A former client sent in an Ask Kim question asking if buying bitcoin as hedge against inflation makes sense? What are the pros and cons of Bitcoin over gold and traditional strategies?
“Hi Kim- I’m enjoying your explanations and evaluations as usual. I have a question that I thought you might (or might not) want to address, in view of the current political climate in our land.
If inflation is impending, what stability (or lack thereof) can obtaining cryptocurrency in advance of rampant inflation provide?
My thought behind this question is that, due to crypto not being tied to the currency of any specific country (other than the transaction you make to initially obtain it), an investor in cryptocurrency could theoretically “cash in” their crypto in another country in that country’s currency and effectively bypass devaluation of their currency in their homeland.
Of course this pre-supposes the individual can get to another country, perform the essential transaction to cash in the crypto and stay in that country for a period of time.”
This is an awesome question, and as I wrote back to Nancy, I don’t see bitcoin as an inflation hedge as politically charged at all. It is, in fact, an important question for Family CFOs to understand, regardless of your political views or current outlook for the country or the even the world.
Doesn’t matter whether we are in the best of times or the worst of times…
An investment portfolio has two critically important jobs to do at all times:
1) to multiply the money you earn and save, in order to create enough for you to live on over 40+ years of retirement; and
2) to protect you from financial risk
Most people have this exactly backwards.
Investing isn’t risky. NOT investing is risky.
To be more specific, one of the jobs your investment portfolio must do, and must be designed to do, is protect against black swan events… whether they be market crashes, hyper-inflation, wars, catastrophic illness, whatever. Because, odds are, somewhere along the way, over the course of a lifetime, you will experience it. We all will. Nancy’s question was specifically whether owning bitcoin and/or other cryptocurrency would act as a hedge if we were to experience either inflation, a systemic financial crisis, or even some sort of terrible geopolitical event?
Of course, all of these are a matter of degree…
For those of us here in the United States and old enough to remember the 1970’s, Michael Bryan, of the Federal Reserve Bank of Atlanta wrote:
“The Great Inflation was the defining macroeconomic event of the second half of the twentieth century. Over the nearly two decades it lasted, from 1965 to 1982, the global monetary system established during World War II was abandoned, there were four economic recessions, two severe energy shortages, and the unprecedented peacetime implementation of wage and price controls.”
Unemployment eventually topped 10%. Inflation, as measured by the Consumer Price Index, which in normal times will typically hover between 2% and 4%, reached a high of 15% in 1980. And the cycle was finally broken by the Federal Reserve taking the brutal steps of raising interest rates to over 20%.
As bad as that was, it pales in comparison to what can happen…
And does happen. And IS happening right now. In countries less fortunate than we are. Inflation in Argentina is estimated to be running at 40%… meaning prices of a basket of standard consumer goods are 40% higher today than a year ago. In South Sudan, 117%, meaning prices more than double in a year. In Iran, they are 200%. According to a July 2018 story in Reuters…
Inflation in Venezuela is 46,305%! Food prices rose by 183% in June alone.
A story, on Axios, noted:
“Less than two years ago, a cup of coffee cost 450 bolivars in Venezuela. Today, as the nation’s hyperinflation continues to skyrocket, a cafe con leche costs 1 million bolivars — which is a mere 29 U.S. cents. But even at 29 cents, it is impossible to get enough cash to buy it. Back in January, CNN Money’s Stefano Pozzebano detailed his attempt to get cash in the Venezuelan capital, ultimately getting 10,000 bolivars — that day’s allowance — after visiting four banks over four hours. Today, that daily allowance of 10,000 bolivars is worth about a third of a US cent!”
So, that is what I mean when I say inflation, and geopolitical turmoil, cover a wide spectrum. Are we talking 5%? 1970’s Great Inflation? Complete financial collapse? Everything is relative.
Traditional hedges against inflation
Up until very recently, the primary mechanism for hedging against rising prices and economic or political turmoil has been owning commodities…. the basic units of production … Meats, metals, grains, energy, etc…. Why that makes sense is pretty straightforward. In periods of low inflation, the enterprises that produce goods and services will tend to outperform the basic commodities, as they combine them together and add value, returning that value, in theory at least, to shareholders. In periods of high inflation, on the other hand, the basic commodities will tend to outperform the enterprises as, by definition, the prices of the commodities are rising. But corporations will have negative return on capital. As Warren Buffett said in a 1977 piece for Fortune magazine:
“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital.”
To which he adds:
“If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner.”
Meaning, market timing is a fool’s game designed to make your broker rich, not you.
You cannot switch between different asset classes based on what you think will happen in the future. Or some guru or newsletter writer tells you. This is a long topic for another day. But I promise you, it is impossible to make money this way. So, the solution is, if possible, to always be holding a diversified portfolio, where different assets have different jobs… Some to earn. Some to protect. To the extent some can do double-duty, so much the better! So going back to the portion of our portfolio whose job is to hedge against risk… For thousands of years, the gold standard among hedges has always been, wait for it… gold! But now there is bitcoin.
Bitcoin as a hedge against inflation. Better than gold?
There is a chart I use in my free training that compares gold, bitcoin and fiat currency as a store of value:
SOURCE: The Bullish Case for Bitcoin (part 2 of 4) – Vijay Boyapati
For purposes of this discussion, there are a few advantages bitcoin has over gold that are more compelling than others.
Bitcoin is censorship resistant… by design
During the Great Depression, Executive Order 6102 made it a criminal offense for U.S. citizens to own or trade gold, anywhere in the world, with exceptions for some jewelry and collector’s coins. It wasn’t until 1975 Americans could again freely own and trade gold. As we have seen in China, a government can try to ban Bitcoin. But it was specifically designed to be censorship resistant. They just can’t.
