Sound Money

In part 1 I described the major differences between bitcoin and Ethereum and in part 2 I spoken about the protocol uncertainty in ethereum’s future vs. bitcoin’s ossifying protocol. In part 3 I return to my investment thesis, which is the reason I remain predominantly bitcoin focused.

Primary investment thesis (5-10 years)

Store of Value is a misunderstood, underappreciated and undervalued characteristic. Central banks and fiscal authorities have corrupted money through unconstrained expansion of money. There are numerous consequences including weak economic growth, low social mobility, inequality and a constrained investment return outlook in traditional financial assets (these themes are the topics of my monthly newsletter.

There is a financial, business, social and ethical imperative to consider alternative destinations for our capital. Not merely to improve returns and protect capital, but to fundamentally invest in a system which promotes sound values, fair distribution of resources and better social outcomes. Society needs sounder versions of money. Gold is the traditional store of value but bitcoin is a decentralised store of value for the digital age with a superior deflationary supply schedule. In this regard, ethereum does not pretend to compete with bitcoin.

Externalities from Experimentation

I am not a bitcoin maximalist. I think other projects are interesting innovative and may add huge value. I’m a strong believer in the externalities from experimentation, and there’s tones of experimentation in the broader crypto ecosystem. But I’m primarily focused on bitcoin because of my investment thesis. The world needs to adopt sounder versions of money and bitcoin is a massive opportunity to step towards this goal. I think that bitcoin’s goal is imperative, whereas ethereum’s goals are less imperative.

I own some ethereum. I push myself to experiment with the developments in that space to learn about them and try to reduce my ignorance. But this experimentation is costly, because it takes time to learn about new protocols.

ETH tends to beat BTC during bull-markets

I view ethereum as an exposure to the broader crypto ecosystem because several protocol’s are built on top of ethereum. I also view ethereum as a high-beta crypto that experiences positive performance relative to bitcoin during bitcoin bull-markets, but negative performance relative to bitcoin during bitcoin bear-markets. We’ve only got data since 2015, evidence supports this relationship. In the last BTC bull-market, ETH gained 2000% vs. BTC, in the last BTC bear-market ETH fell 64% vs. BTC. I do think we are in a bitcoin bull-market, which suggests good prospects for ethereum over the coming quarters.

Speculators will probably make tones of returns in non-BTC cryptocurrencies over the coming quarters and if that’s your thing, go for it. The volatility probably requires an agility and trading skills, which are rarer than you expect so be careful. What I like about bitcoin is the reasonably high conviction that it’ll store value over time horizons longer than 3 years.

Return enhancement, not risk reduction

Backtesting data suggests that allocating to the broader crypto universe would have increased return potential over the past years. But there was no reduction in risk from making this decision. This outcome is virtue of the fact that most cryptos hold a strong correlation with bitcoin and thus they don’t offer much diversification. Ethereum presents a very different opportunity set to bitcoin, yet it still trades like a high beta bitcoin. Here is the 6-month rolling correlation between bitcoin and a few major crypto currencies, displaying a strong positive correlation (anything above 0.5 is a strong positive correlation). Its’ never gone negative.

To dig deeper into this point I created an equally weighted Bitcoin, and Ethereum basket since October 2016 and combined it with a traditional investment portfolio with just 1% in BTC to assess the performance outcomes. (Data availability limits the sample size for this analysis. As a side note, the data restrictions are insightful. Data analysis isn’t the be-all-and-end-all, but its pretty useful to be able to have 10 years’ worth of bitcoin data for research purposes. The data limitation on other cryptocurrencies highlights an immediate risk to investing in those assets).

A global portfolio with 1% in a BTC, ETH, LTC basket improves returns relative to a global portfolio with just 1% in BTC but doesn’t improve the risk statistics. The annualised return from the portfolio increases from 7.2% to 7.5% but the drawdowns and standard deviation are pretty much unchanged. In other words, spreading one’s portfolio into alternative cryptocurrencies is a return enhancement not a risk mitigating measure.

Additional skill-sets

Return enhancement may be desirable for investors who know what they are doing and why they are investing into alternative cryptocurrencies. But remember, this involves monitoring another crypto asset and rebalancing at the appropriate times. Ethereum is much more volatile than bitcoin so this is a non-trivial exercise!

For those who are merely trying to get exposure to bitcoin and are still struggling to get their heads around it, I don’t think it’s necessary to spread your allocation outside of bitcoin. Certainly not from a risk mitigation perspective.

My ethereum holdings are non-trivial but they pale in comparison to my bitcoin holdings. I often suffer from ethereum and defi FOMO but I restrain myself because of the protocol uncertainty and because there’s so much I just don’t understand about those changes and the implications for the network. I recommend that others focus their attention and allocations towards bitcoin too.

In my opinion, 50% of crypto holdings in BTC would be unacceptably low. I’d prefer to keep this number closer to 80/90% and an argument can clearly be made for 100% in BTC. The 10% remainder could be a “trading bucket” to purchase more volatile cryptos, like Ethereum, and experiment with them if you have the inclination for that. For newbies, I’d keep allocations 100% bitcoin focused until you’ve built enough knowledge to venture into the wider crypto markets with all the complexity time demands that they bring.

Conclusion: Store of value remains the primary investment thesis. I hold a pretty strong conviction that you won’t be disappointed if you consider allocating bitcoin to your portfolio and holding for the next 2-20 years. I’m interested in Ethereum but am wary of the protocol uncertainty. I prefer to focus my attention on bitcoin’s ability to provide humans with a store of value and negate the consequences of our unsound monetary system.