Investing in cryptocurrency: Broad market comparisons, insights, best practices

Suddenly, cryptocurrencies are back in the zeitgeist.

In the week ending March 1st, the price of Bitcoin crossed over $60,000 for the first time in over two years and finished the week almost 23% higher.

Then, on March 5th, it hit an all-time high, moving above $69,000.

While Facet does not own any digital assets in its portfolios, we believe it is important to share our view on ALL assets, not just the ones we prefer.  

We will start by explaining why our investment strategy does not include crypto and then provide insights on what to consider before approaching this asset class.

Source: Bloomberg

Why Facet doesn’t own cryptocurrencies

Core to Facet’s investment philosophy is that we view money as a tool to reach your financial goals. As such, we focus our efforts on maximizing the chance that your money will achieve that purpose.

We think the best way to accomplish this is by owning assets with positive drift. This is a technical finance term for an investment with some fundamental reason why it should go up over time, and historically, this has shown to be true.

Stocks have positive drift because as the economy grows, so will company profits, and this should generally result in stock prices rising. Bonds also have positive drift. They pay you interest, which will typically compound over time.

Commodities, like oil or gold, do not have positive drift. They produce no cash flow and have highly variable supply and demand conditions. The chart below shows the percentage of time when stocks (using the S&P 500 as a proxy), oil, and gold have produced positive returns over a 1, 5, and 10-year horizon from 1974 to today.

Source: Dow Jones S&P Indices, Bloomberg

Stocks are almost always higher over longer periods. So, when we think about ways to grow member assets to meet their financial needs, we have much more confidence that a positive drift asset like stocks will increase over time. But with non-drift assets, it is hard to be sure.

Let’s take this one step further to explain our reasoning. 

Positive drift assets compound over time. This is partly due to relatively consistent positive returns and the fact that down years tend to be followed by up years. In other words, investors tend not to stay down for too long. 

Because of this characteristic, stocks tend to produce large upside over longer time horizons. 

Here’s the percentage of periods where an investment in the S&P 500 would have cumulatively made at least 50% or 100% (i.e., doubled in value) over a ten-year horizon.

Source: Dow Jones S&P Indices, Bloomberg

Given this, if you need your assets to increase between 50 and 100% over the next ten years to make your financial goals, what’s your best bet? Historically, stocks have managed that range between 80-90% of the time. While there are no guarantees, we’d rather bet on the predictability of positive drift assets over anything else.

Crypto as digital gold

Bitcoin and other cryptocurrencies have often been referred to as “digital gold.” 

Like traditional gold, people sometimes think of crypto as a form of currency that exists outside the control of governments and central banks. This is a term you might have heard called ‘decentralization.’ 

Some crypto advocates also cite similar reasons for holding it as gold: protection against inflation, a hedge against financial disaster, etc.

Given this, we think gold is a good proxy for how crypto might behave if it reaches a more mature state. Demand would wax and wane as market participants were more or less worried about things like inflation. But overall, the asset would not exhibit positive drift.

This is why Facet does not include crypto in our portfolios. Instead, our focus remains on assets most likely to rise materially over time. 

Right now, we can’t be sure if cryptocurrencies will do that. They might, but then again, they might not.

If you do want to own crypto, have a plan

All that being said, if you do have an interest in owning Bitcoin or other crypto, there’s nothing inherently wrong with that. However, here are a few things you should consider.

First, any investment needs a plan to determine what you will do if it goes wrong. There is a famous Mike Tyson quote that professional investors often share with each other: 

“Everyone has a plan until they get punched in the mouth.”

Specifically, whether you’re investing in crypto, an individual stock, or anything else, you need a double-sided exit strategy: one for the upside and one for the downside.

Crypto’s extreme volatility makes this especially relevant. The chart below shows how often Bitcoin’s price has been at least 10, 20, and 40% below its prior peak compared to the S&P 500.

Source: Dow Jones S&P Indices, Bloomberg

What this says is that about 82% of days from July 2010 (when Bitcoin prices became readily available) until now, the current price was at least 20% below its prior high. 

Note: A 20% decline is the standard definition of a bear market, so we could say that Bitcoin has been in a bear market (or crypto winter) for most of its history. 

The point here is that if you buy Bitcoin today, you are very likely to experience a significant drawdown at some point. 

If that happens, what’s your plan? 

Too often investors don’t have a plan. Without a plan, you are liable to make emotional decisions, like panic selling when it drops or doubling down in an attempt to get back to even. 

On the other hand, if you have a plan, you will be ready to deal with inevitable volatility. That doesn’t guarantee investment success, but it does put you in the best possible position.

Make sure your bet matches your thesis

An investment thesis is a statement that outlines your beliefs about how an asset will perform over time. It’s important to have a clear thesis before investing, and even more important to make sure your actions align with it.

For example, if you believe in the long-term potential of Bitcoin as a store of value, then short-term price swings shouldn't affect your investment decisions. If you believe in the technology behind Ethereum and its ability to revolutionize industries, then you wouldn't be swayed by temporary market dips.

Having a strong understanding of why you are investing in a particular asset can help prevent impulsive or emotional decisions. 

From there, don’t forget to test your thesis routinely to ensure the results align with your plan. Make a sober assessment of whether events are aligning with your thesis or not. This is how the pros determine if they should hold on or move on.

Size it right

Perhaps the most important thing you can do is to size your investment right. 

As the previous chart shows, Bitcoin prices have routinely dropped by 40% or more. Moreover, countless other cryptocurrencies have become completely worthless over the years. 

This is the core reason why you should size your investments appropriately, planning for everything potentially standing in the way of your financial goals.

Two common sizing mistakes to watch out for 

1. Sizing your position based on upside potential. 

This is what happens when you fall victim to “fear of missing out” or FOMO. Professionals choose their sizing overwhelmingly based on downside. So, if there is any scenario at all where this investment gets wiped out, you should only invest as much as you can afford to lose entirely.

2. Doubling down when the asset declines in value. 

This is almost always an emotional decision, usually related to a psychological phenomenon called “chasing losses.” Pros don’t do this. Or if they do, they don’t stay pros for long.

Segmenting your risks

Many of our members like to own some investments on their own. This could be crypto, individual stocks, real estate, etc. While we think very highly of our investment service, we understand if you want to invest in things we don’t offer.

If that’s the case for you, consider segmenting your portfolio risks. One side holds the kind of long-term positive drift assets described above. Call that your boring money, your “down the fairway” money, whatever you like. Segmentation frees you up to take risks in the other piece of your portfolio. 

Suppose your overall financial journey is still on track even if this second segment takes on big losses. In that case, you can buy things like cryptocurrencies without stressing over the huge volatility of doing so. If Bitcoin keeps rising, great. But if it falls, you know you are still positioned to reach your financial goals.

Ultimately, all this comes down to having a good plan. This goes for your overall financial picture as well as your individual investment decisions. We strongly believe that a great plan is the key to financial success.