Follow the time-tested investment approaches based on positive real returns and enduring economic rationale…

The recent regulatory approval and introduction of nearly a dozen spot bitcoin exchange-traded funds (ETFs) in the United States has been generating lots of noise in the global investment industry.

Until recently, US investors who wanted to buy and sell bitcoin had to either trade on cumbersome and costly cryptocurrency exchanges or purchase products that track bitcoin in less direct ways.

While spot bitcoin ETFs have been available in Australia since 2021, many in the cryptocurrency industry claim that the US Securities and Exchange Commission’s long-awaited approval signals legitimacy and the arrival of crypto as a mainstream asset class that can now be more easily recommended by financial advisers.

Even though the ETF format is undoubtedly a more efficient method of accessing almost any asset, before rushing into these new bitcoin ETFs investors should follow time-tested best practices of assessing an asset’s enduring investment merit and ability to generate positive real returns.

First, consider that when you invest in the share market or in bonds, you are essentially investing in the future earnings of a company or, in the case of bonds, a borrower’s ability to pay back a debt obligation with interest.

On the other hand, most cryptocurrencies – unlike shares, bonds or even property – do not produce any cash flows for investors (dividends, interest payments or rent payments).

A second key factor is around valuations. To evaluate the investment case for any asset, one needs to assess its fair market value. This is often done by analysing its discounted future cash flows.

But cryptocurrencies don’t generate any cash flow, so they cannot be objectively valued and therefore their trading prices are purely speculative.

When it comes to valuing, the best one can do is hazard a guess. And, as exciting as crypto may be, guessing is never good enough when it comes to long-term nest eggs.

A third consideration is that cryptos lack any proven industrial usage. In other words, unlike currencies issued by central banks and backed by governments, cryptocurrencies are not widely used for everyday commercial transactions, let alone for personal financial transactions.

The cryptocurrency industry is largely unregulated and accompanied by considerable risks including high rates of fraud and extreme volatility.

Over just the past three years, the price of bitcoin has increased by as much as 150% and declined by as much as 75%. But what is really interesting is that no one can explain why. And it’s important to remember that to make up for a big percentage fall investors need an even bigger percentage gain just to break even. As an example, if you start with a $100 position and it drops by 75% to $25, it will take a 300% gain to get back to break even at $100.

It’s also worth remembering that, depending on the source, there are somewhere between 8000 and 10,000 active cryptocurrencies. A similar number are regarded as inactive, which is really just a polite word for failed.

For most investors, adding cryptocurrency exposure to a portfolio would mean reducing allocations to traditional asset classes with demonstrated long-term investment credentials.

Investors who can’t ignore their craving to speculate in cryptocurrencies would be well served viewing it as a satellite exposure only, leaving their core holdings invested in broad-based, diversified funds.

There is no doubt that some speculators have benefited from bitcoin’s rise, but on the other side of the ledger, many investors have lost significant amounts of money. Over time, given the risk characteristics of cryptocurrency assets, it’s likely many investors will fall into the latter category.

Any investment strategy based on catching lightning in a bottle is very high risk. For that reason, it’s better for investors to shrug off the fear of missing out and not stray too far from the time-tested investment approaches based on positive real returns and enduring economic rationale.

Often the hardest part of creating wealth is not figuring out the most exciting investment portfolio, it’s about remaining committed to a sound investment portfolio.

An iteration of this article was published in the Australian Financial Review.

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