Is Investing in Crypto Irresponsible? A Cake and Icing Analogy for Investing

Recently I have been thinking about Tesla’s decision to invest $1.5 billion in bitcoin and accept payment for Teslas in bitcoin (although later Tesla stopped accepting payment in bitcoin due to environmental concerns).

This decision by Tesla as well as many other companies to invest in bitcoin made me think about the decision. Bitcoin is considered a very volatile asset and so it made me wonder about the merits of companies buying bitcoin. Many businesses are also considering pricing their goods or services in cryptocurrency, but this presents challenges due to the aforementioned volatility of crypto.

After much research, it seems many companies were buying bitcoin as a replacement for idle cash on their balance sheet. All companies have a bunch of assets on their balance sheet related to the normal operations of their business e.g. Tesla would have factories as well as patents on their balance sheet as assets, but companies also need to hold liquid assets such as cash in order to meet expenses. For example, Tesla needs to pay taxes, and taxes are denominated in currency like USD, and so Tesla needs to have USD on hand to be able to pay for these expenses.

Through research, I found that the $1.5 billion in BTC that Tesla had only represented about 8% of its cash. This means that Tesla had about $19 billion in cash and it has converted a small amount of that into BTC.

How does this relate to individuals and early retirement?

Individuals are similar to organisations. In the same way that Tesla holds cash to be able to meet expenses, so too I hold a small amount of cash as well. In the same way that Tesla keeps most of its assets in its business e.g. factories, so too I keep most of my assets outside of cash. The reason why I don’t want to hold too much cash is because cash does not earn much. In fact, given that savings accounts provide virtually no interest, cash does not really earn anything, especially when you factor in inflation. It makes sense to keep most of your net worth in higher returning assets while only keeping a small amount of your net worth in cash in order to meet expenses.

We need to take on more risk to beat inflation

We don’t keep all our net worth in cash because we need to beat inflation. Everyone has expenses and these expenses are denominated in the local fiat currency. For example, for someone living in Australia, they’d need to pay taxes, which are denominated in Australian dollars (AUD). The necessities of life such as food and shelter are also denominated in AUD. According to Numbeo.com, as at May 2021, the cost of living in Melbourne, Australia for a single person is $1322 per month not including rent. The cost of rent is $1715 for a one-bedroom apartment in the city. This adds up to $3037 per month or $36444 per year. If we round this up to $40k and then apply the 4% rule, this means you will need $1 million in net worth to be able to retire in Melbourne.

The 4% rule assumes a rough mixture of stocks and bonds, approximately 50% in stocks and 50% in bonds, which can be acheived with a balance ETF. An example of a balanced ETF with 50% bonds and 50% stocks is the Vanguard Diversified Balanced Index ETF (VDBA).

Basically if you have $1 million and put it into VDBA, you’d be able to live a comfortable life in Melbourne, Australia.

Icing on the cake

But what if you have more than $1 million? Suppose you have $2 million in net worth and you have $1 million in VDBA from which you are drawing $40k per year to meet basic expenses. Because the other $1 million is not necessary for covering basic expenses, why not invest it in higher risk investments e.g. a high growth ETF such as VDHG or even in a diversified basket of cryptos? You can divide this $2 million wealth into two parts: VDBA, which represents moderately volatile investments needed to meet basic necessities denominated in local fiat currency (i.e. the cake); and crypto (or VDHG), which represents more volatile investments that provide extra income (i.e. the icing on the cake).

Volatility is relative depending on the base asset

No asset is inherently volatile. One of the main criticisms of cryptocurrency is that it is too volatile. Let’s take a crypto such as ether (ETH). ETH is volatile if priced in USD. However, if you price USD in ETH, suddeny USD looks volatile.

When most people thinking about volatility, they think about volatility relative to the local fiat currency, and the reason why they think this is because most good, services, and taxes are denominated in that local fiat currency. If I am living in Australia, I need to pay for rent, food and taxes with AUD, so I need to make sure that the $1 million I hold in my “cake” fund is not too volatile relative to AUD, which is why you would hold it in VDBA or similar. However, if I can meet rent, food and taxes with $1 million in VDBA and I have more, why do I need to worry about volatility priced in AUD? Why not increase volatility to the maximum level once you can cover your basic expenses?

Age-based vs wealth-based bond tent

A very interesting idea proposed by Michael Kitces is the idea of creating a “bond tent” to mitigate sequence of return risk.

Sequence of return risk is basically the risk of a severe market crash occuring right after you retire. So imagine you have 100% in equities and it is 2008. You finally amass $1 million in wealth and decide to retire. Then suddenly the GFC happens and the stock market falls 50% thereby reducing your net worth to only $500k.

The bond tent addresses this risk. Basically, in order to create a bond tent, before you retire, you gradually increase the proportion of your net worth in bonds. Then when you retire, you reduce it. The reason why you reduce your bond allocation after you retire is because, according to the theory, you need equities for long term growth. Bonds provide stability but not growth. The risk with holding too much in bonds when you are retired is that you have stability at the expense of not enough growth, which increases the risk you deplete your wealth before you die.

