By now, you have undoubtedly heard of cryptocurrencies, like Bitcoin and Ethereum. Not surprisingly, we have received inquiries about investing in these entities. I am happy to share my thoughts on this, but let’s start by examining the underlying technology, referred to as blockchain.
A good starting point for understanding blockchain technology is to think of a traditional ledger, in which financial transactions are entered one line at a time. A blockchain, in its simplest form, is a digital ledger that is widely distributed, meaning that it is accessible to all its users. Think of it as a Google Doc that is widely shared, verified, and strongly encrypted. The genius of this approach is that it ensures that transactions entered in the ledger cannot be tampered with, while eliminating the need for a central authority, such as a government or bank, to oversee the process. This allows transactions to occur faster, more securely, and more accurately than with traditional means, and at much lower cost.
Cryptocurrencies are digital tools of exchange based on blockchain technology. Bitcoin, the first cryptocurrency, was introduced in 2009 by Satoshi Nakamoto (most likely a pseudonym). Since then, hundreds of additional cryptocurrencies, such as Ethereum, Litecoin, and others, have been created. Trading in cryptocurrencies has reached a speculative fever with a 600% increase in the value of Bitcoin over the past year. Not surprisingly, this has attracted the attention of investors, but also regulators and central bankers. One of the challenges facing cryptocurrencies is that governments and central banks don’t like losing their influence on currencies and exchange rates. China and South Korea, both cryptocurrency hotbeds, have recently banned all initial coin offerings (ICOs), in which funds are raised for new digital currencies. China has also started shutting down cryptocurrency exchanges and further government interference may be on the horizon.
Despite the gaudy recent returns, we are not tempted to jump on the cryptocurrency bandwagon. As with most speculative bubbles, fortunes will be made and many more will be lost. However, we do consider blockchain a disruptive and potentially transformative technology. Any industry that deals in high volumes of transactions, whether financial, legal or otherwise, is exploring blockchain as a means to cut costs and improve operational efficiency. Companies in industries such as banking, insurance, technology, international trade, healthcare, and a host of others are studying the use of blockchain to make transactions more transparent, timely, and secure. Since these industries are all strongly represented within the broadly diversified Dimensional funds held in our client portfolios, we are indirectly investing in blockchain on a daily basis.
The current buzz around cryptocurrencies is reminiscent of the dot-com bubble of 2000-2002. At that time, we resisted the temptation to pour our clients’ hard-earned assets into high-flyers like Webvan and eToys.com, and stuck to our disciplined, diversified approach. This approach is based on economic theory, as espoused by William Sharpe, professor emeritus at Stanford. One of the foundational ideas that led to Dr. Sharpe’s Nobel Prize in Economics is that investors are rewarded for assuming risk, but not just any risk. They are rewarded for bearing the broad societal risk reflected by the markets as a whole, not for taking on the risk of individual stocks or industries that can be easily diversified away. In the 18 years that we have been helping our clients with their investments, we have found that the most reliable way to build wealth is to save regularly and stick to your asset allocation strategy through good times and bad, while avoiding major financial pitfalls along the way.
As always, please feel free to contact me if you have any questions, comments, or concerns.
Jeffrey J. Brown, MD CFA
Principal, Shearwater Capital