MARK RIEPE: It’s generally understood that investments inspired by new technology can sometimes be treacherous, but also, under the right conditions, offer enormous upside.
Depending on the timing, the same investment can be both disastrous and generate great returns.
Solar energy is taking off around the world and its adherents are justifiably proud of its adoption. What you may not know is that the first solar panels were installed on a rooftop in New York City in 1884.
Those early investors were right about the future. But being 125 years too early isn’t a good path to follow if you want to be a successful investor.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
Cutting-edge investments are a petri dish of cognitive and emotional biases. One of those biases is hindsight bias. When we look back on a new technology that became successful, it seems obvious, with the benefit of hindsight, that it was going to succeed.
Similarly, after a failure, we all think that the certainty of failure was crystal clear in advance. But investors at the time don’t have that level of certainty. They grapple with the risk generated by the known unknowns and the unknown unknowns. And, ultimately, they need to make a call.
Steve Jobs unveiled the iPhone in January 2007. It seems obvious, 14 years later, that it would be a hit, but it wasn’t obvious to everyone at the time. The CEO of Palm, the company that made Palm Pilots, doubted a device that worked as a camera, a phone, and an iPod would find a market.
He was an advocate for specialized devices and illustrated his point by asking if there was “a toaster that also knows how to brew coffee?”
He wasn’t alone. A Bloomberg reporter called it a “luxury bauble that will appeal to a few gadget freaks.” Marketwatch cut right to the chase and advised that “Apple should pull the plug on the iPhone.”
Apple shareholders are glad that didn’t happen. Since the iPhone was released in 2007, Apple has sold billions of devices, generated enormous revenue, and it’s become one of the most successful consumer products of all time.
Another issue with innovative technology is that success of an innovation doesn’t necessarily correlate with the results of investors in that innovation.
Alexander Graham Bell invented the telephone in 1876. The telephone was so transformative and such a success that he could have accumulated wealth comparable to John D. Rockefeller. But he didn’t. By the early 1880s he had sold most of his shares in the Bell Telephone Company and didn’t profit from his invention nearly as much as he could have.
Was he right or was he wrong? It wouldn’t surprise me if he was just like so many investors who see a gain and decide to sell and lock in that profit.
On the other hand, maybe he would’ve been happy to hold on to his shares, but he didn’t because he just didn’t see the enormous upside to his own invention. Or maybe money wasn’t that important to him. He was already independently wealthy, so perhaps he didn’t care so much because he was living a comfortable life and had no greater material ambitions.
This episode is about another technological innovation: cryptocurrencies.
The biggest cryptocurrency is Bitcoin. Although the first Bitcoin was mined in 2009, it wasn’t until 2017 when Bitcoin moved onto the radar of many investors. It happened because the price of one Bitcoin soared from $975 in March to $20,000 in December.
On this episode, we’re going to dig into the details. The potential gap between the success of an innovation and investors in that innovation is evident with Bitcoin thanks to its huge price volatility.
For an investor who bought Bitcoin for $1 in 2011, selling at $350 in 2013 probably seemed like an incredible opportunity.
But another investor might have read a compelling argument that each Bitcoin will one day be valued at a million dollars. To them, buying at $63,000 in April 2021 seemed like a steal.
As I’m recording this episode the price of Bitcoin is $29,750. The buyer in April may well be unhappy. The seller at $350 may also be unhappy. Nevertheless, the technology has continued to make inroads.
To shed some light on this topic more I’m now joined by Randy Frederick. Randy is the Managing Director of Trading and Derivatives for the Schwab Center for Financial Research. Randy is a frequent guest on CNBC, Fox Business, and Bloomberg TV, and his reports often appear in the Financial Times, Barron’s, and the Wall Street Journal.
And he’s been a guest on this show in the past, so welcome back, Randy.
RANDY FREDERICK: Thanks for having me back, Mark.
MARK: We are going to be talking about cryptocurrencies and Bitcoin today. Investors have a lot of questions about these types of investments, so I think this is going to be a great topic, and thanks for coming by to talk about it.
