I’m going to tell you of a surprising, hard-to-refute case for “investing” in crypto. But first, let’s look at some background.
If you’re old enough, you may remember the stories that used to be told about the 1920s stock market, shortly before the great crash of 1929. One of the most famous such stories is that old Joe Kennedy (the father of President Kennedy, and by 1929 a wealthy investor) decided to sell all his stock shortly before the crash.
What information or intuition pushed Kennedy to sell? The story is that Kennedy was getting his shoes shined, when the boy shining his shoes, not knowing that Kennedy was one of the most successful men on Wall Street, offered Kennedy “a stock tip.”
Kennedy, so the story goes, saw the fact that a young, inexperienced boy was offering stock market advice as an indicator that there was no one left to buy stocks, and that therefore the top must be nearby.
Crypto
What’s that story got to do with crypto? On Friday I was talking with a friend who also happens to be one of the most sophisticated lawyers in the country.
The subject of crypto arose. My friend said to me, “My brother-in-law made $60,000 in crypto last week.”
“He put $3,600 into some newly issued token, and sold it later that day at a $60,000 profit!”
Is Crypto Only a Speculative Asset?
Such stories are usually much more indicative of a top in markets than they are of a real buying opportunity.
In recent months, I’ve been meeting and speaking with a growing number of people who have made real money by owning crypto assets – mainly Bitcoin but also others, including cryptos that few people have heard of.
With the exception of a few unconventional voices who have been and continue to be tremendous advocates for Bitcoin (names frequently mentioned include Michael Saylor and the Winklevoss twins), most of the financial world sees crypto as a speculative asset.
A speculative asset, in this case, is an asset that people buy primarily because they expect it will increase in value and they will be able, at some future date, to sell it for a higher price. A less polite term for this is the “greater fool theory.”
It is not hard to find critics of crypto. The International Monetary Fund doesn’t like it. The left-leaning Brookings Institute reports “the brutal truth”. And a Pew research poll that reports that “63% of Americans are not confident” in crypto.
And the greatest investor of all time, Warren Buffett, has called Bitcoin “probably rat poison squared.”[1]
All of which leads me to the surprising case for crypto.
The Surprising Investment Case FOR Crypto
There is no shortage of opinions about crypto and its suitability, or lack thereof, as an investment.
I don’t want to offer you more opinions. Instead, I want to offer you an argument that, I believe, a large fraction of readers will have a hard time countering.
Here’s the Argument
If you believe in indexing, you should think long and hard about crypto.
The entire case for stock indexing, such as buying the S&P 500, or the Vanguard Total Stock Market index, or some similar index, rests on an academic theory called the Efficient Market Hypothesis.
The Efficient Market Hypothesis is a formalization of the claim that financial markets incorporate all available information into asset prices. As classically formulated by Eugene Fama and his associated, there are three forms of market efficiency:
- Weak-form efficiency – Past price movements do not predict future prices.
- Semi-strong efficiency – Publicly available information is fully reflected in current prices.
- Strong-form efficiency – All information, both public and private, is instantly factored into asset prices.
Since 1965, when Paul Samuelson published a paper claiming Proof that Properly Anticipated Prices Fluctuate Randomly[2], uncounted hours of research, and uncounted research papers have examined various aspects of the theory, and the real-world data.
I won’t regale you with a review of the Efficient Market Literature. But the idea has tremendous support, and has given rise to the indexing approach to investing.
Recent data suggest that now over half of US equity market investment are indexed.
Market Capitalization Weighting
The key feature of the vast majority of indexes and index funds is something called market capitalization weighting. In essence, that means that a company with a large market cap, such as Apple, has a higher weighting in the index than another company with a smaller market cap.
Apple, for example, might be 7% of the index, while another giant (but relatively less giant) company such as AT&T might be just .33% of the index.
So What?
The “so what” is that for investors who index, the standard method of determining the weighting to give each asset depends not at all on anything to do with that asset’s intrinsic[3] value, or expected earnings, or expected future price.
Instead, the weighting (i.e. how much to invest) is determined entirely by the weight of that asset in the index.
Among other things, market cap weighting means that the more an asset rises in market value, the greater its weight in the index.
At the extreme, it is theoretically possible for an extremely over-valued asset to have an extremely outsized weight in the index.
Indeed, the possibility that an asset can be “overvalued” is implicitly rejected by the Efficient Market Hypothesis, and also by the investment style that uses cap weighted indexes.
Crypto
Finally, we come to crypto. The Efficient Market Hypothesis says, in effect, that “the market knows best.” If the market thinks X-asset is worth Y-dollars, it is.
With current market prices the total value of global stocks is about $110 trillion. The total market cap of global bonds is about $140 trillion.
The total market cap of crypto is about $3.5 trillion.
So, if we consider that we should include crypto in the “index” (and by the terms of the efficient market hypothesis we should include all assets in the global index), we come up with a market cap weighting of 3.5 divided by 253.5, or about 1.4%.
A committed belief in the correctness of the Efficient Market Hypothesis could logically lead to weighting a portfolio with crypto corresponding to crypto’s weight in the global index. This, of course, raises the question of what is the relevant global index. That question is beyond this discussion.
Real World
Based on my discussions with a large number of people, I believe that the average weighting in people’s portfolios is not at all consistent with this calculation.
In my experience, most people have zero crypto, and some people have a very large fraction of their net worth in crypto.
People who hold more than a small fraction of their net worth in crypto, and perhaps “should” – from a risk management point of view — sell, often do not sell.
Taxes
Taxes are one big reason people are reluctant to sell crypto, even though selling would allow them to lock in gains, and reduce risk. If you, or a client, has a large crypto gain, please ask us about tax-efficient ways to diversify without paying tax. Please click here to request a meeting or a case study.
[1] https://www.cnbc.com/2018/05/05/warren-buffett-says-bitcoin-is-probably-rat-poison-squared.html
[2] In Industrial Management Review, now the Sloan Management Review.
[3] “Intrinsic” in the widely accepted sense that the “intrinsic” value of an asset is the risk-adjusted present value of the cash flows expected to be produced by the asset.
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