It is always advised to diversify investments, but when doing so, not all assets are equal. Various assets fill different roles in your portfolio, and proper diversification is like an orchestra: all roles should be filled.
If your goal is to grow your portfolio, a big part of it should be in what’s called “risk assets.” These assets have higher risk associated with them, so are volatile, but in return for the risk, that volatility will compensate the investor with potential growth. A classic risk asset is stocks.
On the other side of the equation, you have assets that are “stores of wealth.”
These are less volatile, or sometimes not volatile at all, and provide security. In some cases, they act as the exact opposite to risk assets, so when the risk side of the portfolio crashes, the store-of-wealth side of the portfolio actually gains in value to offset the losses.
Traditionally, gold has been an essential part of any wealth portfolio as it is not directly linked to banks or the economy and retains value. When there is an economic crisis, a dollar devaluation, or the threat of rising inflation, gold goes up in value as risk assets like stocks or the dollar go down in value.
Bitcoin, and, to a lesser extent, other cryptocurrencies, are now being seen in a similar light to stores of wealth, even though they began as alternatives to fiat currency and not investments.
Bitcoin has even been dubbed “digital gold.” But is this comparison valid? Numerous funds and financial institutions now include digital currencies as part of their portfolios as they become more mainstream.
However, many financial experts and even governments are firmly against alt-currencies. What do potential investors need to keep in mind when comparing gold and cryptocurrencies?
Why are gold and cryptocurrencies seen as investments and not currency?
While both assets can be used as and have been used as currency, neither is ideal.
People have bartered and paid for goods with gold for thousands of years, but it just isn’t practical in the modern world.
Not only are shops unlikely to accept it, but gold also can’t be digitally transferred from one part of the globe to another, something that’s become increasingly necessary since the dawn of the internet.
Cryptocurrencies can be used to buy things and can easily be sent digitally.
However, the transaction fees on digital currency exchanges coupled with its massive volatility mean that while it could technically be an alternative currency, it is not practical.
Gold and cryptocurrencies as investments and hedges — which is better?
Can we alternate between gold and digital currencies as a hedge against market volatility and inflation? Their intrinsic value comes from the fact that both are finite.
There is only a certain amount of gold on the planet, and bitcoin, for example, has a limit of 21 million coins that will ever exist.
While many digital currencies maintain value by limiting the amount that can be ”mined,” the number of different alt-currencies that can exist is infinite, and the differences between them are small, so the concerns about cryptocurrencies as a whole being a limitless, inflationary asset are valid.
Another aspect to consider is that despite being nicknamed ”digital gold,” cryptocurrencies tend to behave differently to real gold when the market turns bearish.
Joseph Sherman, Co-Founder and CEO of Gold Alliance, explains, “When there is an economic downturn, or inflation looks likely, the price of gold tends to work inversely to the market. Investors see the real value of the gold part of their portfolio when the market turns bearish.
“Cryptocurrencies have only been around for a decade or so, most of them a lot less. They have only existed in times of low inflation and bullish markets, and in the market corrections we have seen so far, bitcoin crashed with the markets.
So far, the evidence seems to show that despite their supposed independence, digital currency fluctuations have directly correlated with market trends, making them a risk asset—the opposite of how gold behaves as a store of wealth.”
Sherman continues, “The global economic situation has recently started to change as a result of the Covid-19 pandemic. Many thought that alt-currencies would be a good hedge against inflation, but recently they have dropped in value just when there is direct evidence of inflation rising. So, when inflation rises and gold rises in price but alt-currencies lose value, it seems likely that digital currencies might not serve portfolios as a hedge.”
Sherman points out that this may also be down to external issues. “What clouds the picture when looking at correlations such as these is that cryptocurrencies are also being affected by other influences.
Most recently, it was China’s crypto crackdown and Tesla’s policy changes, so as an investor is looking at parts of his portfolio, cryptocurrencies should be on the high-risk side and not the store-of-wealth side.”
Outside influences and intervention affect cryptocurrencies more than gold
The massive recent drops in digital currencies were primarily caused by a couple of unpredictable events. The first was Tesla CEO Elon Musk announcing that you can no longer buy a Tesla vehicle with bitcoin, reversing the decision from just a few months ago.
The other was China banning institutions from providing services relating to any alt-currency.
China is not the only nation to ban speculation on cryptocurrency trading. Countries around the world have been trying to limit digital currencies and discouraging purchases.
This regulation is likely to increase as digital versions of fiat currency are explored.
Sherman says, “One of the prime concerns for investors when looking at assets like bitcoin is that, unlike gold, it is highly unpredictable. The term “digital gold” is just not true. For example, in May 2021, bitcoin dropped 40% in a couple of weeks while, for the same period, gold rose 5%. Gold is the asset that is the least correlated with stocks for over 100 years, whereas bitcoin in its short existence almost perfectly tracks the Russel 3000 stock market index, which shows how different these assets are. If you want to take your stock market risk and put it on steroids, bitcoin is for you. But if you are looking to protect your retirement account against risk you already have in your stock market allocation, a portion in gold is the way to go.”
For now, gold is undoubtedly the safer asset for investors. Cryptocurrency fluctuation might suit those with a high appetite for risk, but for many portfolios, they are inadvisable.
Alt-currencies not only seem to be linked to the markets, making them an unsuitable hedge, but they also face considerable headwind and disruption that is almost impossible to predict.
Maybe their time will come, but it is better to wait and see how they behave in more adverse market conditions before making them a more significant part of your portfolio.