Bitcoin is portable
If I am fleeing, I can carry billions of dollars of wealth across a border, in my pocket, or even in my head. Or maybe I’m not fleeing. But just storing physical gold in multiple locations where I can get to it and others can’t is challenging, and costly, to say the least.
Bitcoin is spendable
Moreover, it’s very difficult to spend or pay people in gold. Or even buy and sell it person to person. One of the points in Nancy’s question, in terms of mechanics was:
“Of course this pre-supposes the individual can get to another country, perform the essential transaction to cash in the crypto and stay in that country for a period of time.”
That wouldn’t necessarily be necessary. There are people all over the world spending bitcoin and accepting it for payment… even getting their paychecks in bitcoin. Because there is no intermediary bank or government, I can just transfer it from me to you. I can send millions of dollars across the globe, in the blink of an eye, for a couple bucks in network cost. Literally. Eventually, as it becomes more and more common, there will be less and less need to ever convert it into a fiat currency. And, as we have seen in countries in true crisis, that is even more the case. People PREFER something that holds or even increases in value, when their currency is losing value so quickly.
Real life case studies of bitcoin as a hedge against inflation
Take Zimbabwe, as an example. In October, 2017, amid a shortage of bank notes in the country:
“Bitcoin prices traded around $9,600 on the Golix exchange platform in Zimbabwe. On other global bitcoin exchanges, prices are just below $6000.”
In other words, demand pushed the price up well above the global spot price.
“Interest in bitcoin has peaked as people cannot send money outside or pay for international transactions using formal banks,” said Kusangaya. “People have had to look for alternatives and bitcoin has been a useful solution which can be used to purchase goods on Amazon or to pay for vehicles from international suppliers and traders,” she said.
Financial difficulties in Greece and Cyprus have been widely credited with pushing the price of bitcoin up in 2015. And, of course, Venezuela is the poster child for bitcoin. From an article in Forbes:
“As the bolivar continues to fall, many Venezuelans are turning to bitcoin as an alternative. Humanitarians can donate bitcoin to those in need, who can then use bitcoin to buy Amazon gift cards, then purchase goods through the online retailer. One of the biggest strengths to bitcoin, and one often ignored in developed nations such as the United States, is that you don’t need to have a physical bank account to send and receive bitcoin. All you need is an Internet connection, which many Venezuelans have in the form of mobile phones. This lowers the bar for Venezuelans seeking relief, allowing them to receive bitcoin through their phone and use that money for desperately needed goods. Some companies in Venezuela are even exclusively accepting payment in bitcoin, knowing that the bolivar is highly volatile and largely useless right now.”
So, you get the point.
Is bitcoin a viable hedge against inflation and financial crisis. Clearly yes.
But, is it a better hedge than gold? That is still open for debate. There are still plenty of people who say, “Gimme gold.” They don’t trust this new-fangled Internet money. There are several arguments for gold over bitcoin… especially if the proverbial shit is really, really hitting the fan.
Gold has been around forever. Bitcoin hasn’t.
In a true global crisis, would more people flock to gold because of a comfort level with gold as a hedge, thus driving the price up by much more than bitcoin, and therefore serving as a better hedge from a strictly price perspective? Another is that bitcoin relies on the Internet. And therefore electricity. And finally, there is the volatility. Holding bitcoin now subjects you to the nerve-wracking ups and downs in that part of your portfolio. However, as I have argued in my podcast episode titled “How I Learned to Love Cryptocurrency Market Volatility… and You Can Too”, so long as you are not over-allocated, that is less of an issue than naysayers seem to give it credit for. So the real answer is, no one knows for sure which is the better hedge. Bitcoin just hasn’t been around long enough.
My answer is you should hold both.
As I discuss in all my talks on asset allocation and in my free training, the ultimate goal of my waterfall approach to asset allocation is to first take care of your retirement income needs. Then address inflation risk second. Then market risk third. Most people are fighting the wrong dragon.
What that eventually works out to, by Financial Freedom Day, is roughly a 70/30 split between cash flow assets and alternatives.
15% of that is specifically for protecting against inflation and is therefore allocated to commodities and cryptocurrency. And, as you’ve heard me say many times before, since I don’t recommend more than 2% allocation to cryptoassets, at least for now, the rest will be a mix of commodities, overweighted in gold.
As a side note, I would caution that paper assets are not the same thing as physical assets.
Paper assets, such as commodity index ETFs or gold ETFs or owning GBTC instead of bitcoin, may go up in price and provide the hedge you want against something like the Great Inflation. But to protect against a real true financial crisis, some of that, both gold and bitcoin, must be in your possession and control. The gold coverage ratio, meaning paper to physical gold is massive. There are trillions of ounces of derivatives controlling millions of ounces of gold. There is also significant counterparty risk that doesn’t exist when you own and control the asset. Remember what Andreas Antonopolous says, “Your keys. Your money. Not your keys. Not your money.” That is true for gold as much as it is for bitcoin. And finally, notice throughout this article, I have been very careful to say bitcoin, not cryptocurrency or cryptoassets.
Other cryptocurrencies are not interchangeable with bitcoin as a hedge against inflation and financial crisis.
They may. But not by design. If so, it would just be a lucky coincidence. So, in summary, remember one of my key investment principles, plan for the best but prepare for the worst. And the time to do that is always. Not when storm clouds are gathering. That’s reactive and reacting is always, always, always an investment mistake. As always, I hope you found this helpful.
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