The Novice Investor: Cryptocurrency

The Novice Investor: Cryptocurrency

The Novice Investor: Cryptocurrency

However you get your news, it is almost impossible to not hear murmurings of what’s going on in the financial world. For myself, I receive updates from CBC, Globe and Mail, social media, as well as various investment companies. The problem is that everyone has the same story spun a different way. As a reader, it can be tough to untangle the stories and get a good sense of what’s actually happening. It’s as though the news is a pair of headphones (the kind with wires) that you’ve pulled out of your pocket all tangled. With intense focus and precision, you can unwind the complex mess, only to put them back in your pocket to be tangled once again.

So, what’s the point of this article? I simply want to continue tangling earphones.

In all truth, there are certain topics that have hit the investment market that I’d like to address. I hope that this can clear up some misconceptions or terms that most people recognize but don’t understand.

Our first target is cryptocurrency.

Before we dive too far into what cryptocurrency is, I thought we should put it into context.

Cryptocurrency is considered a “Fad” of the 2000’s. Millennials are all wishing they jumped on the Bitcoin train years ago because they would have seen their fortunes made. But cryptocurrency’s infancy takes us back to the 1980’s, when “Digicash” was invented with the goal of creating a non-traceable and de-centralized form of value transfer (learn more here). Over the years it has evolved through growing pains to become a multi-billion dollar network of currencies that range from Bitcoin (the most recognizable), to Dogecoin. The origins of the modern-day Bitcoin are also very mysterious. The publicized paper which started Bitcoin, Bitcoin – A Peer to Peer Electronic Cash System, was written by an entity known as Satoshi Nakamoto. I say entity because they don’t exist. It’s an alias, the real identity of Satoshi is a mystery.

So, we know that since the 80’s people have been trying to develop a method of transferring wealth without having to go through a major bank or disclose private information. In the early days of Bitcoin, this was an open door for terrorism financing and criminal activity to occur without the ability to trace financial transactions. It’s impossible to know for sure, but it’s suspected that in the earlier days, a large percentage of transactions were related to criminal activity.

But… What is Bitcoin?

It’s a figment. It’s a non-tangible, electronic ‘coin’ that has no internal value. It only has perceived value. You may read that sentence and think, “Man, Garrett must not like Bitcoin!” and you’re not wrong, but you’re not entirely correct. I see two main issues with Bitcoin (and other cryptocurrencies):

1. They have no “real” value.

2. They’re traded as an investment and not a currency.

There are other issues that are attributed to my hesitation toward cryptocurrency, but those are the main two, and I’ll go into more detail.

They have no “real” value

Since, at it’s core, Bitcoin is not a real asset, its true value is $0. There is no tangible asset (company ownership, physical property, ect) associated with Bitcoin. Most other assets have some minimal worth. An investment in gold, even if it went to $0, would still leave you with a physical asset that you can touch and feel. At the very least, a gold bar could be used as a shiny paperweight. With Bitcoin, there is no minimum value, and with it being de-centralized, it is un-regulated, which means there is no institution that maintains its integrity. This manifests itself as a higher chance that a cyber-attack or ‘hack’ could leave the investor with nothing.

They are traded as an investment and not a currency

Traditionally, currencies are not held in investment accounts for the purpose of growth. To clarify, when I say ‘currencies’, I’m referring to cash held in an account outside of your equity or fixed income portfolio. They are held for three primary reasons.

First, they allow for the investor to quickly and easily purchase more investments. For example, investors who held cash in their accounts in March of 2020, when the market crashed, were able to quickly put money into the market when stocks were “on sale”. We would call this an “Opportunity Fund”.

Secondly, they are used to hedge risk against inflation. Holding a different country’s currency can see some growth if the dollar in your own country declined. For example, lets say I converted $5 CAD into $4 US. I could hold the US currency with the hopes that the value of the Canadian dollar fell. When it does, I would convert my $4 US back into CAD, at which time it may be worth $6 or $7 dollars.

The third purpose for currency is wealth transfer. This could be as simple as going to the grocery store to purchase food. Every item on the shelf is assigned a dollar value. How would you feel if you went to buy your favorite ice-cream to find out that overnight, the price had increased by 20%? There would be major distribution issues for non-essential materials, which would only be purchased when the price of Bitcoin dropped, and there would be major financial hardships for people buying essential items when prices were high. Bitcoin can never really be a new form of de-centralized currency until it is regulated to the point where price volatility is managed.