RANDY: You bet. As you said, this is a hot topic and it certainly isn’t likely to go away anytime soon. We get lots of questions.
MARK: We’ve got a pretty diverse set of listeners, so why don’t we start off with a basic question? What is Bitcoin?
RANDY: Well, it may be a basic question, but it requires a fairly complex answer. Bitcoin is a virtual digital, or as we now call them, cryptocurrency. And the name comes from the cryptography or the unchangeable computer coding techniques involved in the blockchain code on which they are based. The original intent of Bitcoin was to facilitate easy electronic or online payments directly from one party to another through a worldwide payment system, but without the need for a central third-party intermediary, like a bank. Bitcoin is not issued by a central bank or government, and, technically, it’s not legal tender. Like physical gold, Bitcoin’s value stems from a combination of scarcity and the perception that it’s a store value or an anonymous means of payment. Some people even see it as the ultimate hedge against expansionary monetary policy, which they believe erodes the dollar and causes inflation. But all of these are debatable points.
MARK: This idea of having a new type of currency, how new, actually, is that?
RANDY: Well, you know, it’s fascinating to me, Mark, is that the concept of alternative or even digital currencies, it’s not new, it’s just that cryptocurrencies are the most recent form. Loyalty programs, such as airline frequent flyer miles, hotel points, credit card points, those are all forms of digital currencies. Holdings in these programs are not in dollars, but, rather, the specific companies’ self-created currency. Most of these programs allow the points to be redeemed for value, such as flights, nights in a hotel, even jewelry, electronics, luggage, and other products. These digital currencies have no physical form and they’re also not backed by a central bank, government, gold, or cash, only the company that issues them.
In fact, non-digital alternative currencies go back even further than that. Even trading stamps, such as Top Value and S&H Green Stamps, date all the way back to the 1890s. These were types of alternative currencies. Like today’s modern loyalty programs, individual stamps had very little value, but large numbers of them could be used to purchase merchandise directly from the issuer. Digital currencies differ, in that they can be used by any business willing to accept them, not just the issuer, and while the list of companies that will accept digital currencies is small, it is growing steadily.
MARK: Another difference is this blockchain technology that kind of underlies Bitcoin and other cryptocurrencies. So what is the relationship between those? What is blockchain, exactly?
RANDY: Well, blockchain is the underlying technology that supports cryptocurrencies. It’s an open-source C++ programming code that was first developed in 2009 as a public recordkeeping system. It was created to operate on a decentralized computer network, i.e., the internet, to record transactions between parties in a verifiable and permanent manner. So blockchain provides accountability, because while anyone can access the ledger and view the transactions, they’re designed to be immutable, which means they can’t be altered. And this unalterable characteristic is the key feature that presents potential applications for many types of businesses.
While most of us were probably first exposed to blockchain via cryptocurrencies, it has many potential uses beyond payments, including smart contracts, supply-chain management, digital trademarks, financial services, and more. And this is an important point because ownership of Bitcoin, or any cryptocurrency, for that matter, is not an investment in the blockchain technology. It’s just an investment in a product that uses it.
MARK: Randy, you mentioned earlier that more and more companies are accepting cryptocurrencies as a means of payment, but that doesn’t mean a cryptocurrency is the same as a traditional currency. So what are some of the differences there?
RANDY: No, they’re not the same at all. Fiat currencies like dollars and euros are forms of money that, of course, are issued by governments to serve as legal tender. Cryptocurrencies like Bitcoin are non-fiat, non-governmental forms of digital cash designed to be used for electronic payments. The idea of digital cash isn’t new. It started with credit cards, PayPal, Venmo, and other services’ desire to create an easy, traceable electronic payment process. But those payments are still tied to fiat currencies managed by central banks, whereas cryptocurrencies are managed by technology, specifically, the cryptology.
MARK: Go to any financial website and you’ll see a quote screen, or you can pull up a quote screen, showing prices of different cryptocurrencies fluctuating all over the place. What’s driving that? How are they valued?