However, I think there is a problem with the bond tent. If you look at the horizontal axis above in figure 1, you’ll notice it is based on age. You retire at 65. At that age, the bond allocation is at its peak. Why should this be based on age? Why not make it based on wealth?

As I’ve described previously, you need about $1 million in about 50% stocks and 50% bonds to retire and live a modest life. Why not change the bond tent chart above by replacing the horizontal axis with net worth? The peak of the bond tent should instead occur when net worth is $1 million. This means that when you are young, you should take on more risk because, even if the market goes down, you are still young and have time to earn money to replace money lost. However, as you gain more wealth, the risk grows because you have more money exposed to riskier assets and you are close to the net worth required to cover your necessary expenses. Imagine you are 25 and have $100k in net worth and suddenly the GFC occurs. Then you’d lose $50k. However, you would be able to replace this loss with one or two years of work and savings. However, imagine you are 35 and have a net worth of $1 million and a GFC happens. Then you’ve lost $500k. This loss could take about 15 to 20 years to replace, which sets back your early retirement considerably.

The importance of minimalism

The wealth-based bond tent illustrates to us the importance of minimalism and how it can help you build more wealth. The $40k per month expense is based on Numbeo’s estimate of expenses of a typical person. However, suppose someone is able to live on less. Suppose hypothetically someone can live off $20k per year e.g. rather than retire in Melbourne, Australia they are happy to retire in an area with a lower cost of living. Perhaps they are willing to live in a one-bedroom apartment on the outskirts of the city rather than in the city itself. Regardless of how someone saves money, if you are able to get by on $20k per year, then the bond tent shifts to the left. You only need $500k in VDBA in order to create the “cake” needed to cover your living expenses, and once you hit this $500k net worth, you can quickly put any new money into the “icing” fund, which goes into high risk assets, which provide opportunity for higher returns (and losses).

Imagine two people who earn $100k per year. One is a minimalist who spends only $20k per year vs a normal person who spends $40k per year. The person who spends $20k per year is able to invest $80k per year (assuming no taxes) and is able to accumulate $500k within 6.25 years (for simplicity, assuming no investment growth). However, the normal person spending $40k per year is only able to invest $60k per year which means they will need 16.66 years in order to accumulate $1 million.

By being a minimalist, you are able to overtake the bond tent more quickly and transition your wealth into higher risk assets at no risk to your retirement because you have already built a solid foundation i.e. you have fully developed your “cake” fund and are now simply putting the icing on the cake.

A minimalist who can live off $20k per year is able to provide themselves with financial independence within 6 years and in their seventh years they can invest in higher risk assets such as more speculative tech stocks or ETFs or cryptocurrency. However, a normal person who lives off $40k per year needs to wait 16 years before they can do this.

Lifestyle inflation destroys the icing

A normal person living off $40k needs to invest for 16 years before they can be financially secure or independent, but imagine if that normal person, after 16 years of hard saving, suddenly inflates their lifestyle such that they spend $60k per year. If after you have $1 million you suddenly have $60k worth of spending, then this means $1 million is not enough. According to the 4% rule, you now need $1.5 million, which means you need to save up $500k more, which means you need to work 8 more years in order to build up your “cake” fund.

By inflating your lifestyle, the cake needs to grow, which means you spend more time investing in VDBA or similar assets. Your opportunities for higher growth are impaired because you’re forced to invest in safer assets for longer in order to fund your lifestyle inflation.

Cake spending vs icing spending

What does lifestyle inflation mean? In my opinion, lifestyle inflation occurs only when your necessary ongoing expenses goes up. Suppose you have $1 million in VDBA generating $40k and this goes into food, shelter and taxes. This is the “cake” and your spending on food, shelter and taxes are what I call “cake spending” because these are necessary ongoing expenses. You cannot avoid food, shelter or taxes otherwise you will die or be put in prison.

Let’s suppose you have another $1 million in crypto and you draw out 4% from this for spending. This is the “icing” but you need to spend it on what I call “icing spend” which are unnecessary once-off or reversible expenses.

So a person with $1 million in VDBA and $1 million in crypto draws $80k. $40k goes into food, rent and taxes, but the other $40k can go into a lavish holiday. A holiday is not necessary, once-off and not ongoing. This is important because the icing fund is high risk. Crypto is highly volatile and could drop by 90% within a year. Suppose this did happen and the $1 million in crypto suddenly turns to $100k. Then rather than within $40k in icing expenses you are withdrawing only $4k in icing expenses. This is not a problem because you simply take a cheaper holiday or don’t go on holiday at all. The icing is optional. You don’t have to eat a cake with icing.

An example of ongoing necessary expense beyond food, shelter or taxes is, for example, if you decide to have a family. Paying for a family means added ongoing and necessary expenses e.g. food, shelter, childcare, etc. If crypto prices suddenly fall and you can only draw out $4k per year rather than $40k per year, this is not going to be good if food, shelter and childcare prices are higher than $4k per year. However, a holiday is not necessary and can be scaled back if required.