With Bitcoin approaching $100,000, many of your customers may be wondering if they should add cryptocurrency to their wallets. Some may be angry that they have stood on the sidelines for so long while cryptocurrencies like Bitcoin have gained 100% this year (over 30% since the presidential election) and approx 1,100% during the last five years. Some may be curious about these digital tokens and where they fit into their overall financial plan (if at all).
Initially, I was very curious about cryptocurrency and more than a little skeptical about its value. But as I've done more research, I'm now convinced that Bitcoin is one of the currencies that is here to stay and, in many ways, as good a store of value as gold – maybe better.
At its core, Bitcoin is one of almost 9,000 active cryptocurrencies. However, it is quite unique in that it is decentralized and has a fixed supply. Bitcoin is often compared to gold because of its limited availability (only 21 million bitcoins will ever exist) and perceived store of value. What are the other stores of value? Real estate, stock market, banking, debt. What are the risks associated with these properties? Unlike gold and silver, crypto has no industrial purpose as far as I know.
So why is Bitcoin at record highs today? Quite simply, it has to do with the laws of supply and demand. Again, only 21 million coins are available and there won't be more. Buyers are competing for the limited supply and driving up the price as they try to grab more coins. As Bitcoin becomes more accepted as a store of value, investors rely on it as a safe haven from inflation and deflation. This is because they do not believe that governments can destroy the value of Bitcoin through excessive borrowing as they can with the US dollar. It didn't hurt that the incoming Trump administration seems pro-crypto and favors less government regulation.
The possibility of another collision
From November 2021 to November 2022, Bitcoin sank about 75% from a record high over $64,000 to approximately $16,000 when rising interest rates and reduced liquidity in financial markets reduced its price. You may remember that 2022 was a terrible year for stocks and bonds as well, but the declines were closer 19% AND 13%respectively, not 75%. However, there have been many instances in which Bitcoin has risen when stocks and bonds have weakened, and vice versa. I haven't seen any evidence that Bitcoin or other cryptocurrencies are tied to US stocks or bonds (more on that in a minute).
Adding to customer portfolios
Every client's situation is unique, but there are three important issues to consider when deciding whether to add crypto to a client's wallet:
1. Which crypto? Issues such as market, supply, volatility and liquidity are all important considerations. Not all cryptocurrencies are created equal, and as stated above, there are around 9,000 active cryptocurrencies to choose from. If customers want to hold cryptocurrencies, shouldn't you help them find the one most likely to survive in the long run?
2. Diversification. Crypto can play a role in the overall diversification of a client's portfolio; more on that in a minute. Consider a mix of mining, full ownership in a crypto exchange, and crypto ETFs within the crypto bucket. The recent introduction of crypto ETFs has made it much easier for individual investors to hold the coins, and some hedge ETFs even pay dividends.
3. Temperament of danger. There is no guarantee that crypto will continue to hold value. Advisers must address the possibility of total loss and how a client would handle that outcome if it occurs.
Tax Implications
Taxes on your clients' crypto holdings will depend on how the profits were earned. If the coins were purchased first hand through digital “mining”, then the value at the time of purchase is treated as ordinary income and has no basis. But if they continue to hold them, any appreciation is a long-term gain. Many investors and some advisors have overlooked this fact. If an investor buys coins and later sells them for a profit, the tax is capital gains based on the appreciation of the basis, just like with stocks and bonds. Also, remember that if a client (NII) from capital gains, interest, dividends and any income from cryptocurrency investments exceeds $250,000 (MFJ) or $200,000 (single), they will likely have to pay the 3.8% NII tax.
The Risks
In addition to regulatory risk from various governments, the real risk of holding cryptos arises when a market for the coins no longer exists. This can happen due to fraud, economic disaster, competition or simply a loss of interest. Investors should understand that crypto is a perceived value. As long as this value is perceived, it exists. Once the perception of value is extinguished, value disappears and can become zero. But the same can be said for NVIDIA, Microsoft, and any other publicly traded stock.
Instability
When deciding where cryptocurrency fits in a client's overall portfolio, many advisors try to assign it a measure of volatility, such as beta. or the last report based on Bloomberg data said that Bitcoin is likely to move four to five times compared to the S&P 500. But since the crypto has no constant connection to any market, it cannot be defined as a “beta”. However, because unforeseen events (for example, wars, crashes, and bubbles) can have a detrimental impact on markets, such events will also affect crypto if holders expect the unforeseen event to negatively impact in crypto liquidity and stability.
liquidity
Because Bitcoin is still in its infancy, there is no real market other than self-defined markets. The risk of not being able to sell Bitcoin in a crisis is still unresolved. This is where demand and perception play a big role in determining value. An example was the stock market crash of 2008, when it was almost impossible to get any of the major trading platforms on the phone due to the panic. The bottom line is that if a client wants to own crypto, they need to make sure they won't have significant liquidity needs in the event of a sharp correction or a global crisis.
Defense tool?
Many advisors wonder if crypto can be used to hedge clients' positions in stocks, bonds, real estate, gold or even cash. Again, there doesn't seem to be any statistical correlation between cryptos and other traditional assets. I have found that the best way to invest in crypto is to spread the risk between actual coin ownership, exchange traded funds (ETFs) and miners. But prepare for a wild ride. Many crypto ETFs are available now that the Securities and Exchange Commission has opened that door. There is no reason to think that ETFs will be any less volatile than holding crypto directly. The advantage is the ease of liquidation.
Recommended allocation
Holding crypto is a question of risk tolerance: to what degree can a customer tolerate the prospect of their entire investment evaporating? Setting expectations is crucial. Only a small percentage of our clients meet our risk tolerance criteria. When they do, we advise them to allocate no more than 3% to 5% of their portfolio to crypto – much the same as we advise their emergency cash allocation.
My personal experience with crypto has been very complicated. I started with miners and kept several different ones. After the halving (when the mining value of a coin was halved), I consolidated to just one miner. I was lucky enough to earn a 10x return on one of my early miner purchases. When I sold, I took my capital and continued to invest the profit. I have seen that profit almost disappear and then turn into a 10x profit. There have been some wild swings in value. I am back to 10x plus with the recent rise in crypto values. But for many months, my account was in a heavy negative position. I have also bought a crypto ETF and recently used call options to generate cash premiums paid out as dividends. My son, who works at our firm, had a similar experience. In July, his crypto holdings peaked. By September, they had halved, but by early November, his holdings had returned everything, plus an additional 20% from their July 2024 all-time highs.
Legitimate store of value
Make sure customers go into crypto with their eyes open, don't have short-term liquidity needs, and have reliable safeguards. But unlike sports and adrenaline gambling, I believe crypto is a legitimate store of value. It's a place to park money and keep pace with inflation because it won't move in step with the dollar; it will not decrease when the Fed injects additional dollars into the economy. You owe it to yourself and your customers to keep abreast of crypto developments as crypto becomes more and more mainstream. It represents change, but it's worth the risk.
Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, CA).