[Disclaimer: This article is not and must not be taken as investment advice. Always educate yourself or take professional advice related to investing.]
From boom to bust and back: the rocky road of Bitcoin valuation. But now, with inflation soaring, is the cryptocurrency finally poised to fulfil its promise as a safe haven investment? Can you use Bitcoin as an inflation hedge? Bitcoin has had a bit of a rough ride in terms of valuation. It peaked most recently back in November 2021 at $68,991, but then fell dramatically down to $18,200 by November 2022. In this time, Bitcoin has been more closely correlated with the price of traditional stocks and shares, such as the S&P500, and has not fulfilled an often-lauded promise of being a safe haven (a bit like gold) in times of stock market crashes. Now, we have high inflation (over 10% per annum in the UK) compared to low single digits over much of the last decade in the US and UK, and this is important to any investment you might make.
Why is inflation important to investment returns?
Put simply, the higher the rate of inflation, the less your money in hand today is worth tomorrow. That means that if you invest in something (e.g. a stock or share), the profit or return you make on it must exceed the rate of inflation for you to get at least the money you invested back. If the rate of return was the same as inflation, then you are effectively treading water and not making much of a profit. In fact, there are other assets you could invest in that are less risky and would guarantee a return above inflation, such as government bonds that are often linked to the rate of inflation and guarantee a (usually) small return above that.
What about gold as an alternative to using Bitcoin as an inflation hedge?
So, when the stock market is going down or we are in times of economic weakness and inflation, people often put their money in so-called “safe havens” such as gold. A problem with investing in gold when the stock market is already down is that the price of gold is likely to have increased, so you are paying a hefty premium to buy then. As with most investments (ignoring the risk element), you want to buy when the price is low and sell when the price is high (or when you have to). This behaviour of a price of an asset going up (e.g. Gold) when the price of another asset (e.g. stocks and shares) goes down is called negative correlation. If you knew that one asset you held was going to go down for a period and a negatively correlated asset was going to go up, you could switch your investment from the one going down to the one going up to keep making a positive return.
Gold is often seen as a hedge against inflation, meaning that it is believed to retain its value even when the purchasing power of paper currencies declines due to rising prices. The rationale behind this belief is that gold has been used as a store of value and a medium of exchange for thousands of years and has maintained its intrinsic value over time. Unlike paper currencies, which can be printed by governments and central banks at will, gold is a scarce resource that cannot be easily replicated or inflated.
During times of high inflation, investors often turn to gold as a way to protect their wealth and preserve their purchasing power. When the value of paper currencies declines, the price of gold tends to rise, as investors seek out safe havens for their money. This makes gold an attractive investment option for those who are concerned about the potential for inflation, as it provides a way to diversify their portfolios and mitigate the impact of rising prices.
However, it is worth noting that gold is not a perfect inflation hedge. Inflation can impact the price of gold in a number of ways, such as through changes in demand and supply, fluctuations in exchange rates, and shifts in investor sentiment. Additionally, the relationship between gold and inflation is not always clear-cut, as there are many other factors that can influence the price of gold, such as geopolitical events, interest rates, and market volatility.
Ultimately, whether or not gold is a good inflation hedge depends on a variety of factors, including the current economic environment, market conditions, and individual investor preferences. While gold has historically been a popular investment option for those seeking to hedge against inflation, it is important to carefully consider the risks and potential rewards before making any investment decisions.
So what about Bitcoin, is it digital gold?
Bitcoin is clearly a completely different beast to gold. For one thing, gold is a physical, tangible metal you can hold in your hand while Bitcoin is a virtual digital asset. If the world went to “hell in a handbasket,” I suspect you’d still be able to barter with your physical gold; a virtual asset like Bitcoin requires some digital/internet infrastructure to exchange. For now, we have thousands of years of trust built up in trading and exchanging physical gold; Bitcoin is relatively new and many people do not trust it. So there are lots of elements of Bitcoin that are unlike gold. That being said, gold tends to be seen as an inflation hedge, that is when inflation is high, people buy gold in the belief that it will retain its intrinsic value as inflation is high and other assets (e.g. stocks and shares) fall.
When considering Bitcoin as an inflation hedge, on the other hand, is seen as a potential bet against economic uncertainty and market volatility. Bitcoin is decentralized and operates on a peer-to-peer network, meaning that it is not subject to government intervention or manipulation in the way that traditional currencies are. This makes it an attractive asset for those who are concerned about the potential for economic instability or government overreach.
