Should You Invest In Bitcoin?
Everybody's got an opinion, so I might as well weigh in and hopefully provide some perspective!
- First off: what is Bitcoin? Wikipedia has a pretty good description. Basically, somebody who goes by "Satoshi Nakamoto" (a pen name; Nakamoto's actual identity is unknown) created it, said 'There are only 21 million of these, and people who want them need to put their computers to work to solve these increasingly difficult algorithms.'
Price of 1 Bitcoin, in U.S. dollars, from January 10, 2017 to January 10, 2018 - Based on the massive increase of the price of Bitcoin (pictured above), should you invest in it?
Well, the above graph has a marked resemblance to a graph of the history of the Dow Jones industrial average, or the all-time S&P 500 returns.
There are, however, two notable differences.
- The Dow Jones and S&P 500 have a long history of providing these returns. Bitcoin and other cryptocurrencies do not.
- Corporate stocks represent a small share in the profits of a company that produces goods or services. As an owner of 1 share of stock, you share a tiny fraction of the profits, as well as a tiny fraction of the decision-making process.
ACMECorp provides a real product (or service) for which people exchange payment in the form of legal tender. Therefore, if you're a shareholder in ACMECorp, you're entitled to a minute share of any profit. [Obviously, the profit is spread among other shareholders, employees, the CEO/Board of Directors/other upper management in the form of raises and bonuses, etc.]
The point is that ACMECorp has actual things of value. ACMECorp exists and provides things for which people are willing to pay.
Upon what are cryptocurrencies such as Bitcoin based? Scarcity (the artificially-imposed cap of 21 million Bitcoin)? Mathematics? Computing power? Trust? The World Wide Web? To me, the answer is unclear.
I know what Coca-Cola is built upon. Therefore, if I buy stock in Coca-Cola, I know what I'm investing in: the continued demand for Coca Cola's beverages (including bottled water like Dasani and bottled tea like Fuze).
I do not know what Bitcoin is built upon. Therefore, if I buy Bitcoin, I do not know what I'm investing in!
Bitcoin and other cryptocurrencies are not the same type of investment as company stocks, corporate bonds, etc. Cryptocurrencies are far less reliable, and haven't even been in existence for 10 years!
As I've explained before, the engine powering the stock market's growth is capitalism itself. Companies that fail can only lose 100% of their value; companies that succeed have no limit on their growth potential [theoretically; there's obviously a practical limit]. The 'winners' can have 10% growth per year, 50%, 100%, 500%, 1000% growth, or more! Therefore, as long as the market consists of relatively few 'losers,' growth will continue because value is provided through the sale of real goods and services to real people. That's what has provided the stock market's incredible returns over the past 100 years.
What's powering Bitcoin's explosive growth over the past 3 months?...
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So, after all that, the question remains: should you invest in Bitcoin?
Like Mr. Money Mustache, my recommendation is 'no,' BUT with important caveats.
Here's the bottom line: Bitcoin is very risky, very volatile, and very new. Other cryptocurrencies are probably even riskier.
- If this scares you off, then don't put any money into it! Never invest in something you don't understand!
- If this doesn't scare you off AND you want to pour all of your money into it...
STOP. RIGHT NOW.
If you want to put 100% of your money into something that has an equal chance of crashing to near-zero or skyrocketing 10,000% in a day, then you fail to understand investing! Responsible investing is equal parts risk mitigation and opportunity exploitation. If you do one without the other, you're missing a crucial part!
If you think "investing" is an avenue to get rich with little time or effort, then you're not truly investing. You're recklessly speculating.
Frenzied hypercyclic bidding that results in massive growth followed by equally rapid drops does not indicate stability or promise as an investment. It indicates the type of thing that randomly makes some people multimillionaires and others destitute and angry.
You might buy some Bitcoin, and you might happen to sell it three days later for an 872% profit. But that's more akin to winning big on blackjack or roulette than making a sound, logical long-term investment.
