Two of the hottest investments in the world just collided.

Tesla’s iconoclastic chief executive Elon Musk announced today that his company has purchased $1.5 billion in Bitcoin and will begin accepting payments in the cryptocurrency. Buoyed by the news, investors flooded into the most popular cryptocurrency, pushing it up almost 14% to nearly $44,000 as of writing.

At this time last year, one Bitcoin was worth slightly less than $10,000.

 

 

 

“The story right now is institutional adoption,” said Stephen McKeon, associate professor of finance at the University of Oregon. “The arrival of qualified custodians and other key infrastructure has facilitated the onboarding of significant institutional capital in a way that was unfeasible just a few years ago.”

Despite Bitcoin’s recent rise, you still need to be careful. While the flagship cryptocurrency appears to be maturing, it’s still extremely volatile in both directions. For regular investors, that means you should tread lightly with this speculative asset class unless you have your fundamentals, like an emergency fund and basic retirement portfolio, covered.

Tesla Drives Bitcoin Love

Elon Musk’s infatuation with Bitcoin is nothing new, and it jibes with his affinity for unconventional investments and ideas.

 

This latest development is more than just Musk being Musk. In its annual report, Tesla said it added $1.5 billion in Bitcoin as part of a larger policy to earn more on its cash that it doesn’t need to keep the company going. This alternative reserve will also look into gold bullion, gold exchange traded funds (ETFs), and potentially other assets in the future.

The company, which is valued at slightly less than $900 billion, also said that it plans to begin taking Bitcoin as payment “in the near future.”

Demand for the cryptocurrency exploded upon the announcement.

 

Today’s buying spree appears to be driven in large part by speculation. The irony is that Bitcoin speculation undermines Tesla’s interest in using it as a medium of exchange. One reason we use dollars is that we don’t expect the value of one dollar to rise or fall 14% on any given day. Why use Bitcoin to buy a car when its value fluctuates double-digits on a regular basis?

Institutional Investors See Bitcoin as an Inflation Hedge

Elon Musk and Tesla are only the latest boldface names backing Bitcoin. Paul Tudor Jones, one of the nation’s richest hedge fund investors, appeared on CNBC in late 2020 to make his case for the cryptocurrency, citing concerns about inflation and the Federal Reserve. While inflation remains subdued now, Tudor Jones’s Bitcoin thesis appears to rest on the development of the coronavirus crisis since early 2020.

As Covid-19 spread to Europe and then the United States, starting in late February, governments began imposing lockdowns to limit the spread of the virus. Lockdowns suppressed economic growth, sparking a global recession, and central banks stepped in to support national economies.

In the U.S., the Federal Reserve immediately cut short-term interest rates to near zero and began printing trillions of dollars to buttress the economy. As the economy began to heal, Fed Chair Jerome Powell announced that the Fed would allow inflation to run a bit higher before the FOMC would contemplate raising interest rates again. The new strategy crystallized new thinking and new research at the Fed concerning weak inflation.

Enter Paul Tudor Jones and other hedge fund heavies, who began buying up Bitcoin in May in anticipation of rising inflation.

“The reason I recommended Bitcoin is because it was one of the menu of inflation trades, like gold, like TIPS breakevens, like copper, like being long yield curve, and I came to the conclusion that Bitcoin was going to be the best inflation trade,” Jones told CNBC last month.

PayPal Makes Bitcoin Easier to Own and Spend

Tesla joins mainstream financial services companies in embracing Bitcoin. In October 2020, online payments giant PayPal announced it would let customers buy, hold and sell a range of cryptocurrencies, including Bitcoin, as well as allow them to actually make purchases with Bitcoin at more than 26 million businesses.

In August 2020, Fidelity launched a passively managed Bitcoin fund for accredited investors, the Wise Origin Bitcoin Index Fund I. Fidelity, one of the few mainline Wall Street firms to fully embrace Bitcoin, has created a separate unit—Fidelity Digital Assets—to manage this fund and similar vehicles.

These developments confirm a growing trend of regulatory and institutional acceptance of cryptocurrencies. When Fidelity announced its Bitcoin fund, for instance, it also released survey data showing that 36% of institutional investors in the U.S. and Europe already owned digital currencies, and 60% believed digital assets belonged in their portfolios.

Could Bitcoin Become the New Gold?

So where do we go from here? One Citibank analyst says Bitcoin could hit $318,000 by the end of next year, likening its meteoric rise to the 1970s gold market. An ounce of gold was worth about $35 in the beginning of 1970, compared to a little more than $1,900 now. Part of gold’s appeal, as Paul Tudor Jones noted, is its value as an inflation hedge.

But does gold actually behave that way?

The real story is more complicated, according to Campbell Harvey, Duke professor and senior advisor to Research Affiliates. Over a time frame of hundreds of years, gold may retain its value. But over shorter periods of time, it’s highly volatile and very unpredictable.

Despite this, gold certainly fills a role as a security blanket for investors who are anxious about the state of the world. Gold’s most recent hayday, for instance, was between 2011 and 2012 when the U.S. was stumbling through its post-Great Recession recovery and the Euro Zone was teetering on the brink of currency disaster. For much of the past eight years, as stocks have zoomed, gold has been a dead weight, though.

It appears, then, that institutional investors are hoping to get on the ground floor of the new gold. Bitcoin’s current rollercoaster ride may track the bullish, risk-on appetites of stock traders, but eventually it might replace gold as a safe haven.

“The Bitcoin network currently stores $350 billion,” McKeon said. “In contrast, several trillion dollars are stored in the form of gold. So, Bitcoin is still comparatively small. As the narrative around, and acceptance of, Bitcoin as digital gold grows, the network will store substantially more value. This translates to a higher price for Bitcoin since supply growth is capped at about 2% annually, and supply increases will further decline over time.”

The case, then, is that Bitcoin has much more room to grow than gold and will continue to attract big money in search of high returns in an era of low yields.

The Final Word on Bitcoin: Buyer Beware

Regular investors don’t really have the luxury to stomach wild price volatility and wait out years and years of negative returns on the hope that an esoteric decentralized financial product will conquer the commanding heights of finance and upend gold as the ultimate safe-haven asset. You need a steadier financial plan, like a well-diversified portfolio of low-cost index funds that has proven to make retirement possible.

If you want to scratch your Bitcoin itch, make sure you do so with a fraction of your taxable investments, in your brokerage account. The standard allocation recommended for gold has been a maximum of 10% of your total portfolio. If Bitcoin ends up as the new gold, that upper limit would still make a ton of sense.