In addition, Bitcoin has a finite supply, with only 21 million bitcoins ever to be produced. This scarcity is one of the key factors driving the price of Bitcoin and has led some to compare it to gold, which is also a scarce resource. However, it is worth noting that gold has been valued for thousands of years, whereas Bitcoin has only been in existence since 2009. This means that while Bitcoin has shown itself to be a valuable asset, it has not yet established the same level of trust and reliability that gold has earned over centuries.
Does the volatility in price prevent you using Bitcoin as an inflation hedge?
It is also important to note that Bitcoin is a highly volatile asset, with prices fluctuating wildly on a daily basis. This volatility makes it a risky investment for many investors, and it is not yet clear how it will perform over the long term. Some experts have warned that the current surge in Bitcoin prices may be a bubble that will eventually burst, while others believe that it represents a major shift in the way we think about currency and finance.
Ultimately, whether or not Bitcoin can be considered “digital gold” is a matter of debate. While there are certainly similarities between the two assets, they are fundamentally different in many ways. As with any investment, it is important to do your own research and carefully consider the risks and potential rewards before deciding whether or not to invest in Bitcoin.
So, can you use Bitcoin as an inflation hedge?
Until recently, the price of bitcoin has been more closely correlated with that of stocks and shares. With high inflation, investors demand more investment returns from stocks and shares and if they cannot provide them, they may pull their money out (sell the shares) and look to invest elsewhere. If Bitcoin followed the price direction of shares then you’d expect the same; people would sell Bitcoin at times of high inflation. What is interesting is that recently, the correlation between Bitcoin and stocks and shares has become much weaker with Bitcoin rising about 28% since the beginning of 2023 while the S&P500 (an index of US stocks and shares) has increased approximately 4.5% in the same time. If, and it is a big “if,” that Bitcoin maintains this price growth for the rest of the year, it is returning above the rate of inflation (about 6.4% as of March 2023) and would be a better hedge against inflation than the 4.5% return of stocks. The key point, though, is the “if” in the previous sentence. No one knows with certainty what will happen to inflation or the price of stocks and shares, Bitcoin, or Gold for that matter over the next year; all we can do is theorize or have an educated guess. So can we say that Bitcoin is an inflation hedge? Well, with the benefit of hindsight, it was since the beginning of the year, but we can’t say for sure it will be going forward. In investing, the timescale is very important. Since 1928, the S&P 500 has averaged returns of 10-11%, but the devil is in the detail as over short periods, it has had falls as large as 19-38%! So, to increase the chances of making that 10-11%, you need on average to hold the investment for the 5-10 year horizon at least.
So is Bitcoin a buy?
Of course, as stated earlier, this is all down to your own views on where you think the price of Bitcoin is going to go next and whether it will continue to outpace inflation. Also, if inflation subsides and the returns of other assets such as stocks and shares increase with respect to inflation. The Bitcoin price is very volatile in the short term (it goes up and down quite a bit in the space of a few months). With the lack of trust in Bitcoin (compared to gold) and also the lack of regulation around Bitcoin, there are plenty of risks that it may be worth nothing or get banned by governments (as it was in China). So is Bitcoin a buy – well, it all depends on your views on it and your appetite for risk so there is no clear yes/no answer. What some professional investors do is invest in riskier assets with potentially higher returns as part of a portfolio. So, for illustration, you might invest, say, 90% of your funds in a low-risk asset (e.g., government bond) that might yield, say, 2% above inflation and 10% in a high-risk asset, e.g., Bitcoin that, for the sake of illustration, could yield a ridiculous return of 876,509% over 10 years. So if you put $1000 into this portfolio 10 years earlier, the bonds would be worth approximately $1097, and the bitcoin $876,509. If Bitcoin had gone to zero value in this time, you’d still be left with the $1097 just from the bonds (which is better than zero). If you had invested 100% in bitcoin (a risky strategy) and the price of bitcoin had gone to zero, then you’d be left with nothing from your initial $1000.
Conclusion
So no one can say with certainty that Bitcoin is an inflation hedge over the long term or not. It is really too short a time frame to tell as Bitcoin has only been around since 2009. It has certainly been very volatile in terms of price in that timeframe, and there are many risks such as regulatory issues, that could impact whether it will continue to have any value at all in the future. Following a portfolio strategy is one approach to taking a position on a risky asset going up or down in value while not losing all your investment capital just on that one asset. As we have shown, it is a tricky question and one that is subjective as to whether Bitcoin is an inflation hedge. As always, it is very important to take professional financial advice before investing and educate yourself about the risks and rewards.
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