The Keys to Investing in Digital Assets

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A store of value, a medium of exchange, a unit of account. cryptocurrencies are all things to all investors, just not at the same time“– Paul Ebeling

Bitcoin has been touted by some of the biggest names on Wall Street as a potential hedge against inflation within a portfolio, thus, declaring cryptocurrency as an investable asset.

Which begs the begging the Big Q: What is an investable?

The Big A: According to traditional metrics, an investable asset ought to meet these criteria:

  • Generate steady, reliable cash flow on a contractual basis, like bonds
  • Deliver earnings through exposure to economic growth or from the creation of products or services that are desired, like stocks
  • Provide consistent and reliable diversification benefits to a portfolio, with limited correlation with other assets
  • Dampen portfolio volatility
  • Reliably hedge inflation or deflation as a store of value (discussed here)

On an inflation hedge and store of value

Because the history of Bitcoin is limited, focusing on its ability to hedge against inflation is to miss the forest for the trees.

Even gold, which has been prized for millennia has had a patchy track record when it’s come to its alleged ability to hedge against inflation, demonstrating such properties over centuries, but not within a typical investor’s lifetime.

To serve as a reliable and consistent store of value, an asset would typically not have frequent and large price declines.

And in this regard, even compared against US stocks, Bitcoin has struggled to store its value with more frequent and larger price declines over its 12.5 yrs of existence than the stock of American companies since Y 1928.

Bitcoin has also had too short a lifespan to be properly measured up against inflation because until fairly recently, in the period after the Y 2008 Financial Crisis price increases have been muted.

As such, Bitcoin’s comparison with gold as an inflation hedge is inconvenient at best and misleading at worst.

Unlike Bitcoin, gold has fundamental uses, fluctuating from the aesthetic to the industrial, but it is the demand from investors that sets its price.

Bitcoin and gold have no cashflows and are generally not used as a medium of exchange, but they can have decorative value or an emotional attachment and are best classified as that class of assets considered collectible.

Like a classic car or a baseball card, a collectible cannot be valued using traditional metrics, but they can be priced based on how others perceive that collectible’s desirability and its scarcity and it is in this respect that Bitcoin shines as an asset class.

A fool is often derided as someone who knows the price of everything but the value of nothing, anyone assessing the investable nature of Bitcoin needs the skillset necessary to profit from the cryptocurrency. Here is where we help clients, investors and valued readers.

Tradeable Collectible NFTs

Anyone can trade crypto and become fabulously wealthy in the process, doing so because they are a good trader, and not necessarily because they are a good investor.

So, it is important to distinguish between cash-generating assets like stocks and bonds that can be both valued and priced, and collectibles that can only be priced.

To consider an asset investable an investor would first need to assess its value, compare that value Vs the price and then act on that comparison, either by buying if the price is less than value or selling if the price is greater than value.

As cryptocurrencies enter the mainstream, it becomes all the more important to understand what game investors should be playing when it comes to the nascent asset class

The Big Q2: Are participants playing the pricing game or the valuation game?

The Big A2: Valuing digital assets is challenging from cash flow analysis to the cost of production, because none of the standard approaches to valuing traditional assets yields a useful framework for exercise.

But even if Bitcoin cannot be valued in the traditional sense, but it can be priced.

Playing the pricing game is a much simpler exercise than playing the valuation game and requires an investor to become a trader.

When a trader prices something, they make a judgment on whether that price will go up or down in the following time frame and then make an intuitive pricing bet accordingly.

The thing being priced has little relevance, so long as there are sufficiently liquid and deep markets to play the pricing game for that thing.

To win, a trader has to be right more often than wrong about the direction and to exit before the wind shifts when playing the pricing game.

Whereas price is determined by demand and supply, this demand and supply should not be confused for that of the underlying asset that bets are being taken on, but rather the demand and supply of bids and asks in a market, which are in turn determined by sentiment and momentum.

Incremental information, like news, stories and rumors, that shift sentiment, will move price, even if those shifts have no long term consequences for value.

To play the pricing game, a trader (investor) will need to arm themselves with the tools of the trade and in the case of Bitcoin, that includes everything from technical indicators, price charts, to investor psychology.

Decision-making timeframes need to be adjusted accordingly too. Instead of buying to hold indefinitely, a trader may be very short term (mins) to mildly long-term (weeks to months).

And so a Key skill of the trader is to be able to gauge the market mood and momentum shifts ahead of other traders, which typically requires a unique skillset that the average investor generally does not possess and that we do as professionals.

That set of skills includes recognizing that what has happened in the past has little to no correlation with what will happen in the future, responsiveness, meaning not holding on to losing positions and gaming instincts.

A Key risks when it comes to playing the pricing game is that Key Reversals, aka momentum shifts can appear instantaneously wiping out months of profits in a few hrs or mins.

But, the biggest danger when it comes to playing the pricing game, is assuming that you are trying to play the valuation game too.

Any serious debate about digital assets requires an assessment as to whether it is an investable asset at least according to traditional metrics.

For investors who are carving out a portion of their portfolios to bet it on Bitcoin, it is important to be clear as to the intention behind such a move: It may not be for diversifying a portfolio, or even hedging against inflation, but to leverage trading skills to supercharge portfolio returns.

So, the only option is to price it and recognize that in the long term, the price attached to asset will depend on what other traders will pay for it.

A Key ingredient needed for an investor valuing a nascent asset is absent, which means that the only thing left is to trade.

Anyone can trade Bitcoin and become fabulously wealthy in the process so, know that they did so because they are a good trader, and not necessarily because they are a good investor.

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Have a prosperous day, Keep the Faith!