See why Bitcoin is a good inflation hedge

The Consumer Price Index (CPI), an important measure of inflation, has been rising in recent months at a rate not seen in decades. Record government stimulus aimed at helping people during the pandemic, coupled with struggling supply chains, has resulted in higher prices for everyday items. Now investors are trying to find out where to park the money.

Many speculators out there see Bitcoin (BTC 2.60%), the world’s most valuable cryptocurrency, as an inflation hedge, meaning its price is bound to rise in times like these. However, that was not the case as the top cryptocurrency has dropped 55% since peaking last November.

so it is Bitcoin a Poor Inflation Hedge? I do not think. Let’s take a closer look.

The traditional definition of inflation hedging is flawed

If consumer prices are rapidly increasing across the economy, for Bitcoin to be an effective hedge against inflation, it must also increase. Therefore, we should just buy some of the cryptocurrencies and wait until inflation cools down. Sounds pretty easy, right? Well, it’s not that simple.

For starters, there are several other forces at play that can affect the price of an asset in the short term. Right now, the war in Ukraine and the Federal Reserve’s plan to aggressively raise interest rates are scaring investors away with riskier assets. The general unpredictability of investor sentiment can cause sudden fluctuations in asset prices for no reason.

Furthermore, if everyone believes that something is an inflation hedge, it is likely that the asset in question is already priced according to the highest demand from buyers in the market. So it may be wise to actually sell rather than buy. This is what famous investor Howard Marks calls second-order thinking.

Up until gold, which is widely seen as the inflation hedge of choice by investors, has an uneven track record in this regard. In the early 1980s, for example, when the annual inflation rate was 6.5%, owning gold would have lost investors by 10% a year. More recently, in 2022, the price of an ounce of gold rose by just 2.5% – far behind the April annual inflation rate of 8.3%.

In a short space of time, I don’t think anything constitutes a legitimate inflation hedge, moving in tandem with the CPI value. If that happened, the market would arbitrage the opportunity until the relationship no longer works. I firmly believe that the consensus view of what an inflation hedge should be is seriously flawed, and it has everything to do with how far you are willing to look forward.

Image source: Getty Images.

The time horizon matters

Based on the discussion above, I think the proper test of whether or not an asset is a true inflation hedge is to measure its performance over a long time horizon, like five or ten years, or even longer.

Bitcoin’s five-year return of 1,100% during a period when the CPI rose by just 18.5% suggests that the world’s leading cryptocurrency is indeed an effective inflation hedge. Despite its extreme volatility, those who bought Bitcoin would have seen their purchasing power soar. And that’s the whole premise of investing first — the idea is to increase your spending ability over time, not lose it.

In my opinion, investing would be a lot simpler if people would just extend their time horizons. As many readers know, literally anything can happen in the next month, quarter, or year. And trying to design a portfolio based on what can happen in such a short period of time is a losing game, because it’s really unknowable.

Seeing Bitcoin in this light is the right approach. Despite down 35% so far in 2022, its performance over time speaks for itself.

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