As the world's most valuable cryptocurrency, Bitcoin (BTC 0.75%) has been one of the best financial assets to own, skyrocketing over 4,700% over the past five years. The S&P 500, by comparison, has increased 113% during that time.
In addition to the possibility of massive capital appreciation, investors might also turn to Bitcoin as an inflation hedge. This topic has not garnered more attention in recent memory than it is right now. But is Bitcoin really an effective portfolio addition to protect against rising prices in the economy?
Read on to see what I think.
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The promise of a digital gold
Traditionally, investors have turned to gold as a hedge against inflation. The thinking is that as consumer prices increase, the cost of a hard asset like gold should also rise as the dollar loses value. But gold's history as an inflation hedge is questionable. There have been periods of high inflation, particularly in the 1980s, when owning gold would've actually resulted in negative returns.
Bitcoin, like gold, is characterized by its scarcity and low correlation with other financial assets. There is only a fixed supply of gold in the world, and there will only be 21 million Bitcoin ever. This supply cap means that as demand for the asset increases, prices will as well.
But Bitcoin is such a nascent asset class that its price today moves purely on speculation, not on what inflation is doing. Maybe when cryptocurrency adoption grows and becomes more mainstream, and volatility decreases, Bitcoin will be more of a serious contender to gold in the eyes of investors.
Not a true inflation hedge
Inflation is the decrease in purchasing power of a currency due to rising prices in the economy. The most widely followed measure of this is the Consumer Price Index (CPI). For the month of November, the CPI jumped 6.8% year over year, the highest increase in 39 years. The unexpected surge in consumer demand as economies reopened earlier in 2021, coupled with unprepared supply chains and unprecedented amounts of government stimulus, are to blame.
I view an inflation hedge as an asset that moves in the same direction as, and to a greater extent than, the CPI figure. So, as prices for goods and services go up, the specific asset in question should also appreciate. As a result, an investor's pricing power doesn't diminish over time.
How has Bitcoin performed recently? Over the past two months, the popular cryptocurrency has lost 23% of its value (as of Dec. 30). Therefore, we can see that even with historic inflation present right now, Bitcoin is not holding up as a true inflation hedge according to this definition.
Monster price appreciation
If we use a different approach, however, then a more important insight becomes obvious. To protect against the threat of rising prices, which is part of a functioning and stable economy, owning assets that tend to grow in value greater than the inflation rate is the most important thing. Then, over the long term, you don't lose your purchasing power. You may, in fact, gain purchasing power.
As I mentioned earlier, the price of Bitcoin has soared astronomically over the past five years, much higher than the rate of inflation. Applying this perspective, it is actually an effective inflation hedge. Sure, the volatility is a major source of investor uncertainty and can be difficult to stomach in the near term. But over an extended period of time (i.e., many years), Bitcoin has proved to be a fantastic asset to own.
Is Bitcoin a good inflation hedge? Maybe not in the traditional sense but it's hard to find anything that has performed better in recent years.