RANDY: Well, many proponents believe that the value of a cryptocurrency is determined by the quality of the cryptology, the number of cryptocurrency units created, and the technology that limits the creation of additional units. Like any tradable item—rare coins, stamps, baseball cards, etc.—the value is often driven by supply and demand. The fewer units available, the higher the price buyers are willing to pay.
MARK: And what’s been driving this surge in popularity we’ve seen over the last few years?
RANDY: Well, like many new technologies or products, Bitcoin has attracted followers interested in the innovation and the perceived lack of government control. Speculators see it as an alternative to traditional investments, such as stocks, bonds, and cash, and trading momentum has led to higher prices, but also plenty of volatility. And all of this has attracted a lot of media attention, which drove mainstream awareness, and, ultimately, increasing acceptance. Most recently, companies such as PayPal, Microsoft, Whole Foods, even Home Depot, have announced that they will accept Bitcoin as a form of payment, although the process is sometimes a bit cumbersome because it often involves a third-party application in order for it to work.
MARK: Randy, earlier, you mentioned that there aren’t central banks involved in cryptocurrencies or Bitcoin in the same way they are with traditional currencies. So if there’s no central bank involvement, and let’s use Bitcoin as an example, who is managing the ecosystem? Who is, ultimately, in charge to make sure that the technology is working?
RANDY: Yeah, it’s a bit of a mystery. So Bitcoin was created based on a paper that was written way back in 2008 by an anonymous founder who goes by the pseudonym, Satoshi Nakamoto, although no one really knows who Satoshi Nakamoto is, or even if it’s a single person. No person or agency currently regulates it to ensure that it maintains its value or its liquidity, or to be sure that it works as a means of payment, though network and technology behind Bitcoin is governed by consensus of a private digital community, according to guidelines, based on the community, the cryptology, and the network of computers, i.e., the internet. It’s promoted, it’s protected by the Bitcoin Foundation, but the foundation really has no control over Bitcoin’s trading activity or its value. The original Bitcoin code was structured so that the very last Bitcoin will not arrive through a mining process until the year 2140.
MARK: That mining process, I think is pretty important in determining the... or at least one of the determinants of what the value of these currencies are. Could you talk a little bit more about that? I don’t think people have a full understanding of what mining is or how it is working.
RANDY: Sure. Without going into all the technical specifics, mining is a record-keeping process, and it’s done through the use of computers. It typically involves expensive servers, sometimes thousands of them, and very, very high energy use. Miners keep the blockchain consistent, complete, and unalterable by repeatedly verifying and collecting new transactions into a new group of transactions, called the block, and it’s done through a complex mathematical process that’s called hashing. Each block then links itself to the previous block, and that is what gives the blockchain its name. Through this mining process, the global supply of Bitcoins is increasing at a predictable and relatively predetermined pace based on the original code. As of June 2021, about 18.7 million, or 89% of all Bitcoins, have already been produced, and an estimated four million or so have been lost for good.
While the supply of Bitcoin does increase through the mining process, the overall supply is fixed by the code and set to reach a maximum of 21 million, which, as I mentioned previously, is expected to happen around the year 2140. Now, this can be estimated because we know how fast computer processing speeds are increasing, and the mathematical process continues to get more and more complex each time a new Bitcoin is produced. So as you might imagine, large demand, combined with a relatively small supply is typically a recipe for high volatility. With many decentralized exchanges, the market is also very fragmented, and since Bitcoin can’t be sold short like equities, true price discovery is sometimes difficult.
MARK: Randy, we’ve mentioned Bitcoin many times, but there are lots of other types of cryptocurrencies out there. Could you talk a little bit about them? Why is Bitcoin the most prominent of those? And, again, what are some of the others, and how large are they?
RANDY: Yeah, so Bitcoin is by no means the only cryptocurrency, not even close. Bitcoin was the first cryptocurrency, and it’s definitely the best known, the most widely held, and, still, with about 47% of the total cryptocurrency market cap, still the most valuable by far. However, as of June 2021, there were at least 5,000 different digital currencies in the marketplace, of which at least 70 have a market cap exceeding a billion dollars. Some of the more popular cryptocurrencies include Ethereum, Tether, Bitcoin Cash, which was a spinoff from the original Bitcoin, Cardano, XRP, Polkadot, and Litecoin.
