Bitcoin | Perspectives

Updated: Mar 21


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Key Points

  • Risk of complete loss of capital has materially declined and will continue to decrease over time as Bitcoin's adoption by mass retail, institutional investors, and companies increases


  • Bitcoin's market cap is currently only 3.75% of gold's market cap with increasing odds of displacing the latter which would translate to a 27x return


  • Probabilistic thinking, dollar-cost-averaging, and strict limits on invested capital the optimal way to gain exposure to Bitcoin

Introduction

Bitcoin broke all-time highs on 16 December 2020, close to 3 years since its last high (c. US$20k) and a gut-wrenching 80% drawdown thereafter. At the time of writing, Bitcoin is trading at US$24,870, or 24% above the 2017 peak. In this article, I will reexamine my Bitcoin strategy and hopefully provide some perspectives on the ongoing narrative of this nascent asset class. At the time of writing, Bitcoin's price is US$24,752.20.

My Bitcoin Strategy Then

I began accumulating Bitcoin in Dec 2018 after spending months trying to understand its use case and risk-reward setup. The key observation that gave me the courage to invest in Bitcoin then was that despite the 80% drawdown from its 2017 highs, there were still numerous developments taking place in the cryptocurrency space. Brilliant people all over the world were still coming together to build new projects and infrastructure (e.g. exchanges, on-ramps, and off-ramps). In addition, Bitcoin has had frequent 80% drawdowns in its short history. Each time, detractors boldly claim the bursting of the bubble and the demise of Bitcoin (I was one of them during the 2013 and 2017 bust).


However, bubbles pop and don't recover (or at least, take decades to recover). Since the beginning, Bitcoin has entered "bubble" territory, popped, and recovered stronger each time. This reminds me of the Lindy Effect, which states that non-perishable things like technology age - linearly - in reverse. As such, a longer an idea or a technology lasts, the longer its life expectancy will be.



My back-of-the envelop risk-reward setup then was that there is a 50% chance this thing goes to zero and a 50% chance this thing reaches a decent level of adoption and achieves a US$1 trillion market cap. Bitcoin's market cap in Dec 2018 was approximately US$60b. This meant that while there was a significant probability in the permanent loss of capital, the potential upside made this an asymmetric bet.


My Bitcoin strategy back then was to dollar-cost-average into Bitcoin and limit my invested capital to 5% of my total portfolio. The logic was straightforward, if I was dead wrong and Bitcoin goes to zero, I would only lose 5% of my invested capital. Assuming I am able to generate 10% returns on my investment portfolio, I would be able to recover from the loss within half a year. On the other hand, if Bitcoin does reach a US$1 trillion market cap, it would significantly boost the overall return of my portfolio. I felt that I could take those odds. Over the past 2 years, I've accumulated about 2.26 Bitcoins with a total invested capital of S$16,000. At the time of writing, they are valued at around S$75,000, representing a 369% gain. Bitcoin's market cap now stands at US$462.4b, just shy of half a trillion.


My Current Bitcoin Strategy

Now that we are at new highs and in unchartered territory, I thought now would be a good time to reevaluate the Bitcoin narrative and try to ascertain the risk-reward setup moving forward. The table below shows the timestamp of the major developments and news related to Bitcoin since the beginning of 2018.

There are a few valuable insights to draw from this table:

  1. It is increasingly easy to buy and/or sell Bitcoin for the mass retail market.

  2. Bitcoin is gaining legitimacy as an asset.

  3. Institutional investors (both traditional and tech-focused) have begun deploying capital into Bitcoin.

  4. Companies (e.g. Square and Microstrategy) have begun buying Bitcoin as part of their treasury.

  5. Global banks and payment companies are driving Bitcoin's adoption.

These developments lead me to believe that the risk of complete loss of capital has materially declined and will continue to decrease over time as adoption by mass retail, institutional investors, and companies increases. In order words, I think that the probability of Bitcoin going to zero is no longer 50% but much lower. If I were to hazard a guess, I would say there is now a 20% probability of Bitcoin going to zero. For that to happen, governments globally have to come together and ban Bitcoin. Possible, but highly improbable. Fun fact, the US Government banned gold in 1933 but its success was short-lived (Read here for more). Another way would be for a 51% attack on the Bitcoin network. Once again, it is possible, but highly improbable. To understand and appreciate the robustness of the Bitcoin network, I would highly recommend reading the Bitcoin white paper here.


Upside Perspectives

There are numerous ways of trying to figure out what are the possible, plausible, and probable prices Bitcoin can achieve in the future. The narrative/framework that makes the most sense to me right now would be the disruption of gold by Bitcoin. I will list the reasons how Bitcoin is a better gold than gold itself in a moment. Using this framework, one can derive the implied market cap of Bitcoin (and therefore the price of Bitcoin) by assuming the rate of adoption of Bitcoin relative to the market cap of gold.