For those who don’t understand the concern around centralized currency, you’re not alone. A centralized currency is simply a currency that is controlled by the government (or a ‘higher power’). In Canada, our currency is centralized and controlled by the Bank of Canada. They are responsible for controlling interest rates and money supply, among other things. One of their major mandates is to control inflation, and two major tools they possess to control inflation is interest rates and the ability to print and recall money (money supply).  Bitcoin and other cryptocurrencies have tried to de-centralize this process with the hopes of creating a currency that is controlled by the users, and not by the government. Extreme crypto-fans will go a step further and say that they support Bitcoin because it resets the value of currency. They see the Canadian dollar (or US dollar) as a value of power. For example, in today’s economy, 1% of the population controls a vast amount of the wealth. Some of these crypto-fans support de-centralization because they believe that it will spread out the wealth.

How wrong they are…

This brings me to a THIRD big pet-peeve with cryptocurrency (and bitcoin specifically). It is not uncommon that a fanatic of Bitcoin is also a semi-socialist (specifically in terms of spreading out wealth). The problem with Bitcoin is that it has created a new market. Bitcoin mining is a brand new industry which has become extremely expensive. As a PC gamer in my free time, I saw a huge price jump in the cost of GPUs (graphic processing units) due to people buying all of the supply to build ‘mines’. If you go onto Kijiji, you can search “cryptocurrency mining rigs’ and find lots of different options that have price tags that reach into the ten’s of thousands. In that model, where it costs thousands of dollars to gain access to a production method, how does that differ from capitalism? If the skeptics of capitalism say that its main goal is to separate the worker from the means of production, how is charging thousands of dollars to have access to currency any different? In this world, the top 1% still get to hold all the wealth. In fact, the top cryptocurrency holders are banks and bank owners, specifically owners who got into cryptocurrency exchanges, such as Micree Zhan, who founded the cryptocurrency mining company “Bitman”, or Chris Larson, who co-founded Ripple, which is a new currency of its own. Both of these men were rich well before they got into the crypto market.

So, where does this leave cryptocurrency, and how does it fit into the future?

That’s the million dollar question. It seems like people are ‘betting’ on whether cryptocurrency will either replace or be integrated into the currency our future society. Others believe it is too fragile in its current state to be a real contender to something strong like the US dollar. We could dive into the weaknesses of the US (or Canadian) dollar, but the reality is that our whole economic system is built on the US dollar, regardless of how weak or strong it is.

Since having started writing this article, the CBC posted a story about the international banking system and how it is pushing back against cryptocurrencies for some of the same reasons we’ve discussed. They did however, propose an alternative: “Central bank-issued digital money” (or CBDCs). The advantage of this form of digital currency is that it is supported by the current banking system. This seems like a bad compromise for crypto-fanatics who may see this as another form of centralized currency (which would be correct), but the CBDCs could maintain a transaction’s privacy. For the everyday individual, this alternative would be much more stable, because it’s backed by one of the world’s mega-institutions. At the end of the day, Bitcoin is unstable because there is so much trading. If one entity (or a group of entities) owned a major portion of the currency, individual traders would have a much smaller impact on the ongoing value. It’s the same reason the US and CAD dollar don’t fluctuate drastically on a daily basis.

In My Opinion:

It’s not as easy as saying “yes” or “no” to cryptocurrency. Since the eruption of Bitcoin, there have been a multitude of different variations of cryptocurrency, and there are even more that are in development that haven’t hit the marketplace yet. I believe that cryptocurrency is here to stay, but I don’t foresee it being a major “currency” in the same way as the dollar. As of right now, there are only a limited number of retailers who are accepting various forms of cryptocurrency in exchange for goods. As a business owner, the risk is that you’ll accept the bitcoins right as the value drops. This would cause many stores unnecessary financial hardship, especially while the alternative (US/Canadian dollar) is relatively stable. So, if you’re interested in holding cryptocurrency, the same ‘rules’ apply as with the rest of an investment portfolio.

