Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:19]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez. Thank you, Mary, and welcome to episode 29 of Risk Parity Radio.

Mostly Uncle Frank [0:45]

Today on Risk Parity Radio, since it's election week, we have a special treat for you. And that treat is, I am not going to talk about the election. We're gonna stay in our lane here and talk about investments and risk parity style portfolios at Risk Parity Radio. What we are going to talk about today is something that seems to be just as controversial and emotion laden as the election, which is Bitcoin. We had to talk about Bitcoin sometime. We might as well do it this week. To analyze an investment in Bitcoin, we are going to ask the same 10 questions that we always do. These are the 10 Questions to Master Successful Investing from David Stein at Money for the Rest of Us. And we will go through each of these 10 questions and answer them with respect to Bitcoin and hopefully avoid narratives and emotion in doing so. Now the first question is, what is it? Well, Bitcoin is a digital currency or a cryptocurrency. that is attached to a technology called blockchain. Bitcoin is created, distributed, traded, and stored with the use of this technology, blockchain, which is a decentralized ledger system. Now I am going to link to an Investopedia article in the show notes which has a lot more details about the technology, but for our purposes What we need to know about it is that it only exists in a digital form and that this technology, blockchain, controls it and limits its distribution and keeps track of all of the transactions involving Bitcoin so that you can tell when Bitcoin has been transferred from one place to another. It also limits the amount of Bitcoin in circulation, which should make it more valuable. All right, now that we know what it is, question two is, is it an investment, a speculation, or a gamble? Now let us recall that an investment in this lexicon, in this definition, is something that generates revenue, either because it's a debt instrument or a business or attached to a business. A speculation is something like gold that does not generate any income but has a value in a marketplace and that value could be more in the future or less in the future. And a gamble is something that has a negative expectation. Looking at these definitions, we would put Bitcoin in the category of speculation. And it has been referred to as digital gold. And some people treat it that way. Now it can be used as a currency or a medium of exchange. and it has been by some people, but typically most people that invested Bitcoin simply buy it and hold it. And so it is more of a store of value. It is more like gold than a dollar bill that you might go and take to the store and buy something with. I've also observed that it tends to trade more like a commodity Even more so than gold, because it has a very high volatility as we will see as we get to the later questions here. I would not consider it to be a gamble in this circumstance. It may have been a gamble in the past, but it seems to have had traction and it certainly has had an extremely large positive return over the course of its existence. which has been since about 2009. All right, question three. What is the upside? The upside is that it does behave like it has value, a store of value, that it has become more accepted by more people. And most recently in the past couple of years, large investors, famous investors have gotten involved in it, have put significant amounts of money into it. You may be familiar with Michael Saylor of MicroStrategy, who has bought a lot of it for that company. Another famous investor who has bought into it in the past couple of years is Paul Tudor Jones, who is one of those billionaire investors you read about in the financial news. But all of this suggests that it is getting a wider acceptance and therefore is likely to have a greater value in the future. But it is relying on the fact that the more people that value it, the more valuable it will be as it has really no intrinsic value as data in a computer. You can't consume it in any meaningful way. so its value is derived by its demand worldwide. All right, question four. What is the downside? Well, the downside is that perhaps it will go out of favor at some point and become worthless or worth less than it is today. It is certainly very volatile, has experienced drawdowns of 80 or 90% in some years. And so it's unclear just how quickly it will increase in value, although I do know today it's up about 10% in value. There are a number of other downsides to Bitcoin in the form of risks that we need to be cognizant of. And I'll just go through a few of them here and then tell you a little bit about my own personal experience as being somebody on the sidelines of this. The risks for Bitcoin investing include a regulatory risk that a government would seek to regulate or prevent its citizens from holding Bitcoin or using Bitcoin. There is a security risk inherent in Bitcoin. Bitcoin is stored on electronic devices. And while the creation of Bitcoin has not been proven to be hackable, the stealing of Bitcoin has. And just today I read an article about $1 billion of Bitcoin being transferred out of some wallet somewhere in Europe. with speculation as to whether it has to do with this Silk Road operation which sent a few people to jail a few years ago. But in any event, it still is a risk that somebody can steal it if it's in a place that is public, as in one of these exchanges where it's often held or traded upon. There is an insurance risk. Bitcoin is not insured. There's no FDIC or SIPC backing for it. So if you lose it, it's just gone. If it declines in value, there is no way of getting that back. And then going along with the security risks, there is also a risk of fraud. that