Bitcoin as an alternative asset class

The spike (and volatility) in the Bitcoin price has attracted renewed interest from many individuals, investors and businesses in recent weeks.

Today, I’ll take a bit of a deeper dive into the numbers and look at the reason why more people are considering Bitcoin as an alternative asset class.

Bitcoin’s main use cases (for now)

Bitcoin is new and evolving technology. For the first time in human history is it possible to create, send and operate a currency without the need of a central government, company or individual.

We are very much at the early stages of development, with some of the most exciting use cases yet to come, but there are already two that are crystal clear:

1. Bitcoin as a transfer or payment mechanism
2. Bitcoin as a store of wealth, an alternative asset class

This article will focus on the second.

What is an asset class?

Other than spending (consumption), investors (broadly defined as “those with money after consumption”) will typically put their money into an asset or group of assets, with the goal to preserve or grow their money.

Again, broadly speaking, an investor usually chooses one of the following asset classes:

• Stocks, ETFs or mutual funds, where you own a small part of a company
• Bonds, where you lend money to a country’s government and they promise to repay you, with interest, over time
• Cash, which you may keep in a bank, under your mattress or in a foreign currency
• Real estate, in the form of land and residential or business property
• Commodities, such as precious metals or oil, either in physical or derived contract form

An asset class is simply a group of related assets, which can be grouped into as much or as little detail as you want.

The relationship between asset classes

Most savvy investors, won’t put all of their proverbial eggs in the same asset class. This is due to the relationship –correlation and inverse correlation– between most asset classes.

Correlation

Let me sketch an example:

Let’s say there’s a housing crisis in a country, where properties were terribly over-priced, due to dodgy bank lending to customers who couldn’t actually pay back their loans. Suddenly (or eventually) the housing market takes a dip.

Since a lot of banks were backing the home loans, which won’t get repaid, their credibility gets called into question and their stock value begin to get pulled down too.

This, in turn, makes investors in other related financial services nervous, and they start selling those stocks.

This could again trigger other things, like the stock market as a whole or the exchange rate of a currency to get dragged down.

In this case, we had various asset classes influence each other, due to some external event. This is because they are correlated (some are highly correlated, others are loosely correlated).

Inverse correlation

In another example, you may have a factor trigger the uptick in an industry: a government declares that 80% of cars run on electric and hybrid energy in five years. This will boost the price of stocks in electric cars, which may (due to asset class correlation) pull up the value of other industries, such as renewable energy.

Inversely, what may happen is that the stock price of dirty, gas guzzling car manufacturers and even fossil fuel companies, may go down because of it.

A savvy investor will not just have her investments in a diverse basket of equities, but in a diverse basket of asset classes. This means that during a downturn in a certain asset class, those with an inverse-correlation will offer some protection.

What does this have to do with Bitcoin?

Bitcoin has been found to neither be correlated nor inversely-correlated with most other asset classes. It is, rather, uncorrelated.

This is truly catnip for investors: an asset class that operates mostly independent of the movements of all other asset classes.

Absolute performance

Bitcoin shares some of its characteristics with other assets: like stocks, it is traded on multiple markets in multiple currencies around the world; like gold, it is limited in supply and generally seen as a safe haven against currency depreciation; like cash, you can use it to make payments and transfer wealth; like real estate, it is seen and taxed by some authorities as property.

Although I don’t think that Bitcoin should be compared with other currencies and should be seen as something completely new, it is interesting to compare Bitcoin’s performance last year against other world majors:

It has actually held that position of “best performing currency” for three out of the past four complete years (save 2014 when it was, admittedly, the worst performing currency).

When compared to other industries, such as the S&P500 (9.77%), the JSE All Share Index (-0.37%), Bitcoin stands head and shoulders above the rest (+126%, when measured in USD).

In closing

I’m not saying that you should liquidate your their investments to buy Bitcoin. Don’t put all of your eggs in one basket, remember?

Also, it is a new technology with a fair amount of volatility (which is going down over time) and not suited to everyone’s appetite. That said: there’s a clear trend of hedge funds, banks and institutional investors researching and investing in Bitcoin, as a new asset class with a completely new set of rules.

Don’t invest in anything you don’t understand. Instead, start educating yourself about it and then start considering making it part of your portfolio.

But start you must, before you miss what is probably the most important financial innovation of our time.