Diversify.

With hindsight being 20/20, how would you feel if you had bought Bitcoin in March or April of 2021 during it’s huge expansion knowing where it is now? Here’s a reference:

I would safely presume that cryptocurrency will be part of the future, but who knows which version will be the main form in 10 years time? If you want to have crypto as part of your portfolio, I’d recommend spreading your investment over various cryptocurrencies instead of one or two. You may not see the drastic increases in value in comparison to just holding Bitcoin, but you also won’t experience the dramatic fall in value if Bitcoin itself falls. Either way, it’s a bit of a gamble. If you’re going to hold it, don’t put all of your eggs in that basket. Trend-setting investment options often don’t last long. Bitcoin will continue to be a thing until it’s not, sort of like bell-bottom jeans. Somehow they were extremely popular, but now they’re only used as the bottom half of my Elvis Presley Halloween costume. There will always be a new trend, and once the focus is taken off of Bitcoin, it’s anyone’s guess what will happen next.

 

Amendment: My wife, as she read this over for me, told me that Bell Bottom jeans are apparently coming back into style. Now I get to wear my Elvis costume all year round!

The Novice Investor: Piecing Together Your Investment Vehicle

The Novice Investor: Piecing Together Your Investment Vehicle

Investing… Stocks… Bonds… Mutual Funds… Markets… Internal Rates of Return… Value versus Growth Investing… ESG Investing… Portfolios… ETFs… Savings Rates… Risk Profiles…

There is so much out there when it comes to the parts and principles of investing that it can be hard to digest. On one hand, we are told to invest, and on the other, we are told to not do anything without knowing what we’re doing. That ideology can force a rift in people’s planning and cause them to be idle. I have had clients who sit on tens of thousands of dollars in their bank account, and most often the reason is that they don’t understand their options.

The richest men in the world have built their fortunes by having multiple streams of income. Jeff Bezos, the founder and owner of Amazon, is currently the richest man on earth. If we looked at his income strategy, you would see multiple inflows. First, he has his salary from Amazon. Secondly, he has his Amazon shares that increase in value as the company grows. Third, I imagine we would find that he has money tucked away into shares of other companies, which are also growing. All of these sources accumulate to roughly $2500 per second in income (from “The Registered Citizen”).

Especially with the current ongoing crisis, there are lots of headlines that say you should stay away from the world markets. Oddly enough, you can often find a link nearby that will tell you how to setup a ‘side-gig’ from home to earn more money. Each person has a unique situation, and in this post, I would like to explore how you can design your own secondary income streams. I will be using the analogy of a car, as it makes it easier to conceptualize investment components.

First, I would like to define the difference between ‘Active’ and ‘Passive’ income. It’s pretty self-explanatory, but active income (also known as “earned income”) refers to income you have to physically make. This would include going out to a job and getting paid a wage/salary. Passive income on the other hand is income gained for you by others. Investing falls into the category of passive income.

For the purpose of simplicity, I will speak in terms of mutual funds (which I will define later). Investing can be broken down into two parts: Equity and Fixed Income.

Equity:

Equities, also known as stocks, are the engine of our car. To have ‘equity’ in something is to own it. For example, Jeff Bezos has equity in Amazon because he owns shares (or stock) in the company. As the company increases in value, the market price of your shares increases. This means that every time you purchase something on Amazon, not only does Amazon’s revenue increase (which increases Jeff Bezos’s salary or bonus), it also increases the value of the company, therefore increasing the price of each share.

It doesn’t necessarily have to be companies. There are some investments that hold their equity in other areas, such as gold. In this case, the fund manager will buy gold, and sell ‘shares’ of the gold on the open market. As the value of gold increases, the value of each share also increases and people can sell their shares for a profit. 

Equities can define how fast and how long your car will run. Within equities, you can dive into asset qualities and other specifics that can be as different as the electric engine is to a V8 supercharged sports car’s engine. Equities give us the power and growth potential we need to earn our passive income.

