How To Include Cryptocurrencies As Part Of An Inflation-Proof Investment Portfolio

Consumers and investors alike pay close attention any time a new announcement is made about the movements of the U.S. Consumer Price Index (CPI), which represents a reliable gauge on inflation or deflation. While consumers fret over the effect inflation has on their purchasing power in the here-and-now, investors are more concerned about how inflation will affect their purchasing power in the future.

During heightened periods of inflation, as the cost of goods and services begins to increase, faster than expected, investors will reassess their current strategy and portfolio allocation to ensure the long-term health of their investments. If a portfolio does not grow at a rate faster than the increasing cost of goods and services, that means it is actually losing value in real terms, as the purchasing power it represents is decreasing over time.

For investors looking to inflation-proof their portfolios, assets that yield a fixed income -- such as bonds -- will actually be yielding a smaller and smaller real return over time. To preserve future purchasing power and counter the effects of inflation, investors are increasingly looking to assets that have variable yields, including traditional options like equities and commodities. As access to cryptocurrencies has broadened, though, investors are also incorporating them as a hedge against inflation.

Ways That Investors Try To Make Their Portfolios Inflation-Proof

The first course of action investors typically take during inflationary periods is to reduce their portfolio’s allocation to bonds, which typically perform poorly during inflationary periods and are unlikely to return real yields. However, investors have the option to purchase inflation-indexed bonds. In the United States, for example, Treasury Inflation-Protected Securities (TIPS) are a popular option, because they are pegged to the Consumer Price Index. However, the CPI is not adjusted for seasonality and may understate inflation. Additionally, TIPS are considerably more volatile than cash, especially during stock market crashes, and tend to underperform traditional treasuries over the long term.

Real estate is another inflation-proof investment option because any debt used to finance it will be eroded away by the effects of inflation. As a word of caution, investors should closely consider the type of debt mechanism used to purchase real estate, particularly on the cusp of a market bubble. When the bubble bursts, the investor could end up with an “upside-down” mortgage, where the amount of money they owe on the property is higher than the asset is worth.

To ensure the retention of value against inflation, some investors may increase their allocation of equities, which are likely to outperform bonds. However, performance will depend on the type of equity as well as its valuation going into the inflationary period. Commodities -- such as crude oil or metals -- tend to do well in periods of high inflation. Investors should be careful, though, since some commodities, like cotton, can fluctuate back down rather quickly. The most popular long-term protection against inflation is gold. Gold has served for thousands of years as a scarce commodity with money-like properties. Advantages are that it’s easily understood and has a store of value that shouldn’t change drastically over time. Gold is not without its own volatility issues, though, which has led some investors to explore additional alternatives for portfolio diversification.

Adding Crypto As An Inflation-Proof Asset

Mike McGlone of Bloomberg Intelligence recently said that Bitcoin is on its way to replace gold. Those who understand Bitcoin’s limited supply and hard-coded inflation rate have dubbed it “digital gold.” Over 18.5 million of Bitcoin’s 21 million total supply has already been mined, with the remaining supply being generated at a slower and slower rate until the final Bitcoin is created in 2140. Bitcoin is therefore a form of “sound money” or hard currency, possessing features that make it an effective store of value.

It’s taken over a decade for Bitcoin to build acceptance, with 2020 proving to be a pivotal year. High-profile investors such as Tesla, Inc. TSLA and MicroStrategy Incorporated MSTR have brought cryptocurrencies into mainstream parlance, and in March 2021, Morgan Stanley MS became the first U.S. bank to allow customers to access Bitcoin funds. Even billionaire hedge fund manager Ray Dalio himself admits that he would “rather own Bitcoin than a bond.”

Institutional investors are beginning to understand that Bitcoin has its place in a diversified portfolio and that even 1-2% allocations can achieve significant increases in the Sharpe ratio, which measures and compares the performance of investment products against risk-free assets. A June 2020 analysis by Iconic Holdings, which provides Exchange Traded Products (ETPs), found that a traditional 80/20 stock-bond portfolio saw its Sharpe ratio increase from 6.6 to approx.8.2 with 1% crypto, 9.5 with 3% crypto, and 9.8 with 5% crypto allocated.

Investors should be aware that capital gains from crypto are likely to be taxed similar to capital gains in other asset classes, although this depends on a person’s jurisdiction. Long-term capital gains are preferable to short-term capital gains, making it advisable for investors to seek out cryptocurrencies that they would be comfortable holding for the long term.

Opportunities For Low-Risk Yields In Crypto

It’s possible to earn yield in the digital asset space in a similar way to the yield previously offered by fixed-income products, as well as through low-risk yield opportunities. For example, over 8% per annum can be earned by lending out stablecoins, which are assets whose value is pegged to fiat currencies like the Dollar or Euro.

A feature of digital assets that is being used even more widely than lending is staking, a process by which assets are used to verify blockchain transactions and earn rewards for doing so. According to Staking Rewards, a data provider for staking and crypto-growth tools, over 70% of the supply of Cardano and Solana are being staked, and over 50% of the supply of Polkadot, Algorand, Binance Coin, and Avalanche.

The most recent and sophisticated method for earning yield in the digital asset universe is by providing liquidity to trading pools on decentralized exchanges. These ‘exchanges’ are actually programs running on the blockchain which rely on a type of smart contract called an automated market maker to facilitate the trading of tokens. Users can earn a share of trading fees by placing their assets into a liquidity pool, with rewards adjusting automatically to ensure that each pool remains liquid enough to support the volume of trading taking place. This is all made possible by the smart contract functionality of blockchains like Ethereum, and, together with on-chain lending and borrowing, constitutes the emergence of “decentralized finance” or “DeFi”.

Everyone Should Have The Same Access To Inflation-Proof Asset Options

With the U.S. CPI having increased beyond 5.4%, inflation is already here in a very real way. While the Federal Reserve maintains that this is a temporary state of inflation, the market is likely to begin to react to this new reality, if inflation does not fall in the near future, and certainly if it continues to rise. Investors who are not taking a look at the allocation of their asset portfolios may find themselves with a reduced future long-term spending power.

Currently, many traditional investors may find themselves shut out of the opportunities presented by cryptocurrencies and DeFi, as participation is still largely limited to those with significant technical savvy or knowledge of the crypto ecosystem. However, large swaths of the digital asset industry are working to remove barriers and improve access to these yield-bearing opportunities for anyone, regardless of technical skills.

The barriers that make it difficult for investors to understand how to incorporate crypto into their portfolio are being brought down one by one. Traditional banks and investment brokers, such as Charles Schwab Corporation SCHW have started educating their clients about digital asset classes and how to invest in them. Platforms, where people can purchase or trade cryptocurrencies, have gone mainstream with the likes of PayPal Holdings Inc. PYPL and no longer present confusing interfaces that scare off non-technical potential investors.

Inflation doesn’t discriminate -- it affects the cost of goods for everyone, no matter what economic demographic they are in. Therefore, it’s important to enable the greatest number of investors at all levels to access the widest variety of high yield-bearing assets to safeguard themselves against inflation and maintain their purchasing power over the long term.

About Marius: Marius Smith is the Head of Business Development at Finoa, a European digital asset custody and financial services platforms for institutional investors and corporations. Prior to joining Finoa, Marius worked at N26 and Google.