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With that in mind, I'm not as down on Bitcoin or other cryptocurrencies as some other people. I perceive advantages in a couple of cases:- One of the primary motivations for supporting cryptocurrencies like Bitcoin is political / ideological in nature. For those who don't trust governments, banks, regulatory bodies, or other features of the current economic system, cryptocurrencies provide an alternative.
Some people don't trust the government for ideological reasons. In the U.S., at least, people who advocate decentralization are typically called libertarians.
I have my own sympathies to such a perspective; government intervention certainly is not the answer to every problem, and can sometimes make problems worse! However, there are other situations that do seem to require a large, powerful, non-profit-making regulatory organization. For example, supporting a military or creating infrastructure (roads, as a common example) is in everybody's best interest, but few would pay for these things if they were not forced to do so.
Government, and thereby taxation, certainly isn't perfect, but it's better than some of the atrocities that occur under the warlords who take advantage of anarchy.
To illustrate this mindset:
A hot topic, at least in the U.S., is the role of the government in defending the freedom of the Web from privateering ISPs that are usually local monopolies. Did these local monopolies arise due to government interference in the free market, or because starting an ISP is very difficult and prohibitively expensive for many would-be entrepreneurs? Probably a bit of both.
But the question—what do we do about it?—remains. If we completely deregulate and allow "the free market," with its already-privileged huge ISPs like Comcast and TimeWarner, to decide, the effective result at this point will be that big and entrenched ISPs can essentially have their way. In this instance, regulation might be necessary to prevent even worse problems than already exist.
But, in general, Libertarians believe that the answer is less government, not more. Therefore, cryptocurrency would appeal to people with this political philosophy. Here's why:
Aside from all of this focus on U.S.-centric political hot buttons, Bitcoin certainly makes sense for tech-savvy individuals who live in countries with unstable / oppressive regimes. (A country with an unstable regime that has reliable Internet access may be tough to find, though...)
Such regimes may scuttle the value of their own currencies, as Zimbabwe famously did in 2008. If you're facing a situation like this, putting some of your assets into Bitcoin makes sense—it's difficult for a government to confiscate, and impossible for a government to ruin due to mismanagement.
The roots of Bitcoin and other such Web-based 'currencies' lie in cryptography—that is, the attempt to generate secret codes. In instances with oppressive and/or incompetent regimes, such as the unfortunate case of Zimbabwe, Bitcoin and its counterparts display their biggest strength.
- Bitcoin can make sense for individuals who are looking for extra diversification for their investments AND have high risk tolerance AND fully understand the technology.
-Bitcoin is a finite resource, kinda like gold, except that gold physically exists and is useful in certain industrial or medical applications.
-Bitcoin's proponents often derisively refer to traditional money (like the U.S. dollar) as "fiat currency." Decades ago, the U.S. dollar was tied to the government's reserves of silver and gold, but this is no longer the case. Like the dollar, Bitcoin isn't tied to any physical source of value.
As snide as the term "fiat currency" may seem, it's also pretty accurate. I still remember a teacher (I believe it was in my government & economics class) telling us that the monetary supply used to be based on the government's supply of precious metals, primarily silver and gold, until this was suspended 1933 in an effort to combat the falling value of the U.S. dollar during the Great Depression. In fact, up through 1964, some coins were made out of 90% silver!
But the economy was growing beyond the government's ability to store enough precious metal, so Nixon decoupled the dollar from the government's gold reserves in 1971. My teacher then followed up with something along the lines of, "So the dollar isn't really backed by anything other than trust. Isn't that a little scary?"
A deeper dive into the topic shows that my teacher's lesson checks out: the paper in your wallet is based on nothing more than that everybody agrees that a dollar bill is worth $1, and that the "full faith and credit" of the U.S. government is good enough. If people were to collectively stop trusting the government (I can't imagine why anyone would ever do such a thing), then what is your money actually worth?
Before you predict the impending doom of the financial system, however, it's worth asking: why is Bitcoin worth about $13,000 per BTC (until it changes, 1 day or 1 hour or 1 minute from now)? Why is gold worth $1300 per ounce? Why is anything worth anything?