Fixed Income:

Fixed income (also known as ‘bonds’) are the safety features of the car and this form of investment is far simpler than equities. In every sense of the phrase, it is an “IOU”. You, as the investor, are lending money to governments or companies for them to use in their operations. This is a lower risk and lower reward strategy for investing. The company or government gets a loan, and you receive a regular interest payment. For example, if you were to lend Amazon $10,000, they would pay you an interest payment (i.e. 1.5% or $150) either annually or divided monthly and return the $10,000 balance at the end of the term.

One common factor you’ll often hear about bonds is related to the interest rate.

If we paused time and looked at interest rates now, we would see a sharp decline in a new bond compared to 1 year ago. This is because the Bank of Canada (along with other country’s banks) have dropped interest rates in an attempt to stimulate the economy. Interest rates play a large role in the ‘risk’ associated with a bond, but that analysis is for another post.

Traditionally, bonds are a much safer way to invest, as there is little risk of a government or company not honouring and paying that debt back, but it also carries a lower reward. Your $10,000 does not participate in company growth in the same way equities do.

In regards to it’s relationship to our car analogy, with fixed income being the safety system, bonds protect the car as it moves. If there was an event that was cause for concern (for example, the markets dropped in value and you were unable to go to work), the fixed income component would preserve a portion of the investment to limit the damage.

The whole purpose and the relationship between equities and fixed income is to get you from Point A (where you are now financially) to Point B (retirement, first house, education, etc.). This is where mutual funds come into play.

Mutual Funds:

What are mutual funds?

Again, by their name, it is easy to guess that they are a funds designed to be invested by multiple people pooling their money toward a mutual goal. There are lots of different types of mutual funds. For example, there are funds designed for people who want to invest in certain parts of the world, different industries, or even subject to certain moral or ethical standards.

At it’s core, a mutual fund is a makeup of equities and/or bonds that provide growth opportunity while minimizing the downside potential. Since everyone’s risk tolerance and time horizon is different, finding the right mutual fund (or funds) to invest in takes more thought than most people would imagine. If you are considered ‘high-risk’ you may want a mutual fund that holds more equities than bonds. Vice versa, if you were closer to retirement and wanted to preserve your investment, you would lean toward a higher allocation of fixed income and safety.

Common Question: How is this better than buying individual stocks?

Quick answer: it depends. Do you have the time?

A long time advisor once shared an analogy with me that I thought was powerful. Unfortunately, it is highly visual, but I will do my best to paint the scene.

Diversification is one of the main strategies used by mutual funds. Imagine you have a pencil, and that pencil represents a stock. It can be any stock you’d like, but it is one single stock. You have heard that this company has a strong future and will grow in value for you, so you ‘get in at the ground floor’, and invest everything into that company. Now, fast forward in time. We have an event such as the recession of 2008, the tech bubble of 2000, or the current COVID-19 crisis. That company is put under financial stress, as this is an unforeseen position and the world is rapidly changing. Some companies are able to adapt and survive, and others can’t change fast enough and are forced to shut down. A real example of this may be the loss of mega-companies such as Sears. Sears couldn’t adapt to cater to the online shopper and subsequently ‘died out’. Any stock that Sears had is worthless today.

bunch of pencilsSo… take your imaginary pencil and bend it. Imagine that you bending the pencil is the company going through a stressful period. Does it snap? Maybe not, but you, as the share holder, are not protected from the companies failure. The money you invested could be gone.

Now imagine you have a box of 50 pencils, each pencil still representing a single stock. You take them out of the box, you strap an elastic band around them, and you try to bend them all together.

They don’t break so easily.

The difference between trying to buy individual stocks and buying a mutual fund, is that the mutual fund offers greater diversity and protection from market fluctuation. Theoretically, you could go out and buy 50 individual stocks and manually create your own diversification, but most people would find it takes a lot of work to purchase, research, value, sell, re-balance and execute a specific investment strategy while also earning income at their own career. The mutual fund offers a much simpler solution to investors and can create a stream of passive income.

Summary:

The value of not putting all of your eggs in one basket is that you are more protected from a depressed market. A crazy and unexpected event occurs and some of the companies feel the stress, but even if one company falls to the wayside, your portfolio is held together by the remaining mix of equities and fixed income.

Creating passive income can be more than working a 9-to-5 career and investing in mutual funds, but investments are a staple in most successful people’s financial structure.

I want to circle back to my original analogy.