Firstly, let's derive the current market cap of gold. According to the World Gold Council, the total above-ground gold stock stood at 197,575.7 tonnes in 2019. At the current price of US$1,900 per troy oz, the market cap of gold is US$12 trillion. At the moment, Bitcoin is only 3.75% of gold. My initial target of US$1 trillion Bitcoin market cap implied only an 8.3% adoption rate. Hence, the multi-trillion dollar question now is whether Bitcoin will replace gold and what is the probability?

It is also worth noting that the rate of adoption along the S-curve has accelerated over the years due to advancements in technology. At the current 3.75% adoption rate, we are still in the early innings for Bitcoin.


Bitcoin A Better Version of Gold

Investopedia has done a brilliant writeup on the superior characteristics of Bitcoin relative to gold. You can read more about it here. The key takeaway for me here would be that Bitcoin is a better version of gold as a store of value and stand a good chance of replacing gold as we continue the shift towards a digital world.


Suppose Bitcoin displaces gold and reaches US$12 trillion in market cap, each Bitcoin would be worth approximately US$570k, or a 27x return from current levels. This is in line with Cameron and Tyler Winklevoss' price target of US$500k. Guggenheim Partners' CIO Scott Minerd has a lower price target of US$400k.


Once again, if I were to hazard a guess, I would say there is a 20% probability of Bitcoin displacing gold. The remaining 60% could be divvied up as follows:

I added 3 additional scenarios each with 20% probability and the respective price targets. With these scenarios, I derived a probability-weighted price of US$183,400. Obviously, this price target of mine should not be taken seriously. However, it does serve as a useful mental exercise in probabilistic thinking and showing the asymmetric risk-reward profile of Bitcoin. You could come up with your own scenarios and assign probabilities yourself to come up with your own probability-weighted price.


Putting everything together, my current Bitcoin strategy is to quite simply HODL (i.e. not sell anything) and not increase my invested capital. At this point in time, assuming my narrative is correct (i.e. Bitcoin will displace gold), the risk-reward setup is still as attractive as it was in late 2018. While the price of Bitcoin has risen substantially since then, the odds of permanent loss of total capital has declined significantly while the prospect of displacing gold is steadily increasing. Therefore, while my initial 5% allocation to Bitcoin has outperformed the rest of my portfolio and now accounts for 16%, I am comfortable with the allocation. That said, I would likely pare down my Bitcoin allocation should it reach around US$80k - US$100k, in-line with the Stock-to-Flow model shown below.


Here are some additional data points supporting my Bitcoin thesis:


Google Search Trends

Despite breaking new highs, Google searches for the term "Bitcoin" remains a fraction of peak interest in late 2017. This suggests that the current rally is not retail-driven and still has room for further upside. To put things in perspective, during the 2017 Bitcoin rally, when the Google search index stood at 27, Bitcoin's price was around US$7k. When the index topped out at 100, Bitcoin's price reached around US$20k, or 2.9x in 2 months. If we assume history repeats itself, Bitcoin's price could reach around US$75k in 2021.


Stock-to-Flow Model

According to the Stock-to-Flow Model, Bitcoin is forecasted to reach US$100k as early as 2021 and US$1m by 2025. This implies a market cap of approximately US$2.1 trillion (17.5% of gold's market cap) and US$21 trillion (175% of gold's market cap).


Strong Hands Not Weak

This chart shows the total number of Bitcoins sitting on exchanges. Since March of this year, there has been a consistent outflow of Bitcoin from exchanges. This suggests that the holders of the Bitcoin intend to hold them over the long-term and not trade them on the exchanges. This is a healthy sign of a sustainable rally.


My Favourite Data Point

According to Credit Suisse's Global Wealth Report 2020, there are 52 million millionaires globally. With a definite supply of 21 million Bitcoins, not all millionaires will be able to own 1 whole Bitcoin each.


Concluding Thoughts

Metcalfe's Law states that the value of a network is proportional to the square of the number of participants in the network. The recent developments in Bitcoin have brought on an influx of new participants (i.e. Institutional investors, companies, and mass retail), adding value and strength to the Bitcoin network. Each participant serves as a node in this incentive-based network.


I am bullish on Bitcoin and believe that probabilistic thinking, dollar-cost-averaging, and strict limits on invested capital is still the optimal way to gain exposure.


I could be dead wrong. Only time will tell.


Wishing you a happy new year,

Kenny


Disclaimer: This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/The Snowball do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such.


Cover photo source: Dmitry Demidko

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