The answer is: because people agree on it.
Why has gold always been seen as valuable? Because it's pretty. No, seriously. Because it's easily identifiable, malleable, unreactive, and reasonably rare—all qualities that make it useful for coinage, particularly in preindustrial societies.
So, U.S. citizens generally agree that the U.S. dollar can be exchanged for goods and services at a pretty stable rate. Citizens of Japan generally agree to use the yen. Citizens of South Africa use the rand; citizens of Saudi Arabia use the riyal. And so on.
Prisoners used cigarettes as a medium of exchange for a long time (but Ramen noodles are apparently worth more these days), and people involved in the illegal drug trade apparently use Tide laundry detergent.
At least these things have some intrinsic usefulness; most currency (in and of itself) has none. This is true of Bitcoin as well, which is ultimately just a string of cryptographically-encoded bits of data.
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But the question at hand is: is it really worth $15,000 USD per Bitcoin, or 19,000, or 6000, or whatever other value it's had over the past 3 months?
Yeah, no kidding! One Bitcoin was valued at a then-record-high $6300 USD on October 29, 2017. One month later, on November 29, it hit $11,000. The latest all-time high of nearly $20,000 per Bitcoin occurred on December 17, 2017! But it dropped over 25%, to about 14,500, on December 22. In fact, in just the last couple of days, as I wrote this piece, I've watched the price of 1 Bitcoin go from over $15,000 to barely $13,000.Will Bitcoin continue to fall in value, or will it rebound? I have no earthly idea, and anybody who claims to know is probably trying to sell you something.
How does that uncertainty differ from stocks? Well, I can be confident that in 20 years, a given stock will still hold some value.
Better yet, in 20 years, the stock market in general will still be there, and I am 99.9999% confident that the U.S. stock market will be valued higher in 2038 than it is today.
This is why I put so much faith in total stock-market index funds! I can't be confident that I'll find the proverbial needle, so I better just buy the whole haystack!
Nobody can say what will become of Bitcoin by 2038, however. It might be the cryptocurrency. Or it might be replaced by some other form of cryptocurrency, in much the same way that Friendster and SixDegrees were replaced by Facebook and Instagram. Or cryptocurrency may be outlawed by then, rendering it worthless outside of the online black market.
That level of uncertainty and risk are not features of a good investment. A wise investor focuses on the strategy, properly diversifying to ameliorate risk, rather than on buying a particular product or asset class.
Still want to buy some Bitcoin, Ethereum, LiteCoin, Ripple, or another cryptocurrency? Go ahead! But in the same way you wouldn't bring your entire life savings to a casino, you shouldn't buy more cryptocurrency than you can afford to lose.
You never know; cryptocurrency might end up making you wealthy beyond your wildest dreams! But it's just as likely—probably more likely, given that the current hype came after the enormous spike that already peaked in November and December of 2017—that the big opportunity has passed, and the bubble is now popping. So, just to be safe, don't throw in more than about 5% of your wealth (preferably less).
If my bear-ish outlook is wrong, you may miss out on gaining a few thousand dollars. But if my outlook is right, you'll be glad you didn't sink all your money into the speculative asset.
***
Good resources for further education about the Bitcoin,
including the advantages and pitfalls:
including the advantages and pitfalls:
-Want to understand cryptocurrencies (like Bitcoin)? Adam Ludwin, the co-founder and CEO of Chain, gives the most insightful and balanced explanation I've seen: https://blog.chain.com/a-letter-to-jamie-dimon-de89d417cb80
-He points out that very, VERY few people truly understand cryptocurrency, and
that massive speculation is resulting in digital assets like Bitcoin being way
overvalued.
that massive speculation is resulting in digital assets like Bitcoin being way
overvalued.
-He also observes that Satoshi Nakamoto's paper proposing Bitcoin was published
in the middle of the 2007-08 'Great Recession.' It is not unreasonable to assume
that an idea like Bitcoin was ripe to be spread at the time.
