Classification of Investments
January 28, 2021 in news

Prof. Damodaran, who is my favorite finance writers, wrote a post on the classification of investments into assets, commodities, currencies and collectibles. Here’s a brief summary.

  • Assets: An asset has expected cash flows.
  • Commodities: A commodity derives its value from being an input into a process to produce a item (product or service) that consumers need or want.
  • Currencies: A currency serves three functions. It is a measure of value (used to tell you how much a product or service costs), a medium of exchange (facilitating the buying and selling of products and services) and a store of value (allowing people to save to meet future needs).
  • Collectibles: A collectible’s pricing comes from the perception that it has value, driven by tastes (artwork) and/or scarcity (rare items).

While most investments fall into one of these buckets, there are some that can span two or more. Out of the four, assets can be both priced and value, commodities can be roughly valued but are mostly priced and currencies and collectibles can only be priced.

Investing versus Trading

The essence of investing is assessing value, and buying assets that trade at prices below that value, and selling assets that trade at more. Trading is far simpler and less pretentious, where successful trading requires one thing and one thing only, buying at a low price and selling at a higher one.

Cryptos

There are some who believe so intensely in bitcoin that any critique or viewpoint that is contrary to theirs evokes an almost hysterical overreaction. On the other hand, there are others who view bitcoin as speculation run amok, with the end game destined to be painful.

  1. Bitcoin is not an asset.
  2. Bitcoin is not a commodity.
  3. Bitcoin is a currency, but it is not a very good one (at least now)
  4. Bitcoin is a collectible, but with a question mark on longevity

Let’s explore the third point, about it not being a currency, in detail.

Every year, since its inception, we have been told that Bitcoin is on the verge of a breakthrough, where sellers of products and services will accept it as payment for goods and services, but twelve years after its creation, its acceptance remains narrow and limited. There are simple reasons why it has not acquired wider acceptance.

  • First, if the essence of a currency is that you want transactions to occur quickly and at low cost, bitcoin is inefficient, with transactions times and costs remaining high.
  • Second, the wild volatility that makes it such a desirable target for speculative trading makes both buyers and sellers more reluctant to use it in transactions, the former because they are afraid that they will miss out on a price run up and the latter because they may be accepting it, just before a price drop.
  • Third, a currency with an absolute limit in numbers is one that is destined for deflation in steady state, in economies with real growth. I know that stories about the Silk Road have enshrined the mythology of bitcoin being the currency of choice for illegal activities, but a currency designed purely for evasion (of crime and taxes) is destined to be a niche currency that will be under assault from governments and law enforcement.

Here’s the video lecture from Prof. Damodaran based on the same post. As always, it’s very informative and you should read it in its entirety. I found his thoughts on Bitcoin and crypto in general, very fascinating.