now used in multi-billion dollar institutional investment portfolios to manage the systematic risk inherent to the global financial system.


In short, this remarkable asset has matured significantly and from 2021 onwards will grow in importance in every capacity that we mention here.

An Investment Chameleon




In considering a Bitcoin allocation, investors should be aware that Bitcoin has traded as a different asset at different times. It has been a technology asset, a store-of-value (similar to gold and silver), a speculative asset, a systematic hedge and has also enjoyed secular, uncorrelated moves of its own.


This shifting centre makes establishing Bitcoin as a specific type of asset with a specific valuation methodology and use-case difficult. It has been very difficult for regulators to establish what it actually is.


Some of this problem has been overcome in 2020, although it has been this attribute -Bitcoins lack of correlation to other assets - that make it important, and why it is rapidly growing in popularity.


As Bitcoin matures with acceptance in institutional portfolios it may begin to adopt more permanent investment characteristics. We are looking to 2022 and beyond to begin to see this type of maturation.

But where Bitcoin sits in early 2021 we still see multiple use-cases for investment, including

· Speculation

· Hedging

· Technology

· Store of Value

Speculation

In the speculative use-case the considerations are whether we consider Bitcoin to be a form of money (it is), and what the lower-bounds of market capitalisation are of an alternative form of money to the established global financial system. This could include a measure of systematic risk, (although Bitcoin itself is one of the better measures of systematic risk at present).



Risk

It is up to each speculator to come up with a number, but we think that a market capitalisation of 1-3 trillion U.S. dollars is the correct way to think about Bitcoins market cap. This figure considers the necessary value of money for a new, minor financial system to function.


The speculation in Bitcoin is in believing that systematic risk is under-priced in the global financial system, in the which case we would consider a speculative investment in Bitcoin.


We might also speculate on its ability to be disruptive, or in the potential for its use as a hedging instrument or in other institutional flows – which we cover in the next section on hedging.


In considering how much to invest for speculative reasons, speculative investments in alternative assets are typically 2-20% of a portfolio depending on how aggressively the portfolio is positioned.


In the case of Bitcoin investment, calculating the position size can begin to turn the speculation into a form of hedging.

Hedging

Hedging in Bitcoin can be useful in a number of ways. One possibility is in hedging against the potential for volatility in the U.S. dollar.


Investing in Bitcoin

For example, if we see the U.S. dollar declining by 10%, and we see Bitcoin tripling in value in that scenario, then we may consider a 3.33% investment in Bitcoin. This is a simple hedge and does not take the appreciation in other portfolio assets into account (the S&P500 has recently been appreciating in a way that matches the decline in the U.S. dollar).


Similarly, perhaps we are hedging against systematic risk in the financial system. Considering extraordinary monetary and fiscal intervention in markets we might calculate the gains and losses for this systematic risk in the stock index, and each individual portfolio will have different hedging requirements. For example, a portfolio with oil and commodities may require less hedging of this alternative monetary base than a portfolio full of U.S dollar denominated fixed interest assets.


Perhaps we are constructing a multi-asset monetary hedge for an entire portfolio? In that case we might consider Bitcoin along with gold, silver and oil or assets with exposure to these factors in ratio’s that would reflect the specific attributes and assets in the portfolio and use derivatives to reflect those positions.


Or, we could be hedging traditional financial industry assets with this disruptive technology. Again, a metric would be required in which we calculate the decline in values due to disruption, and the multiple we expect to gain in Bitcoin to derive our capital allocation. In the current climate of monetary and fiscal interventions and with current advances in digital assets, any portfolio holding equity in financials should be actively considering a strategy regarding Bitcoin and digital assets.

Technology

With Bitcoin now achieving one of its highest level value-adds as an institutional asset with exceptional investment characteristics, given its low correlation and store of value status; and with de-centralised finance being proven (although not yet refined), there is interest in Bitcoin as a technology asset. Bitcoin as a technology asset is viewed through a lense of a compounding, exponential return structure, similarly to how Tesla, Amazon and Google have performed in the past (and present).



Technology assets are essentially an algorithm that either achieves, or does not achieve, its stated aim. If it does, then re-iterating it many times brings an often low cost-base down to a negligible cost-base and the technology achieves exponential growth, shown through a valuation methodology such as Metcalfe’s law as well as enormous economies of scale. Pricing this is difficult and can involve more prophecy than calculation, evidenced by the Intelligent Investor Warren Buffet’s historical difficulty in engaging with technology assets.


In the case of Bitcoin, the technology still has surprises in store to achieve exponentially greater functionality such as a functional payment layer, and a de-centralised finance ecosystem that will also add enormous – incalculable – synergies between Bitcoin, de-centralised computing platforms such as Ethereum, Polkadot, Cardano and Algorand and de-centralised finance applications (including the link between digital and physical in ‘oracles’ – technology assets that tie this digital universe into physical reality.)


As a technology asset, Bitcoin has some of the greatest potential in full consideration of these synergies – probably the greatest synergies we have ever seen for anything and investment as a technology would take this into account. For more information on constructing digital asset portfolios, please find our article here.

Store of value



As a store of value – as digital gold – Bitcoin is also an interesting asset. Investors willing to consider Bitcoin as a store of value should consider its role compared to gold. Bitcoin may not be useful to hedge fiat currency exposure the same way that gold may be. Gold's market cap allows a less speculative position to be taken on various risks that Bitcoin is more sensitive to and may make sense for many functions of hedging the denomination asset of their investments (most assets are denominated in fiat currency such as U.S. dollars.)


However! If a portfolio has an allocation to alternative assets and technology, Bitcoin can act as the fiat currency hedge, as well as an alternative allocation, as well as a technological allocation! This ability to achieve multiple use-cases with a single asset frees up portfolio capital for other assets, (or perhaps, for margaritas?). This multiple use-case of the single asset is a unique and attractive role for Bitcoin to play in a portfolio and is one reason why it is achieving extraordinary growth.


So depending on the particular view that we take of Bitcoin, we can give it many uses in institutional portfolios to allow fund managers to take sophisticated positions. Bitcoin gives us a unique ‘out’ for the systematic risk and moral hazard we see with the arc of monetary and fiscal policy. The asset is still new, exciting and dynamic while the industry itself has attracted some of the best, most intelligent and ideologically committed people that we could find anywhere today. We believe that Bitcoin and digital assets are a once in a 100 year opportunity that will fundamentally change the future landscape for finance and global commerce.

By Thomas Kuhn, CFA


Thomas is the author of 'Bitcoin: A Revolutionary Investment' and has previously written for the Asia-Pacific Research Institute of the Chartered Financial Analyst Institute, QuantumEconomics, Hackernoon and Medium.


For more information on his book, please visit here.