somebody may attempt to sell false bitcoins or sell you something else. There have also been documented cases of Bitcoin price manipulation on various exchanges, which is another form of fraud. And then there is a tax risk associated with Bitcoin. It is treated right now as property under US tax law, but there is nothing to say that its status could not change in one way or another that may be favorable or unfavorable. And just thinking a little bit more about these risks, I had at one point back in around 2014, it could have been 2013, it was fairly early on, thought that I might Invest a few thousand dollars in Bitcoin as a speculation just because it seemed novel and exciting and I wanted to see what it was like. So I opened an account at one of the Bitcoin exchanges and I was about to fund it but I never got around to funding it. And then I looked at it and it had gone up tenfold in the next year or two. And I said to myself, gee, that was a missed opportunity. I should have got in on that when I got in on it, when I didn't get in on it, rather. But then something happened. The exchange where I would have put my money was an entity called Mt. Gox. I believe that's the proper pronunciation, but I could be wrong. Anyway, what happened to Mt. Gox is it was poorly run and it got hacked and most of the people who had Bitcoin there had it all stolen. So there is a good chance that any money I would have made, I would have lost all of it simply due to this security risk and this fraud risk associated with these exchanges. After that I've been reticent about making any investments in Bitcoin for that reason. Now, there are many people who are comfortable with the way things are, or they do what's called cold storage, where they take it and they put it on a stick or some device that's not attached to anything. But that seems to kind of defeat the purpose if you're trying to use a financial asset and be able to exchange it or trade it publicly if you've got it stuck away somewhere in a safe. I'm also concerned simply with losing it. A lot of Bitcoin has simply been lost, put on devices, and then those devices malfunction or are accidentally thrown away or otherwise destroyed, or people lose their codes and can't access their Bitcoin anymore because you need a code in order to be able to transact in Bitcoin, and if you can't transact in it, pretty much becomes worthless and useless. Now question five. Who is on the other side of the trade? Well, there are a lot of people on the other side of the trade these days. Bitcoin started as just a very small group of people that held most of it. There are still relatively small numbers of people that own and hold Bitcoin if you compare it to other financial assets. But its acceptance is growing and there are many more people involved as I mentioned, famous investors, companies are starting to buy it. There is at least one fund that we'll talk about in a minute that holds it. there are other people who are trying to develop funds for it. And it's one of many cryptocurrencies. I'm just let's focus on this one here though. But there is becoming more of a demand for more people and more ways of holding it that make it more interesting to be something that you would consider holding in the future or want to hold for the future. Right now there is not a lot of institutional desire for Bitcoin. You don't have pension funds out there making lots of investments in Bitcoin or governments or central banks like central banks would hold gold or bonds or something like that. So it does not have that kind of acceptance. and you won't be trading with those types of entities. If you're going to be buying or selling Bitcoin, you're more likely to be transacting with individuals or these funds or investors that are beginning to be formed. All right, what is the investment vehicle? Typically the investment vehicle is the Bitcoin itself. self. Now there are these exchanges now Coinbase or Gemini several other ones that are have either been running for a while or up and running. I don't have a laundry list of them. I couldn't tell you which ones are the best ones, but I'm just telling you what I'm aware of. Some of these now are located in the United States. and have some legal protection. I mean, you could sue somebody in the US if they mishandled your Bitcoin. So that gives you some legal protections, unlike the Mt. Gox, which was off in Asia and pretty much left people hanging out to dry when they lost their money. But the other way of holding Bitcoin these days, besides holding it directly, either in your electronic device yourself or in an account on an exchange, which I mean by holding it directly, is to buy it through a fund. There is really only one tradable fund out there right now. It's called Grayscale GBTC. It is not the most desirable fund in the world. It kind of overcharges for what it does. It trades at a premium to the Bitcoin it actually holds. It has a 2% annual fee, which is pretty darn high for a fund. But it is really the only one that's readily available to most investors that you can actually go onto your stock exchange and go buy and sell over the counter. There are many that are trying to get a standard ETF set up in the US, but so far the Securities and Exchange Commission has not approved any of them outside of the registrations that GBTC has done. I suppose the other way of investing in Bitcoin would be to mine it. That is beyond my Knowledge or capabilities. I know it requires a lot of computing power and a lot of electricity in order to do that. And a lot of it is being done in places like China where people can hook into electric grids and not pay as much as you might in a country like the United States. But that is beyond my capabilities. All right, question seven. What does it take to be successful? Well, there are a couple ways you could deal with Bitcoin. You