Should You Be Using Crypto as an Equity Asset?

On this episode of The Long View, View 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 a few excerpts from Edelman's conversation with Morningstar's Christine Benz and Jeff Ptak:

Bitcoin and Intrinsic Value

Ptak: When it comes to things like stocks and bonds, we use cash flows to try to estimate intrinsic value. But that's not possible with bitcoin as there are no future cash flows. Given that, what confers bitcoin's value, especially considering its volatility currently makes it hard 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. We serve at Edelman Financial Engines 1.4 million people around the country. And so, yeah, I've been working with individuals on managing assets for a long time. And when you try to value bitcoin and other digital assets, your head explodes. What I have found is that as I've trained thousands of financial advisors over the past six, seven years in this area of crypto, I found that the more knowledge and experience you have as an advisor, the more experience as an investor, the more training, designations, college degrees you have in managing money, the more your head explodes, because all of that traditional training and all of that knowledge from Wall Street does not have any applicability in the crypto space. They are totally separate conversations. But most in the crypto world, or those in the Wall Street world, are trying to apply their knowledge to the crypto world. This is why you get people like Jamie Dimon, very bright guy, saying crypto has no value; why Warren Buffett calls it rat poison squared. These are brilliant Wall Streeters who are trying to apply their world to the crypto world. It is a non sequitur. It simply doesn't work. And here's why.

When you apply, as you said, Jeff, traditional valuation models, you're looking at the company, you're looking at the employees, you're looking at the product, the revenues, and the profits. And you look at other companies in the same industry that have been sold to determine relative valuations. And all of that helps you determine what the value of your company is that you're examining to establish the price of that company. Well, that works fine when you're evaluating a stock. But it doesn't work with bitcoin for the simple reason that bitcoin is not a company. It has no employees, there's no product, there are no revenues, and there are no profits. All of those numbers are zeroes, leading Jamie Dimon and Warren Buffett to say, therefore, bitcoin's value is zero. What they don't understand, very simply, is that bitcoin's value may not be something that we can clearly understand, but it certainly has a price. And that's the real key. We have to understand that the marketplace of investors—buyers and sellers—have ascribed a price to bitcoin—as we record this, about $40,000. That's all that really matters. It's a supply/demand equation. It isn't a stock valuation equation. And until you’ve begun to accept that fact, your head will continue to explode.

Where Does Crypto Fit in Your Portfolio?

Benz: We've heard you advocate for allocating 1% to 2% of a portfolio to crypto, and we're hoping to drill down on that. What types of investors would such a recommendation be appropriate for? I would think people with long time horizons because of the volatility. Also, how does crypto fit within a portfolio? Does it take the place of stocks, making it worthwhile to think of the opportunity cost for crypto as the difference between expected stock returns and crypto returns?

Edelman: You've got three good questions in there, Christine. First, yes, it would. Instead of a 60/40 portfolio, I would argue that it's a 59/40 and 1 portfolio. So, this isn't ownership asset. Stocks are ownership. Bonds are loanership. You're lending money to earn an interest rate. So, I would consider digital assets as a sleeve within an equity ownership position. So, I would use this as a replacement for or a reduction from your equity exposure, meaning stock market, real estate market, gold, oil, commodities, and so on. I would take it out of that sleeve. So, instead of a 60% allocation, for example, I'd have a 59/1 or a 58/2 allocation using 1% or 2% in digital assets.

And yes, long term. This is clearly a long-term play. We are looking at this as a transformative technological innovation in the world of commerce. This is going to take the next several years, the decade, to get implemented in global commerce. So, this is a long-term investment strategy. It is not a get-rich-quick, although clearly, a lot of people have gotten rich quick. That's a nice happenstance. That's not the point of it all. This is a transformational, technological innovation, just like investing in automobiles in the 1920s, airlines in the 1950s, and the internet in the 1990s. This is a long-term play. So, yes, you have a long-term outlook 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 of, and I believe it will be part over the next several years, of every routinely diversified portfolio. If you believe in diversification, and you believe in owning a wide variety of asset classes—stocks, bonds, government securities, real estate, oil, commodities, foreign securities, and so on—then you want to own as many diversified asset classes as you can. And crypto has proven itself to be the first noncorrelated asset class. And that's what you want in a diversified portfolio. It allows you to rebalance more efficiently. It allows you to capitalize on the volatility. And believe me, as you know, there's a lot of volatility here. It's wonderful for dollar-cost averaging and tax-planned investing such as tax-loss harvesting at year-end. There's a lot of advantages that this brings to the portfolio. And for that reason, any long-term investor who believes in diversification should routinely have a 1% or 2% allocation.

But that's worth an elaboration—why only 1% or 2%? If the growth pattern is so strong, if the projections are so widespread, so many people arguing that the price is going to rise so substantially over the next several years, why only 1% or 2%? There are two reasons. First, it could go south. There's still a lot of newness to this. There's still a lot of regulatory uncertainty. We've got competitive pressures. We don't know what consumer interests will be in the future. We don't know what market demand may be. There could be technological obsolescence. There's a lot of unknowns. It's still new and different. So, let's not take an undue risk in our portfolios. Let's not risk our future financial security on this.

Second, there's no reason to. The price history of digital assets has demonstrated that you can have a material impact on your portfolio with a very low 1% or 2% or a 5% allocation. You don't have to put 30% or 50% of your money into this in order to have it materially improve your life. So, all the academic data shows us, not just my research that I've been talking about with a 1% allocation. If you look at Yale, the study they came out with in 2018 said the same thing. They argued for a 3% allocation. Bitwise's research, which they did in conjunction with the CFA Institute, said, a 2.5% to 5% allocation. Pretty much everybody is in agreement. Low single digits is all you need to have the benefit of the risk/reward improvement to your portfolio.

Institutional Trading of Bitcoin

Benz: Well, that was definitely one of my follow-up questions—why just 1% to 2%—and you answered that really well. Another question, though, is on correlations. You made the point that correlations have been low relative to traditional assets. They seem to be rising though, at least, with the equity market. What's your take on that?

Edelman: This is an important observation. We did notice from October of 2021 through February of 2022 that correlations between crypto and stocks grew dramatically. That has ended as we went through the month of March of 2022, at our recording now, those correlations went away, and bitcoin has returned to its more historic pace or pattern of low correlation. In other words, the jury's out. Is that correlation that existed for a few months late last year, was that an unusual thing? Or will that become more common and become a trend? Why did it happen? And will it persist? That's the key set of questions we've got to answer.

The reason that it began to occur and never did before is a reflection of bitcoin's mainstreaming. Throughout most of the life of crypto, it has been individual investors, often fringe investors, those that are avant-garde truly doing something new and different. And that's a relatively small community. Suddenly, finally, many of us would argue, over the past year, institutional investors have gotten engaged. In fact, in 2021, institutional trading of bitcoin was twice as much as retail trading. We now have pension funds, endowments, major 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 engaging finally for the first time by buying this and adding it to their portfolios, recognizing that this asset class has added values for both diversification purposes and return potential.

Well, when institutional investors add crypto to their portfolios, what we're discovering is that they're considering it another sleeve of their equity assets. And when they decide to sell off those equity assets, like we experienced in January and February of 2022, they sold off their crypto just like they sold off their stocks. So, they're treating crypto more like an equity asset than they are a noncorrelated asset. And the question is, are institutional investors going to persist in that behavior? If so, we will probably see higher correlations of crypto to stocks than we did over the past decade. Jury's out. We're going to have to wait and watch, but your observation is important because this could have an impact on one of the benefits of owning crypto, meaning the noncorrelation element.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.