Asset formula

Should you use crypto as an equity asset?

On this episode of The long viewView is Ric Edelman, founder of the Digital Assets Council of Financial Professionals, or DACFP, sits down to talk crypto, portfolio strategy and retirement planning.

Here are some excerpts from Edelman’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Bitcoin and intrinsic value

Ptack: When it comes to stocks and bonds, we use cash flow to try to estimate intrinsic value. But this is not possible with bitcoin because there are no future cash flows. Given this, what makes bitcoin valuable, especially since its volatility currently makes it difficult to use as a medium of exchange?

Edelman: This is where people’s heads explode. I’ve been managing money for 40 years. I built the largest RIA in the country, managing $300 billion in assets. At Edelman Financial Engines, we serve 1.4 million people across the country. And so, yes, I’ve been working with individuals on asset management for a long time. And when you try to value bitcoin and other digital assets, your head explodes. What I’ve found is that as I’ve trained thousands of financial advisors over the past six or seven years in this area of ​​crypto, I’ve found that the more knowledge and experience you have as an advisor, the more experience you have as an investor, the more training, designations, college degrees in money management, the more your head is exploding, because all that traditional training and all this Wall Street knowledge has no applicability in the crypto space. These are totally separate conversations. But most in the crypto world, or those in the Wall Street world, try to apply their knowledge to the crypto world. This is why people like Jamie Dimon, a very smart guy, say that crypto has no value; why Warren Buffett calls it rat poison squared. They are brilliant Wall Streeters trying to apply their world to the world of crypto. It is a non-sequential. It just doesn’t work. And here’s why.

When you apply, as you said, Jeff, traditional valuation models, you’re looking at the business, you’re looking at the employees, you’re looking at the product, the revenue, and the profit. And you look at other companies in the same industry that have been sold to determine relative valuations. And all of this helps you determine the value of your business which you are looking at to price that business. Well, it works well when you are evaluating a stock. But it doesn’t work with bitcoin for the simple reason that bitcoin is not a business. There are no employees, there is no product, there is no revenue and there is no profit. All of these numbers are zeros, leading Jamie Dimon and Warren Buffett to say that bitcoin’s value is therefore zero. What they don’t understand, very simply, is that bitcoin’s value may not be something we can clearly understand, but it certainly has a price. And that’s the real key. We have to understand that the market of investors – buyers and sellers – has put a price on bitcoin – as we record it, around $40,000. That’s all that really matters. It’s a supply/demand equation. It is not a stock valuation equation. And until you start accepting that fact, your head will continue to explode.

What is the place of crypto in your portfolio?

Benz: We’ve heard you advocate allocating 1-2% of a portfolio to crypto, and we hope to expand on that. What types of investors would such a recommendation be appropriate for? I would think of people with long time horizons because of the volatility. Also, how does crypto fit into a portfolio? Does it replace stocks, making it worth considering the opportunity cost of crypto as the difference between expected stock returns and crypto returns?

Edelman: You have three good questions in there, Christine. First, yes, it would. Instead of a 60/40 portfolio, I would say it’s a 59/40 and 1 portfolio. So it’s not a property asset. Shares are owned. Bonds are loans. You lend money to get an interest rate. So, I would consider digital assets as a sleeve in an equity position. So I would use it to replace or reduce your equity exposure i.e. stock market, real estate market, gold, oil, commodities etc. I would take him out of this round. So instead of a 60% allocation, for example, I would have a 59/1 or 58/2 allocation using 1% or 2% digital assets.

And yes, long term. It’s clearly a long game. We see this as a transformative technological innovation in the world of commerce. It’s going to take the next few years, the decade, to be implemented in global commerce. It is therefore a long-term investment strategy. It’s not a get-rich-quick scheme, although it’s clear that a lot of people have gotten rich quick. It’s a nice coincidence. That’s not the point of everything. This is transformational technological innovation, just like investing in automobiles in the 1920s, airlines in the 1950s, and the Internet in the 1990s. It’s a long game. So yes, you have a long term perspective for this. Don’t try to get rich quick. Consider yourself lucky, not smart, if you do.