can just buy some of it and hold it. Hold on for dear life is an expression that it goes with Bitcoin, the hodlers. Other people trade it. They wait till it goes down and watch it go up and it's extremely volatile and I Wouldn't venture to guess as to how to trade it successfully, but those are the two ways that people deal with it. After purchasing it, all you need to do is keep it secure. There is no other action that you need to take to be successful. All right, question eight. who is getting a cut? Well, really, you may have some exchange fees for the whatever exchange you use. If you use this Bitcoin Trust Grayscale operation GBTC, you would be subject to that 2% a year and whatever transaction fees you have. But other than that, nobody's really getting a cut. You might say that the people that invented it and are holding lots of it are simply getting a cut from what they did in the past, but that's kind of more of an existential application of that question in terms of a transaction fee. There isn't really anybody that is sitting there taking a commission for doling out a Bitcoin. All right, now we get to question nine, which I think is always the most interesting question in terms of Constructing Risk Parity Style Portfolios and question nine is how does it impact your portfolio? Now in order to consider that we need to consider two things really. We need to consider what kind of returns is it generating and then what kind of volatility does it have? Because those two things are going to determine both whether it's worth holding and how much to hold. The other question to look into is how correlated it is with our other assets. Because if it's very well correlated with something we hold already, perhaps it's not that useful, but if it's uncorrelated, then it has a lot more use or value in a risk parity style portfolio. Now in order to analyze that, and we do need to do an analysis, we can't just tell stories about it and how it might behave, we need to look and see how it has been behaving. So fortunately because there does exist this GBTC, it can stand in for an analysis of Bitcoin in terms of our analyzers, and we can look at its returns over the past five years or so, and we can look at its volatility over the past five years or so. And so we did that. We ran an analysis at Portfolio Visualizer and one of our analyses was looking at a portfolio that was 100% Bitcoin compared with one that was 100% gold and one that was 100% total stock market. Just to get an idea of what the relative volatilities are of Bitcoin. and looking at these three 100% portfolios, the one with the Bitcoin in it, and this only goes back to 2016, had a compounded annual growth rate of 89.94% with a best year of 1557% gain and a worst year of 82% loss. so it was extremely volatile the standard deviation comes in at 156.82% now how does that compare with gold and the stock market the standard deviation for gold in this period is 13.69% and the standard deviation for the stock market was 15. 39% so basically what you're talking about is Bitcoin is about 10 times more volatile than the other kind of standard investments you're going to find in your portfolio, such as stocks and gold. Now, over this same period, the compounded annual growth rate for gold and stocks was 12.1% for gold and 12.3% for the stock total stock market fund. And so when you translate these into sharp ratios, it's kind of interesting. because the Sharpe Ratio essentially is the risk reward overall for these assets. And you see that Bitcoin is comparable actually to these other assets, to gold and to stocks. Bitcoin had a Sharpe Ratio in this period of 0.88%. 0.88, it's just a ratio, it's not a percentage. And the gold had a Sharpe Ratio of 0.82. and the stocks had a sharp ratio of 0.76. So what that is telling you is that at least so far the returns that you've seen out of Bitcoin are commensurate with the kind of risk that is being taken by holding Bitcoin in a portfolio. So let's now consider whether Bitcoin is correlated or uncorrelated with other assets. And we did another analysis of that at Portfolio Visualizer, which we'll also link to in the show notes. And we compared GBTC, this Bitcoin fund, with VTI, the Total Stock Market Fund, TLT, the long-term Treasuries, gold, GLD, and also we threw in VNQ, which is the Vanguard REIT Fund, and VNQI, which is the Vanguard International REIT Fund, for comparison purposes. And what we see in this analysis is Bitcoin has a low but positive correlation to most of these other assets. In fact, it's pretty close to zero, so you would say that Bitcoin is fairly uncorrelated with the other assets and going down the list here it was 0. 11 with this total stock market, 0.09 with the long-term treasuries, 0.15 with gold, 0.09 with real estate, VNQ, and 0.17 with the International Real Estate Fund VNQI. So what that tells us is that this could be a useful thing to put into a portfolio because a risk parity style portfolio because of this lack of correlation. Now where does this leave us? It leaves us with question 10, should you invest? And again the answer to that as with respect to a lot of these alternative Investments is a maybe. The issues here have to do with risk and volatility. As I mentioned, Bitcoin is still not in a place like other financial assets where you can easily buy it and sell it through in a desirable ETF. You do have that GBTC Bitcoin Trust that you can go to, but it's not terribly desirable. as a vehicle for investing in Bitcoin, it would be better to own it directly or wait until you have something that has a much lower fee associated with it and is not trading at a premium to the value of Bitcoin, because that would only add to its volatility. So you can also hold it through an exchange. You can also hold it directly by yourself. All of these things seem to me to be a bit undesirable. I'm