All-in On Cryptocurrencies

The guy who just sold everything he owns to go all-in on cryptocurrencies isn’t as crazy as you think he is.

“The kingdom of heaven is like treasure hidden in a field. When a man found it, he hid it again, and then in his joy went and sold all he had and bought that field.”

“Again, the kingdom of heaven is like a merchant looking for fine pearls. When he found one of great value, he went away and sold everything he had and bought it.”

— The Gospel according to St. Matthew, 13:44–46 (New International Version)

Asso often happens, when change comes, it seems to arrive out of the blue, though the conditions for it have been carefully laid out in front of our eyes over many years.

Whether it’s climate change or cryptocurrencies, revolutions don’t happen overnight, but in plain sight, and that’s the case even for investment portfolios.

Every change mints its new moneyed elite and ushers in a new age, from the Carnegies and Rockefellers of the Industrial Age to Gates and Jobs of the Computer Age, to Zuckerberg and Bezos of the Information Age.

Could the next age be the Decentralized Age?

New & Misunderstood

In the early days, like so many other new inventions, Bitcoin was dismissed as being a tool for shadowy figures or the tech fringe, a worthless digital asset favored by criminals looking to obfuscate their transactions.

But gradually (Bitcoin has been around for over a decade), the tectonic plates that move in the corridors of power have shifted.

From being derided by institutions, with JPMorgan’s Jamie Dimon famously calling Bitcoin “a fraud” in 2017, there are now signs everywhere of greater institutional acceptance.

To be sure, part of that increasing institutional acceptance has to be attributed to Bitcoin’s outperformance relative to any other asset on earth over the past decade, but the other is simply by dint of circumstance.

The so-called “smart money” is allocating to Bitcoin as a portfolio diversification strategy and once skeptical money managers are now advocating allocations of around 5% in the cryptocurrency, as part of a complete and healthy portfolio.

Smart Money Makes Money

In the past year alone, US$17 billion worth of institutional capital has moved in to support cryptocurrency startups and ancillary businesses.

A recent study by Fidelity Digital Assets found that as many as 70% of institutional investors surveyed expect to buy cryptocurrencies or invest in the space in the near future.

BlackRock, the world’s largest asset manager with over US$9.5 trillion in assets under management, has already added cryptocurrencies to its balance sheet, with growing signs that other managers will follow.

And the companies that support the growing cryptocurrency ecosystem are also attracting valuations that until fairly recently, were the stuff of fantasy.

From Coinbase Global to Bitpanda, blockchain.com to Chainalysis, the list of cryptocurrency-related unicorns whose valuations exceed US$1 billion is growing.

CoinDCX, an Indian cryptocurrency exchange recently attained unicorn status in a US$90 million funding round, despite cryptocurrencies being banned in India.

Hong Kong-registered cryptocurrency exchange FTX, recently raised 10 times that amount, with investors pouring in a cool US$900 million to help the firm achieve a valuation of US$18 billion.

Venture capitalists who up till just a few years ago, were cool on crypto, are now lining up, fistful of dollars to bet on the digital asset sector and its startups.

In the first six months of this year alone, the amount of venture capital raised for cryptocurrency companies is more than double that of all the previous years combined.

The question investors will be asking is why now? And even more significantly, why crypto?

Why Now? Why Crypto?

While an excess amount of liquidity is one reason that cryptocurrency startups are attracting more venture cash, more liquidity chasing fewer deals is only part of the equation.

For venture capitalists, cryptocurrencies provide an interesting case where multiple factors including the ability to mint tokens to unlock immediate value and greater arbitrage inefficiencies, make it an interesting and potentially more lucrative proposition than typical startups.

The unprecedented fiscal and monetary stimulus from governments and their central banks in response to the coronavirus pandemic has also helped fuel fears of the debasement of fiat currencies like the dollar.

Against this backdrop, the day that the cryptocurrency faithful had hoped would arrive is finally here — the institutions are coming, with this year setting the benchmark for institutional interest in cryptocurrencies.

And consider the industries which have been disrupted by technology and the one glaring incumbent that hasn’t so far has been finance.

Until fairly recently, the ability to transact without the need for a trusted intermediary was impossible.

And while the internet facilitated digital payments, it didn’t foster digital trust, making us ever more reliant on the legacy plumbing of the institutional financial services infrastructure, exacting its pound of flesh from every transaction.

But the pace of innovation wrought by decentralized ledgers and cryptocurrencies is set to replace the antiquated rails of the financial services sector, whether it be through financial institutions co-opting the technology, or decentralized actors usurping the system, the genie is out of the bottle.

Brokerage, custody and settlement are all experimenting or have already adopted or co-opted many aspects of both blockchain technology and central banks globally are studying the issuance of their own digital currencies with some like China’s central bank already issued their own central bank digital currency.

Against this backdrop, investors need to determine if the decentralized future promised by cryptocurrencies and blockchain technology is a durable one, or merely another product of excess liquidity and hype.

And that determination will go a long way towards remaking investment portfolios.

All In?

As with so many other transformative technologies, the prospect and promise of decentralization is equal parts hype and equal parts potential and that begs the question how investors can participate either way.

While high net worth individuals and institutions can benefit from a small allocation to cryptocurrencies, especially given that the entire market cap of cryptocurrencies was just US$2.5 trillion at its zenith, retail investors looking to generate transformative wealth for themselves and their families need to explore a slightly different approach.

As many retail investors have demonstrated over the past year, the idea of growing money reliably with a diversified portfolio is starting to look a little long in the tooth.

Instead, investors are making concentrated bets, taking a leaf out of the playbook of billionaire investor Mark Cuban, who declared over a decade ago that “diversification is for idiots.”