MARK: These currencies, you know, as you mentioned, 5,000 different currencies, you know, they sort of come into existence. How does that happen? How does one go about creating a new cryptocurrency?
RANDY: Well, one way to create a cryptocurrency is to do what’s known as an ICO, or initial coin offering. An ICO is similar to an IPO, an initial public offering of a corporation. Now, with an IPO, a company can obtain working capital by offering its private shares for sale to the public on a stock exchange. With an IPO, investors get shares of the company, but with an ICO, they don’t. They get non-equity interests called a token. Now, tokens are often paid for, either with dollars or with another existing cryptocurrency. And while tokens do not represent ownership in the technology company, like shares of stock in an IPO, tokens can potentially be exchanged for the new cryptocurrency at a later date, and, of course, if the price has gone up, a profit can be made.
But ICOs are extremely risky because they’re completely unregulated and there’s very little protection from fraud, scams, or theft. There are literally hundreds of examples of ICO fraud and cases where the SEC, despite having relatively unclear oversight, has taken enforcement action against companies that have launched ICOs for violation of US securities laws.
MARK: Let’s go back to one of the reasons for the popularity of cryptocurrencies, and one of those is the belief that, eventually, these digital currencies will, in fact, be replacing existing fiat currencies and become, really, the new global currency. Talk a little bit about that, and is that going to happen?
RANDY: You know, I really don’t think so, at least not anytime soon, but time will tell. To be a viable currency usually requires three characteristics—that it can be used as an inexpensive, reliable medium of exchange, that it can be a unit of account, and it can be a store of value and legal tender honored as a means of payment. As long as Bitcoin is subject to high volatility, hefty transaction fees, and slow transaction times, it’s likely that it will only have limited use as a medium of exchange, or as a unit of account, or a store of value.
Another barrier to broader public acceptance as a true currency is that as cryptocurrencies have become more widespread, stricter government regulation and even outright bans have dampened their appeal. So, for example, China currently has an outright ban on cryptocurrencies and Russia has declared them illegal. Cryptocurrencies are also banned in the South American countries of Bolivia, Colombia, and Ecuador. But not everyone is on the same page, because in June of 2021, El Salvador actually became the first country to declare cryptocurrencies legal tender.
MARK: Let’s talk about taxes. I think I’ve said before that, if there’s some sort of an aspect of your financial life, you should be thinking about the tax implications of that. So how are cryptocurrencies treated from a tax perspective, at least in the US?
RANDY: Well, the IRS treats Bitcoin as property, not as currency. Cryptocurrency transactions are considered taxable by the IRS whenever a taxable event occurs, such as selling Bitcoin for a fiat currency or trading it for another asset. Investors are responsible for tracking their own cost basis, gains, and other reporting, even if the firm where they buy or sell doesn’t do it for them. The tax code states that all income from whatever source derived, is taxable, even if it’s not reportable to the IRS. In fact, for the very first time, this year, if you look at the very first page of IRS Form 1040, you’ll notice that the first question, right below the name and address line, is this: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
MARK: So, Randy, probably the second-most popular question we get after “what is Bitcoin?” is, “should I invest in Bitcoin or other cryptocurrencies?”
RANDY: Well, “invest” is probably not the right word. Bitcoin and other cryptocurrencies are speculative instruments and buying them should be considered as such. Bitcoin doesn’t really fit within traditional asset allocation models because it’s not really a traditional commodity such as gold, nor is it a traditional currency. In fact, it’s not even a traditional hard asset, like real estate, coins, artwork, even something like rare cars. Because it also has no industrial value, Bitcoin’s dramatic volatility is driven primarily by supply and demand, but it has no real intrinsic value. Bitcoin also doesn’t have earnings or revenues, it doesn’t have a price-to-earnings ratio or book value, and, of course, it pays no dividends. Traditional value metrics simply don’t apply. And since its history is fairly short, there really are no proven methods for assessing its value.
