When constructing an investment portfolio, diversification is essential to balance out investment risk caused by the natural price fluctuations seen in financial markets. In an effort to offset some of that inherent volatility, many investors naturally seek to hedge their traditional portfolio positions with alternative assets. The approach of adding to the portfolio mix from a range of alternative assets that are weakly correlated with traditional financial assets is what introduces the “diversification effect” to an investment portfolio, which reduces its overall risk.
Depending on an investor’s liquidity requirements, investment horizon and risk tolerance, one may typically allocate a portion of their invested capital to real estate, art, private equity and hedge funds, structured products, and precious metals, principally, gold. However, most of these alternative asset classes are typically only accessible to or suitable for institutional investors. Due to this fact and to their relatively broader accessibility, specifically real estate and to a lesser extent gold, in many ways tend to be the main drivers of diversification in mainstream investment portfolios.
Such has been the case until the recent emergence of crypto assets, with the launch of Bitcoin in 2009 in response to the economic turmoil caused by the Great Recession. Mainstream retail investors were the first to see Bitcoin as a hedge, not only to their traditional investment portfolios, but also as a hedge against the overall global economy. Fintech platforms and exchanges supporting the unbanked and underbanked, tech-savvy early adopters, speculative investors, as well as the hardcore libertarians, were some of the early adopters who propelled the network to its current market position as a real and entirely new investible asset class, well before the likes of Wall Street took it seriously.
Over the course of its fledgling existence, Bitcoin has managed to concretely assimilate itself into global financial markets at an unprecedented pace for a new financial asset. The original cryptocurrency initially emerged in 2009 as “internet money”, freely sloshing around the World Wide Web in an open and permissionless peer-to-peer electronic cash system. Bitcoin now ranks handsomely among the ten largest world currencies, having gained entrenched adoption over a relatively short period of time, with over 1.1 million active wallet addresses conducting daily transactions, and with daily volume exceeding $10 billion, Bitcoin’s liquid market cap is approaching $600 billion, according to live market data from Messari.io as of January 24, 2021.
This strong momentum has continued to build up more and more steam much to the chagrin of many archaic central banks and stagnant financial institutions, with little exception (eg. Central Bank of The Bahamas with its Sand Dollar national digital currency), even as some of their rudimentary tactics lose efficacy, and bullishness on Bitcoin proliferates throughout global financial markets. As we enter into the first global recession since its inception, the environment for which Bitcoin was originally designed to thrive, and it has securely nestled its way into some of the most venerable institutional investment portfolios as a dedicated investment allocation, solidifying the digital asset as a viable portfolio construction component for institutional investors.
Having undergone legal, technical and public scrutiny by regulators, in addition to robust investment analysis by respected investors, over the course of more than a decade, a balanced view has begun to take shape whereby Bitcoin is emerging to be perceived as “digital gold”. Ironically, a few years back, the big banks were only interested in the potential of blockchain, i.e. the underlying technology that was actually engineered within the Bitcoin codebase. Now this elite cohort of institutional investors that extends from ultra-high net worth individuals and big corporations to pension funds, hedge funds, university endowment funds, asset managers, banks, family offices, which have all been largely on the sidelines until recently, are beginning to buy Bitcoin. Why? They see it as a hedge to anticipated inflation in the money supply—a space previously nearly exclusively occupied in financial markets by gold. In short, Bitcoin is being bet on by Wall St. to disrupt central banks as a negatively correlated hedge against fiat currencies. Hence the recent movement across the globe by many governments and central banks engaging with regulatory bodies with respect to CBDCs, or central bank digital currencies, evidently a realization that they must adapt norms and standards to reflect the reality that is the new digital money paradigm.
Therefore, it’s no surprise that Bitcoin is being accepted as a virtual version of gold because it certainly appears to pass the “duck test”. Like gold, Bitcoin is also a relatively scarce asset that is useful (gold→industrial production; Bitcoin→money transfer system). And like gold, Bitcoin has a low correlation with traditional assets such as stocks and bonds. And, although relatively infrequent, both can also be accepted as a medium of payment. Furthermore, both gold and now Bitcoin are simultaneously viewed as speculative investments as well as safe-haven investments, where many investors tend to flock at times of market distress. [correlation increases with economic shocks like with all non-cash risk assets].