And third, who should own this? It should be part, and I believe it will be part over the next few years, of any regularly diversified portfolio. If you believe in diversification and believe in owning a wide variety of asset classes – stocks, bonds, government securities, real estate, oil, commodities, foreign securities, etc. – then you want to own as many diverse asset classes as possible. you can. And crypto has emerged as the first uncorrelated asset class. And that’s what you’re looking for in a diversified portfolio. It allows you to rebalance more effectively. This allows you to capitalize on volatility. And believe me, as you know, there is a lot of volatility here. This is wonderful for periodic fixed-sum purchases and tax-planned investments, such as harvesting tax losses at the end of the year. There are a lot of benefits it brings to the wallet. And for this reason, any long-term investor who believes in diversification should consistently have a 1% or 2% allocation.

But that deserves elaboration—why only 1% or 2%? If the growth model is so strong, if the projections are so widespread, if so many people claim that the price will increase so substantially over the next few years, why only 1% or 2%? There are two reasons. First, he could go south. There is still a lot of novelty to this. There is still a lot of regulatory uncertainty. We have competitive pressures. We don’t know what consumer interests will be in the future. We do not know what the market demand may be. There could be technological obsolescence. There are a lot of unknowns. It’s still new and different. So let’s not take undue risk in our portfolios. Let’s not risk our future financial security on this.

Second, there is no reason to do so. Digital asset price history has demonstrated that you can have a significant impact on your portfolio with a very low allocation of 1%, 2% or 5%. You don’t have to invest 30% or 50% of your money in it for it to materially improve your life. So all the academic data shows us, not just my research that I talked about with a 1% allowance. If you look at Yale, the study they published in 2018 said the same thing. They pleaded for a 3% allowance. Bitwise’s research, which they did in conjunction with the CFA Institute, indicated an allocation of 2.5% to 5%. Almost everyone agrees. A low single digit is all you need to benefit from the improved risk/reward ratio of your portfolio.

Institutional Bitcoin Trading

Benz: Well, that was definitely one of my follow-up questions – why only 1% to 2% – and you answered it very well. Another question, however, is about correlations. You argued that the correlations were low compared to traditional assets. They seem to be increasing, however, at least with the stock market. What is your opinion on that?

Edelman: This is an important observation. We noticed from October 2021 to February 2022 that the correlations between crypto and stocks increased dramatically. This ended during the month of March 2022, at our current record these correlations have disappeared and bitcoin has returned to its more historic pace or low correlation pattern. In other words, the jury is out. This correlation that had existed for a few months at the end of last year, was that an unusual thing? Or will it become more common and become a trend? Why did this happen? And will it persist? This is the main set of questions we need to answer.

The reason this started happening and never has before is a reflection of the integration of bitcoin. For most of the life of crypto, it has been individual investors, often fringe investors, those who are forward thinking, who are really doing something new and different. And it’s a relatively small community. Suddenly, finally, many of us would say that over the past year, institutional investors have stepped up. In fact, in 2021, institutional bitcoin trading was twice as large as retail trading. We now have pension funds, endowments, big corporations, like MassMutual, last year they bought $100 million worth of crypto. MicroStrategy owns $5 billion worth of crypto. We have Tesla. You can do this through PayPal and Square. There are hedge funds, family offices, all finally committing for the first time by buying this and adding it to their portfolios, acknowledging that this asset class has added value both for the purposes of diversification and yield potential.

Well, when institutional investors add crypto to their portfolios, what we find is that they view it as another part of their equity assets. And when they decide to sell those assets into stocks, as we experienced in January and February 2022, they sold their crypto just like they sold their stocks. Thus, they treat crypto more like an equity asset than an uncorrelated asset. And the question is: will institutional investors persist in this behavior? If so, we are likely to see higher correlations between crypto and stocks than we have over the past decade. The jury is out. We’ll have to wait and watch, but your observation is important because it could impact one of the benefits of owning crypto, and that is the element of non-correlation.

This article was adapted from an interview that aired on Morningstar The long view Podcast. Listen to the full episode.

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