The decentralized, libertarian philosophy surely appealed particularly to people
who were suffering due to the mismanagement and shortsighted greed of
sprawling banks, combined with the government's failure to rein them in.
Along with the ever-burgeoning power of personal computers, the time for a
digital currency revolution was surely at hand!
in the middle of the 2007-08 'Great Recession.' It is not unreasonable to assume
that an idea like Bitcoin was ripe to be spread at the time.
The decentralized, libertarian philosophy surely appealed particularly to people
who were suffering due to the mismanagement and shortsighted greed of
sprawling banks, combined with the government's failure to rein them in.
Along with the ever-burgeoning power of personal computers, the time for a
digital currency revolution was surely at hand!
-Mr. Money Mustache is not impressed by Bitcoin's potential as an 'investment.' http://www.mrmoneymustache.com/2018/01/02/why-bitcoin-is-stupid/
-Warren Buffett agrees: https://www.marketwatch.com/story/heed-warren-buffetts-warning-bitcoin-is-pure-fomo-2017-12-26
-You could argue—and some people have—that Buffett and his strategy are
relics of a past that is quickly becoming obsolete. But the flip side is that
Buffett's principles are time-honored and have been shown, again and again,
to be sound.
Bitcoin shows some characteristics, like overwhelming hype, that are alarmingly
similar to past bubbles that have burst.
-Merits or demerits of the technology or philosophy aside, I think it's quite evident
to an impartial observer that Bitcoin has become insanely overvalued.
relics of a past that is quickly becoming obsolete. But the flip side is that
Buffett's principles are time-honored and have been shown, again and again,
to be sound.
Bitcoin shows some characteristics, like overwhelming hype, that are alarmingly
similar to past bubbles that have burst.
-Merits or demerits of the technology or philosophy aside, I think it's quite evident
to an impartial observer that Bitcoin has become insanely overvalued.
-English lawyer, blockchain company founder, and securities adviser Preston Byrne compares Bitcoin to pyramid and Ponzi schemes: https://prestonbyrne.com/2017/12/08/bitcoin_ponzi/
-I'm not sure this comparison is warranted, but some of the similarities ARE pretty
tough to deny...
tough to deny...
-On the other hand, the case for a decentralized payment system is perfectly illustrated by this UK small business owner's story: https://medium.com/@photonstorm/hsbc-is-killing-my-business-piece-by-piece-d7f5547f3929. If you don't want your business to drown in the sea of apathy of a bureaucratic clusterf***, it may make sense to use a decentralized payment system. Or, at least, two different banks...
-Bitcoin is currently the leader in cryptocurrency, motivated in large part by the value of name recognition. But is it destined to be the eventual 'winner?' Or might the dominant cryptocurrency be one like Ripple, or even a type that hasn't been invented yet? https://hackernoon.com/amazon-is-the-biggest-threat-to-bitcoin-right-now-62a56d8435e4
-It has not escaped my attention (particularly in recent years) as to the crucial
importance of a large, centralized organization in gaining influence, user
adoption, etc. That large organization may be a government, a big business,
a respected media source, the evangelism of a prominent and famous individual,
or some other source.
importance of a large, centralized organization in gaining influence, user
adoption, etc. That large organization may be a government, a big business,
a respected media source, the evangelism of a prominent and famous individual,
or some other source.
For evidence of this, look no further than the constant buzz about Donald Trump
as a major factor in his Presidential campaign. Recognition is powerful.
-There's a solid case to be made that, at least in certain social circles, Bitcoin bears another resemblance to gold: it's a Veblen good.
http://www.businessinsider.com/bitcoin-price-factor-could-be-social-status-2018-1
UPDATE (10:52 AM): Had to add this great summary of how cryptocurrency came to be a multi-billion dollar asset class by Ben Carlson at A Wealth of Common Sense:
http://awealthofcommonsense.com/2017/12/how-does-something-like-bitcoin-happen/
It sounds to me like we came to the same conclusions, which makes me feel a bit better about my long piece, because Mr. Carlson is insightful, and I very much enjoy reading his work!
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