Bitcoin is clearly similar to gold if you credit the foregoing metrics. One could even construct a similar investment thesis and strategy for Bitcoin as one would for gold, as a traditional portfolio hedge. However, Bitcoin displays certain characteristics that arguably make it in several ways superior to gold as a hedging instrument for investment portfolio diversification and long-term value preservation. For example, while gold’s value is based on stock-to-flow models and other traditional market-based valuation methodologies, Bitcoin’s value is derived on similar ones, plus a number of other economic forces such as network effects, more akin to what is seen with network-based valuations in the tech sector.
Maybe Bitcoin is in essence “digital gold”, but perhaps it is also better at being gold than gold itself, primarily because of its impact on global payments, but of course due to many other factors. They are actually in two different asset classes, both having shown historically weak correlations with traditional financial assets, and while Bitcoin might compete with gold as a portfolio hedge, there is not much competition between them apart from gold’s first-mover advantage in capital markets due to its ancient usage as money.
While Bitcoin and gold can both generate the desired diversification effect from including them in traditional portfolios as a hedge, Bitcoin outperforms gold in the following ways, which should result in superior value appreciation over the long run:
- Generational Shift in Investing Behavior: Bitcoin represents a generational shift in investing behavior, a phenomena that is just beginning to play out, one in which investments in gold are deemed to be lame by the younger generations. This may be because Bitcoin is more like money than gold in the way money is used today, mostly via digital payments, etc., and that so much debt is tied up with traditional assets that they wish to hold a real asset that is totally unencumbered by the brewing debt-asset bubble fueled by unbridled money printing.
- Absolute Scarcity: Bitcoin was perhaps designed to perform as the best long-duration store of value asset due to its limited supply and the fact that it has no single point of control or failure. More specifically, the decentralized network protocol is absolutely capped at 21 million bitcoin, and interested parties can easily verify online any market data firsthand. When it comes to gold, no one knows how much of the precious metal is on the planet. Miners can find gold under the surface of the earth, and it also exists in seabeds. Some companies have even started working toward creating a space mining industry, in a global race to mine gold and other precious metals and minerals in outer space. Therefore, the absolute scarcity of Bitcoin supports the preservation of its long-term value in absolute terms and relative to gold.
- Dynamic versus Static: Contemplate this stark contrast: Bitcoin is a dynamic network, whereas gold is a static metal element. Such a massive, indefinitely activated, open global network provides a new paradigm for internet based business models to thrive in uncharted ways, compared to the obvious limitations found in the opaque, disintegrated and fragmented gold industry, which is riddled with logistics issues and added costs of doing business, which introduces unwelcomed complexity and makes it quite difficult to purchase gold for investment purposes. As Bitcoin continues to evolve its technology and further develop the capacity and security of its already massive network, the significance and soundness of its value proposition actually increase exponentially in relation to traditional financial assets like gold, because they do not behave in this way.
- Speed, Efficiency and Access: Bitcoin overcomes the limitations of gold because it is engineered “virtual gold” with all of its benefits and none of its liabilities (e.g. its lumpy, so storage and transportation cause friction and thereby increase costs). It is electronic so it moves at the speed of light. You can build on it and engineer it into fintech platforms, to enhance its utility, ease of use and accessibility. Bitcoin is a living ecosystem that is constantly evolving, and it is simply smarter and faster electronic dematerialized gold, which is bought and sold in a worldwide and borderless market, available 24/7 (weekends included) to anyone with an internet connection.
- Transparency & Verifiability: The Bitcoin blockchain provides full transparency, real-time audit, immutability of all transactions. For this reason, Bitcoin offers pristine collateral that is readily verifiable and reliable to prove execution and provenance. In the gold market, it is both difficult and costly to achieve a similar standard of verifiability by counterparties for it to hold water as bona fide collateral.
- Seigniorage: Participants in the Bitcoin network can enjoy the benefits of asset seigniorage by participating in the mining, or digital creation, of Bitcoin and benefit from the prevailing market price of Bitcoin less the cost of actually producing it. Gold’s creation is capital-intensive and dominated by oligopolistic players.
Based on the foregoing arguments, is it accurate or even appropriate to refer to Bitcoin as “digital gold?” Perhaps, but doing so would be a gross understatement. The uncorrelated price action of the cryptocurrency is proving that it can be a viable and effective alternative portfolio hedging instrument for investment diversification and long-term value preservation - so much so that one might venture to call it the “Golden Hedge.”
The above views and opinions are my own and do not reflect the views of any organizations or institutions with which I may be employed, directly involved or affiliated. Before purchasing or speculating on either gold or Bitcoin, prospective investors can benefit significantly from consulting with professional financial advisors and conducting thorough due diligence and research.