But Cuban is hardly alone when it comes to putting all his eggs in one basket, with legendary investor Warren Buffett noting,

“Diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing.”

Buffett goes on to suggest that investors put all their eggs in one basket, and watch that basket closely.

A parade of highflying investments has reinforced that lesson in recent years, demonstrating that big concentrated bets can be a reliable way to make life-changing investments.

From Bitcoin, which is up over 10 times from its low in 2018, to electric vehicle maker Tesla, whose stock has also risen 10 times in just over a year, there seems to be no shortage of assets which have delivered life-chaning generational wealth to the plucky investors who studied hard, bet big, and went all-in.

To put things in perspective, investors lucky enough to generate 7% or 8% a year consistently over an investing lifetime can expect to take between 30 to 35 years to grow their money by 10 times.

Making things worse, expectations of what a diversified portfolio can achieve have also become unrealistic.

Adjusted for inflation, the historical average annual return of the S&P 500 is around 7%, but over the past decade, the benchmark index has returned investors 13.6%.

Against this backdrop, it’s no surprise that a recent survey by French lender Natixis reported U.S. investors expect their portfolios to generate an unreasonably high long-term return of 17.5% a year after inflation.

Outside of early stage venture capital investments, where statistically only one out of nine investments hit it out of the park, three are so-so, and everything else crashes and burns, there simply isn’t a single asset class that has produced a long-term return that high that could meet these expectations.

There’s little reason to believe that a diversified portfolio will either.

Diversify If You Must, Concentrate if You Can

Take BlackRock for instance, the world’s biggest money manager, which publishes its expected returns for a wide array of investments and over multiple periods — its highest mean expected return over the next 30 years, is about 16% a year, from leveraged buyouts.

For every other asset class, BlackRock expects returns of under 10% a year, with around half clocking in at less than 5%, is it any wonder then that the world’s biggest asset manager is considering cryptocurrencies?

Exacerbating the issue for a diversified portfolio is that the unprecedented flood of money into the system thanks to fiscal and monetary policy is making many assets expensive, from equities to real estate and elevated valuations are a drag on future returns, regardless of diversification.

And that’s assuming that inflation stays within the targeted 2% band of the U.S. Federal Reserve, a level which all signs point to being exceeded for this year at the very least.

Even with indices, where the seductively simple logic is that it’s safer to buy a broad representation of stocks reflective of the U.S. economy, than try to pick the winners, are becoming unknowingly concentrated.

Just six U.S. stocks dominate the S&P 500 Index and account for a quarter of its weighting, and no surprises here, they almost uniformly come from one industry, technology — Apple, Microsoft, Amazon, Facebook, Alphabet and Tesla, have all averaged a total return of 41% annually over the past 5 years.

Even so-called diversification through an index is really just a concentrated bet in disguise, and if so, why not just make a concentrated bet outright?

The reason why family offices and high net worth individuals don’t make such risky concentrated bets is because they’ve already created generational, life-changing wealth and in their case, they have too much to lose.

For the already well-heeled, the goal is wealth preservation, which is why investment banks like Morgan Stanley (rightly) recommend an allocation of no more than 5% of their overall portfolio into cryptocurrencies like Bitcoin.

But consider the math.

For a family office running a modest US$100 million, a US$5 million bet on Bitcoin at an average price of US$45,000, could potentially be worth US$11.1 million if Bitcoin were to hit US$100,000, or a portfolio return of around 11%.

That US$11.1 million is significant enough to purchase other assets, invest in startups or buy into some private equity.

Yet even if Bitcoin was to end up becoming worthless, that same family office portfolio would at worst take a write down of 5%, hardly enough to drive its beneficiaries back into the poor house.

On the flipside, a small family investment portfolio of US$100,000 that allocates just US$5,000 or 5% of its portfolio into Bitcoin at an average price of US$45,000, would also see a return of 11.1% on the portfolio, but an absolute amount of just US$11,111, hardly life changing money.

The problem with advising retail investors not to concentrate their bets is that while it may seem financially prudent and responsible, it may not be the best advice to help them achieve their ultimate financial goals.

Eleven thousand dollars and some change just simply isn’t enough to retire on or quit a day job for.

But imagine now an investor who went all in and bet US$100,000 on Bitcoin after having done their research and been convinced that this was the way of the future.

That same “modest” investment would yield US$222,222.22 or over double the money invested, to achieve a return of over 222%, which would otherwise have taken over 25 years to achieve at a rate of around 7% per annum.

Is it any wonder then that retail investors are shrugging off conventional wisdom to diversify and instead going all-in whether it’s meme stocks or cryptocurrencies?

The truth of the matter is that there will be far more retail investors who will get obliterated by concentrating rather than diversifying.

There will be even more retail investors who hold a specific asset or security for far too long (diamond hands) despite the rest of the market moving on and they’ll get left behind.

But for those investors who are willing to walk the Buffett way, put all their eggs in one basket and not take their eyes off the basket, concentration and going all-in on an asset class has the power to change their lives.

No successful startup was created while its founders kept their day jobs.

Facebook wouldn’t have come to define social media while Mark Zuckerberg was coding out the website between classes at Harvard.

And Amazon would be the name of a river instead of an e-commerce juggernaut if Jeff Bezos built it while still working full time at D.E. Shaw.

Diversification is exactly that — hedging and everyone knows that hedging doesn’t yield supernormal returns, it delivers precisely what it promises, average results.

Every generation has its once-in-a-lifetime opportunity and while the jury is still out on whether cryptocurrencies are that opportunity, by the time the verdict is delivered, that window of opportunity would have already closed.