Regardless of these factors, in the last 13 years since Bitcoin first came on the scene, the cryptocurrency market has developed beyond an initial experimental phase and continues to mature as a new, unique, and now, really, very sizable asset class. Several institutional investors and corporations have begun to invest in Bitcoin and some traditional capital market participants have introduced crypto-market infrastructure services to make it more accessible. Some investors believe that if there is a lack of correlation with other asset classes, cryptocurrencies could add diversification to a portfolio, but the evidence on that is still a little bit questionable, though sometimes, a stubborn belief in such things, despite evidence to the contrary, can be self-reinforcing in itself, even with significant uncertainties regarding legal, regulatory, and compliance considerations.
So whether or not you should buy cryptocurrencies probably depends on your income, your goals, your risk tolerance, and time horizon as an investor, all the things that we talk about for traditional investing. But no matter what you decide, it’s best to approach it as a speculative investment with very high volatility and risk. If you already have a diversified portfolio and a long-term investing plan, cryptocurrencies are probably best used only for trading purposes, and I might even suggest that you limit them to no more than perhaps 1% or less of your portfolio.
MARK: For those who are interested in taking a closer look at this, how can they get exposure to cryptocurrencies at Schwab?
RANDY: Well, we currently don’t offer direct exposure yet, but they can get indirect exposure. You can’t purchase or sell Bitcoin or any other cryptocurrency at Schwab. We don’t accept posits or make withdrawals in cryptocurrencies, but we do offer a few ways to access the cryptocurrency markets. A company called Grayscale offers over-the-counter cryptocurrency trusts on Bitcoin, Ethereum, and Litecoin that can be bought and sold in a regular Schwab account. Now, these trusts look like ETFs, but they’re a little bit different. They do offer exposure to the underlying cryptocurrencies, but they can involve high expenses and other risks, including a high tracking error, and, of course, that means that the prices can sometimes vary a lot. They can trade substantially higher or lower than the underlying cryptocurrency would suggest. Schwab clients with a futures account can also trade Bitcoin futures on the Chicago Mercantile Exchange. However, it is possible to get a real-time quote for Bitcoin on Schwab’s trading platforms, and you can do that using the symbol $GXBT.
The thing is the cryptocurrency market is very immature and that can pose risks for both our clients and for Schwab. The Securities and Exchange Commission has approached this space with a lot of caution and has denied numerous applications from firms wanting to launch an actual crypto ETF. The most recent was just in June of 2021.
MARK: Randy, let’s talk a little bit more about the risks associated with these types of investments. What are some of the unique risks of Bitcoin and other cryptocurrencies?
RANDY: Yeah, there are plenty of them, not the least of which is government intervention. We already mentioned how China, Russia, and several South American countries have banned or restricted cryptocurrencies and those announcements oftentimes cause sharp downturns and price moves. When China first took action by shutting down all of the cryptocurrency exchanges and threatened to halt Bitcoin mining operations back in January of 2018, that was the time Bitcoin went into a 60% downturn, because at the time, China was mining about 90% of all Bitcoins, by far, the most of any country in the world. More recently, in May of 2021, China officially banned all financial institutions and payment companies from transacting business in cryptocurrencies. Bitcoin went into a 40% downturn. And then, just a few weeks ago, China officially banned all Bitcoin mining, which caused another 16% downturn.
Some people might assume that this maybe is due to concerns about energy consumption or the environmental impact of mining, both of which are significant, but the reality is that it’s more about maintaining control over its currency. China announced back in April of 2021 that it is creating a digital version of the yuan, which will be controlled and issued by the People’s Bank of China. The digital yuan might be considered less desirable since it will not have the same anonymity as Bitcoin. So the Chinese government needs to be sure that there’s no domestic competition. China also intends for the digital yuan to be used for international trade in a manner that will be untethered from the global financial system. Currently, only about 4% of global trade is done in the yuan, and China has been working for years to change that.
All of this, of course, could also threaten the dollar. And that’s the currency, of course, through which 88% of all global trade is currently done, and this also hasn’t gone unnoticed by Treasury Secretary Janet Yellen, or by Federal Reserve Chair Jay Powell, both of whom have expressed various concerns about Bitcoin.