still reticent to invest after knowing what happened to my account at Mt. Gox. Fortunately there wasn't anything in it at the time, but the fact that somebody can hack into these accounts and steal the Bitcoin, and evidently this was just done to the tune of a billion dollars, just yesterday or very recently, there is still some question as to whether this asset is secure unless you are to put it in what is called cold storage where you have it on an electronic device that is separated from the rest of the world. But again, that kind of defeats the purpose of a digital currency which needs the rest of that digital world in order to be used or transacted with. But assuming you are interested in investing in Bitcoin in your risk parity style portfolio, and we can see that the returns could be substantial, the question then becomes, well, how much, what kind of percentage of your portfolio would you allocate to an asset like this? and it has to be small. The reason it has to be small has to do with this volatility issue that since Bitcoin is at least right now 10 times more volatile than the other assets in your portfolio, you would want to have a very low amount invested in it because otherwise the returns of Bitcoin are going to dominate everything that happens in your portfolio if you were to hold something like 20% in it or something of that magnitude. So what you're really probably looking at is holding 1 to 2% of your assets in this kind of asset class because that would match up with say if you're holding 10 to 15% gold and 1% in Bitcoin, those are going to have similar volatility characteristics, even though they are uncorrelated and could go up or down, but that 1% of Bitcoin could go up or down as much as that 10 or 15% held in gold. And that gives you, knowing what those volatility metrics are, gives you an idea of how much you should be holding. And it is true that if you look at some of these sophisticated billionaire investors like Paul Tudor Jones, how much Bitcoin are they holding? Are they putting 20 or 30% of their assets into it? The answer is no. They're putting 1 to 2% of their assets into this because they know it's a speculation. It could pay off tremendously, but in the event they were to lose all their money, it is only 1 to 2% of your portfolio. So the idea here is that you're hoping for a much more outsized reward in the end. I will say that it appears that the volatility of Bitcoin is beginning to decline, at least over the past couple of years. It's been more or less in a range in the thousands. It hasn't gone down to be worth 20 bucks or 100 bucks and it hasn't gone up to being worth hundreds of thousands or millions. It has been sort of in a range between about $5,000 and $19,000 over the past several years. As that seems to stay in a range like that, that means that the volatility is going to decline. It also means that Bitcoin may eventually trade more like gold with that kind of a volatility and that kind of performance where, you know, sometimes it goes up and sometimes it goes down and you're never quite sure why it's going up or down, but you know that it is. I think one thing you need to be careful about is telling yourself stories about what Bitcoin might do or might not do, because chances are whatever story you tell is likely to be wrong, either in the time frame you're telling it or in the direction you're telling it. It's better to simply wait and see if you're not confident in an investment like this one. So where do I come out? I'd like to invest in Bitcoin, but I'm not that comfortable with the mechanisms right now. If I did put any money into it, it would probably be a small amount, a test amount. It wouldn't even be 1%. It would be an irrelevant amount, maybe 0.1% or something of that nature. If an ETF though that is regulated under US law by the SEC and the SIPC comes into existence, I might be more convinced to invest in it that way. I would like to see an ETF that looks kind of like GLD or one of those gold ETFs where the expense ratio is somewhere down around 0. 2 because that seems to be a fair amount and that something like that is likely to trade along the same metrics as Bitcoin itself as opposed to GBTC which now carries this premium because it's kind of the only game out there in terms of finding a fund to put these things in. Then I suppose there's a question that concerns whether you would go beyond Bitcoin to other cryptocurrencies. I'm not ready to do that because I'm not even sure how many of these things will ultimately survive and thrive and what's going to happen to them. And you also need to avoid getting that FOMO, that fear of missing out, that Oh my gosh, you have to get into this now or it's going to go away. Truth of the matter is your risk parity style portfolio is probably going to be fine whether or not there's any Bitcoin in it at all. So put this on the maybe category and not on as the must have or must avoid categories. With that, I see our signal is beginning to fade. If you'd like to reach me with questions or comments, you can send an email to frank@riskparityradio. com that's frank@riskparityradio.com or through the website www.riskparityradio.com there is a contact form and you can contact me that way. We will be continuing this weekend with our weekly portfolio review. It's looking like a very interesting week here since everything went down last week and everything is roaring back to life this week. It reminds me of what Jack Bogle said that the best strategy to do or adopt in a storm is don't do something, just stand there, which we have done and we are happy we did. Thank you for tuning in. This is Frank Vasquez with Risk Parity Radio, signing off.

Mostly Mary [33:59]

The Risk Parity Radio show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here. making sure to take into account your own personal circumstances.