A car has a single purpose. The kind of car, how fast you drive, and where you are going is up to you. But at the end of the day, the car’s role is to transport you from where you are now to where you want to be in the future. If you start your journey without enough gas in the tank or with worn out tires, you are putting yourself at risk of stalling or having problems down the road. Like an investment strategy, a car with proper care and maintenance will ensure you eventually reach your goal.

Proper investment strategies can provide peace of mind when traveling down life’s roads. You never know when there will be an unexpected twist or turn, and being prepared is a key to success.

What Lies Ahead…

What Lies Ahead…

As I prepare for each week, I like to do my own recap of the markets. I look at trends over the last week and scale it back to the month and quarter to see how the big picture evolves. Even though everyone is linking the market depression to COVID-19 (which is fair), I thought it would be an interesting opportunity to look at the previous market fluctuations and evaluate how this one compares.

I found a great article from Forbes that breaks down different recovery patterns, and I thought this would be a good place to summarize it and give my impressions.

There are four common shapes to describe market recoveries. The “V”, “W”, “U”, and “L”. The “V” and “W” are the most common, because the “U” is really a variation of the “V”, and the “L” is very uncommon. But let’s start in alphabetical order.

The “L”

The “L” is associated with a worst case scenario. As the shape implies, there is a sharp drop in the market which doesn’t recover, or at least takes a long time to transition to an upward trajectory. This shape hasn’t been seen in a long time, but most recently appeared in the 1990’s in Japan, known as the ‘lost decade’.

The “U”

If we look backwards in time, we’ll see that the “U” shape was a part of some of the bigger market events. It depicts a downward movement followed by a “bottoming out” period. This shape is seen through the Great Depression, as well as some of the market events in the late 1900’s. The “U” illustrates an economy that has declined without an individual stimulus of recovery. It leads to a slow incline in the valuations of the market rather than a stark climb.

V shape graph of market recoveryThe “V”

The “V” is a more common variation of recovery. It represents a sharp decline and a quick ascension back to original (and most often higher) values. It is more likely that the contraction and expansion are a result of an outside factor. For example, in 1952, when the market was still ‘booming’ after the Second World War, the US Federal Reserve raised interest rates in the anticipation of disproportionate inflation. This caused a “V” recovery from Q4 1952 to Q1 of 1955.

W Shape Market RecoveryThe “W”

Most people who are preparing for retirement remember the crash of 2008 vividly. The Lehman Brother’s went under and the economy fell in hot pursuit. Hindsight being 20/20, we can see the market crash of ’08 as a representation of a “W” recovery pattern. In the late stages of ’07, there was a relatively small and quickly resolved market depression followed by the major fall halfway through 2008. The minor correction combined with the major event form a “W” pattern.

So, what does this tell us?

Having knowledge about the ABC’s (or rather UVW’s) of market recovery is only helpful if we can apply it. Unfortunately, we can’t see a pattern until after it has appeared and it has joined the rest of the recoveries as part of our history. That being said, we can look at the behavioral patterns of people and how the COVID-19 pandemic varies or resembles patterns seen before/during previous market disruptions. Experts would agree that the market behavior would best point toward a “V” or “W”, but only time will tell. The rational for the “V” is that once we are allowed to mingle in public again, people will return to stadiums and restaurants, causing a quick surge of money flowing in and out of the economy. Specialists fear a “W” recovery if governments re-open the economy too soon. The news has mentioned the idea of a ‘second wave’ of Coronavirus stemming from healthy individuals returning to ‘normal’ and interacting with asymptomatic people. This would cause a second impact of new patients in hospitals, and see governments re-think their strategy, having potential economic consequences.

If we self-isolate and flatten the curve, a “U” shape could emerge. This would be caused by a slow and strategic introduction of economic stimuli. It could be even more pronounced if people were to be skeptical at first. Imagine the governments fully opening markets trying to create a “V” response. People are still fearful and decide to continue the limitations on their interactions. This means there is a slow and steady increase to economic activity rather than an ‘opening the floodgates’ response.

All that being said, we can’t predict what the market will do. People have been trying to time the markets for decades. And some have made careers out of it. It will be interesting to see how this plays out. I imagine that whichever way it pans out, this will become a unique lesson for us all to learn from.