At the moment, there is a group from MIT called the Digital Currency Initiative that is reportedly studying the concept of a Central Bank Digital Currency, known as a CBDC, in partnership with the Federal Reserve Bank of Boston and a more detailed research report on that particular topic is due out at any time from the Federal Reserve. The more viable the idea becomes, the more downward pressure we might see on the existing cryptocurrencies, and I think it goes without saying that if, for some reason, there was an outright ban in the US, that would be catastrophic to the industry.
MARK: Randy, what are some of the just more traditional risks associated with an investment like this that, you know, really come into play, no matter what type of financial asset you’re looking at?
RANDY: Yeah, owners of cryptocurrencies shouldn’t underestimate the financial risk of just simple price movement with or without these central bank activities, Bitcoin and other cryptocurrencies have historically been extremely volatile, and such fluctuations can result in significant losses. For example, Bitcoin rallied over 100% in the first four months of 2021, then it proceeded to fall 50% over the subsequent two months. What that means is it basically wiped out all the gains for anyone who didn’t own it before 2021. There are also numerous lesser-known cryptos that have launched and quickly dropped to zero. Even a few of the celebrity investors have got caught up in some of those.
MARK: Randy, last question. What are some of the risks that may not be unique to cryptocurrencies, but the nature of how they work makes them more susceptible to them?
RANDY: So we already talked about regulation, and it’s still lacking. Cryptocurrency trading is not well-regulated at all, and the exchanges have very little oversight. Many of them have had extended computer outages, and those tend to happen during times of very high demand, and their cybersecurity on the internet is somewhat questionable. We talked about the ICO fraud earlier, but there have also been cases where the founders of cryptocurrency exchanges have disappeared with large sums of money. And then, of course, there’s the risk that your login ID or your password could be lost or stolen, which, again, would likely leave you holding the bag.
MARK: Thanks for your time again, Randy. Appreciate you coming by.
RANDY: It is my pleasure, Mark. It’s always great talking with you.
MARK: I started this episode with a discussion of hindsight bias and how extremely successful technologies seem inevitable, but really aren’t. We also sometimes suffer from a selective memory where we remember successes because those successes still exist and we’re reminded of them every day. We also sometimes remember failures, especially if they’re vivid and spectacular failures.
In both these cases, we lose sight of the fact that innovations don’t happen in a vacuum. They usually happen as part of an ecosystem. And in that ecosystem are both winners and losers.
Even if an innovation is world-changing it doesn’t mean that the pioneer in that space is guaranteed to be the one that survives. In 2003 or so social media was just becoming a thing.
In 2021 Facebook is the 800-pound gorilla of that industry. That’s not how things were in 2003. MySpace and Friendster were the dominant firms then, but MySpace barely exists today and Friendster is permanently shut down.
That historical example is one of the reasons the cryptocurrency space is fascinating.
What started out as just Bitcoin has morphed into a universe of cryptocurrencies and, increasingly, many other types of digital assets. Given the many forces at play, it’s entirely possible that the future of this type of investment will look quite different just a few years from now.
As for the question of whether Bitcoin or another cryptocurrency should play a role in your portfolio, I suggest that you think about what your portfolio is trying to accomplish.
A portfolio is a tool with lots of features associated with it. Every investment in that portfolio is playing a role. If it’s performing its role it should be helping the portfolio do its job for you. During my interview with Randy he laid out the characteristics of cryptocurrencies. Your job is to think about your situation and decide whether those features are useful to you. This show has too many types of listeners for me to even pretend that I can make a blanket statement that makes sense for everyone. Only you can answer that question. If you can’t and need help, then work with an advisor.
If you’d like to learn more about cryptocurrencies go to schwab.com/insights and look for our Bitcoin FAQs article. It covers some of what we talked about today in more detail, but also provides more information on how to invest in Bitcoin-related investments through Schwab.
Thanks for listening. That’s it for Season 8. We’ll be back with more episodes later in the year.
If you’ve enjoyed the show, please leave us a review on Apple Podcasts.
You can also follow us for free in your favorite podcasting app.
You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.