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The Bitcoin paradox

We must, though, be wary of such big stories. These can lead us astray by causing us to overestimate how comprehensible and predictable the world actually is: psychologists call this the narrative fallacy.

So, let’s take a different approach and think of Bitcoin as if it were an asset just like any other. What then can we say about it?

My chart shows one thing. It shows that Bitcoin has massively outperformed equities in recently years. If you’d put £100 into Bitcoin at the start of 2015 you would now have over £10,000. If you’d put the money into a global equity tracker fund you’d have less than £200 before dividends.

But this doesn’t mean that Bitcoin and equities are completely different. They have a big thing in common: they fall at the same time. During 2018, for example, Bitcoin lost over 70 per cent while equities also fell, albeit by only 5 per cent. And this March, Bitcoin fell by more than equities – losing 23 per cent in sterling terms while equities lost only 12 per cent.

Bitcoin, then, is a high-beta asset. Looking at monthly changes since 2015, it has a beta with respect to MSCI’s world equity index of over two. Which is another way of saying it is a risk asset. It rises a lot when appetite for risk rises, and falls a lot when appetite for risk falls.

Another fact corroborates this. It is that the 10-month rule works for Bitcoin – the rule that tells us to be in an asset when its price is above its 10-month average and out of it when its price is below that average. If you had put £100 into Bitcoin in December 2015 you’d now have just over £5,000. But if you’d followed the 10-month rule you’d have over £5400, because it would have got you out of Bitcoin in the spring of 2018 thus saving you a big loss.

Granted, this is an artificial example: dealing costs would have eaten into those profits. But it tells us something important – that Bitcoin is prone to momentum. Which in turn suggests that it is a sentiment-driven asset rather than a value-driven one: the 10-month rule doesn’t work in a market dominated by value investors because these buy on dips and sell on rallies thus preventing the long up and down trends that cause the 10-month rule to work.

Bitcoin cynics might read this as evidence that it has no intrinsic value and that its price instead depends only upon investors’ opinions (or their opinions of others’ opinions and so on.) For me, though, this is not a decisive objection. The price of many assets, such as gold, currencies and (yes) equities also depends upon opinions rather than intrinsic value. The question is: how well anchored are these opinions? And the volatility of Bitcoins suggests they are less well so than is the case for other assets.

Such volatility, however, has a benefit. It should mean high returns.

We can roughly quantify this. Conventional economic theory says that the expected return on any asset should be equal to the product of four things. One is the asset’s volatility. A second is our risk aversion. The third is our background risk: if we are in danger of losing our job or business, we can less easily afford to take risk with our other investments, and so need higher returns to induce us to do so. And the fourth is the correlation between the asset and that background risk: an asset that falls when the rest of our finances are doing badly is especially dangerous and so must pay us well in normal times to compensate.

Let’s quantify these. Since 2015 the annualised volatility of monthly changes in Bitcoin has been 79.7 percentage points: that compares to less than 13 percentage points for MSCI’s global equity index. A reasonable assumption for the coefficient of risk aversion would be three, where one betokens risk neutrality and higher numbers great risk aversion. Background risk varies enormously from person to person: it’s negligible if you’re retired on an inflation-linked pension, but high if you’re in a risky job. Let’s call it 0.1. This leaves the correlation between Bitcoin and background risk. Two facts suggest this is high: Bitcoin’s correlation with equities; and the fact that it fell so much in March when the economy slumped. On the other hand, though, its very volatility argues for a lower correlation. So let’s call it 0.4.

Multiplying these numbers together gives us 9.6 per cent: 0.797 x 3 x 0.1 x 0.4. So we should expect an average annual return on Bitcoin of just under 10 per cent.

Of course, you can quibble with the precise numbers here: think of this as a Fermi estimate. The point, though, is that expected returns on Bitcoin should be high. This doesn’t of course predict it will rise next month or next year, just as similar calculations for the equity premium don’t predict shares’ short-term returns. The point is that this is the sort of return Bitcoin must offer merely to compensate for its risk. It’s a fair value return.

In fact, this estimate helps explain why Bitcoin is so volatile. Many of its holders are hoarding it in the expectation of further profits: it has been estimated that 97 per cent of Bitcoins are held by only 4 per cent of holders. Such hoarding means Bitcoin is illiquid – and illiquidity generates volatility.

But, of course, anything that is illiquid and volatile is lousy as money – because money’s key features are that it should be a stable store of value and an easy-to-use medium of exchange.

Which yields a paradox. The more attractive Bitcoin is as an investment, the less useful it is as money. And, conversely, if it is to become useful as money it will lose its use as an asset offering high expected returns. Bitcoin’s advocates can tell two stories – but they cannot both be right.