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Writer's picturetomrimer

Be Cautious about Bitcoin

When the price of anything goes from $30,000 to $40,000 in just a few days, people take notice. And so the Bitcoin bandwagon is back in full steam.


Please don’t ask me to explain blockchain technology to you. I’ve tried to understand it, I’ve read numerous articles about it, I even read an outstanding paper one of my students wrote about it last spring, and I still don’t get it. Then again, there are features on my cell phone that are still a mystery to me.


But there is a lot I do understand about Bitcoin, even if I don’t understand the technology behind it. I’ve had a great many students, clients, and others ask me over the past several years if Bitcoin is something they should invest in. My answer now is the same as it has always been: it’s not an investment, so no, you can’t really “invest” in it. But that doesn’t mean you shouldn’t (or should) buy it.


I’m not trying to be picky or pedantic with wording, but I really do want all of you to understand the difference between an “investment” and a “speculation”. While that alone is the topic of an entire chapter of my upcoming second book, I’ll briefly summarize the difference like this (and look at it in more detail toward the end of the post): an investment is something you can adequately research; a speculation is basically a gamble. An investment is something for which you can adequately gage the risk/reward scenario, and a speculation is something for which you cannot.


Again, I’m not telling you not to buy Bitcoin! That’s not the point of this post at all. What I’m trying to do point out a few things to give you a more solid foundation from which to make a decision as to what to do with your money. That’s actually one of the definitions of “Finance”, and it’s one of the main purposes of this blog!


Let’s take a look at why we’re even talking about Bitcoin: as I said at the beginning of the post, the price recently made a 33%+ move in a matter of days, which is not unheard of in the realm of Finance, but it’s hardly the first time Bitcoin’s done something like that.


I first heard of Bitcoin in 2009 or 2010, when it was at about $3. My father and I were going to buy some, but within days it went to $4, and we decided it was too volatile. Yes, I know I could be a millionaire right now if I had made the purchase back then, except that the exchange we were going to buy and store our Bitcoins on, Mt. Gox, went bankrupt, and “lost” all of their customers’ Bitcoins.


Most of Mt. Gox’s customers lost all of their Bitcoins, and thus of the money they had put into it. Shortly after closing up shop, Mt. Gox “found” some of the lost Bitcoins, and some people got some of their money back. I don’t know about anyone else, but those kind of shady dealings are a pretty big turnoff to me, and I pretty much wrote off ever buying Bitcoin. But I’ve been told something like that could not happen today or ever again. Ok, I’ll go along with that.


I really didn’t pay much attention to Bitcoin after that until early 2017, when the price went over $1000 for the first time. That’s when it hit me that the 1000 Bitcoins I was going to buy in 2010 would have made me a millionaire, Mt. Gox’s tomfoolery notwithstanding. I thought it was an insane price, but less than a year later it was almost 20 times that, nearly hitting $20,000 before crashing by over 83% six months after that.


Even though Bitcoin bounced back from around $3,200 to $10,000, it stayed somewhat range-bound until the summer of 2020. Its recent meteoric rise started in October, when it rose from $11,000 to $20,000 in less than 2 months.


But that turned out to be nothing compared to what came next. It only took Bitcoin 2 weeks to add another $10,000 to its price, and another week to add a further $10,000. Bitcoin hit $40,797.61 on January 7 before pulling back below $34,000 a few days later. You won’t find a wilder rollercoaster ride at any theme park on the planet.


Ok, so that’s all in the past; what happens now? If I knew that, I’d be writing these posts on a beach in Tahiti! Of course, nobody knows. But that’s not stopping the pundits from emerging back out of the woodwork.


I fully expected a phalanx of market “experts” to be making predictions all over the proverbial map, but I really didn’t anticipate JP Morgan, a very respectable firm, to go off the deep end. Despite their CEO calling Bitcoin a ‘fraud” a few years ago, JP Morgan recently said that Bitcoin could rise to $146,000. Yes, it could! It could rise to a million, a gillion, it could fall to 0, or land somewhere in between. I’m pretty confident I’m right about this!


Having spent over 20 years in the financial industry, much of it as an investment analyst, I know first-hand how difficult it is to come up with a reasonable estimate of the true value of stocks, bonds, mutual funds…traditional investment vehicles with a lot more data to analyze they you’ll find on gold or Bitcoin. Knowing what Bitcoin is really (intrinsically) worth is, at least at this point, next to impossible.


How exactly to valuate Bitcoin is something that has perplexed financial experts pretty much ever since it was created. JP Morgan, in the article I mentioned above, seems to think it should be evaluated similar to gold. Others think it should be looked at like a currency, since after all it is called a cryptocurrency.


Let’s look at what currency is: it a means of exchange, legal tender, that allows one to “buy” physical goods or services without having to trade a different type of good or service (known as barter). It’s also a store of value. Is Bitcoin either of these? Well, it certainly has created a lot of value for some people, but since it’s own value fluctuates so wildly, I wouldn’t consider Bitcoin to be a very good store of value!


Yes, a growing number of businesses are accepting Bitcoin as a form of payment, mostly in the cyber world. But it’s still pretty rare to find a way to spend your Bitcoin. The overwhelmingly vast majority of businesses in the world do not accept Bitcoin as payment. So until and unless many, many more businesses do start to take Bitcoin, I hardly think it can be considered a currency.


This means that we have to look at Bitcoin in the same light as gold, at least when trying to figure out what it’s really worth. And this is why it is next to impossible. Economic 101 tells you that prices are set by supply and demand. For both gold and Bitcoin we can figure out what the supply is, and when it comes to Bitcoin, the supply is fairly fixed. But what is the demand?


Unfortunately the demand side of the equation for these two is much harder to get a handle on. Gold has few industrial uses, though it is extensively used in jewelry. As it happens, demand for gold is very difficult to determine, and it doesn’t really help explain its price swings anyway.


It’s the same for Bitcoin. The price of both gold and Bitcoin swing far more on emotion than anything else. When there are difficulties in the world, and people on a large scale become fearful about one thing or another, they turn to the “safety” of gold. Bitcoin certainly doesn’t look safe (is gold really that safe either?), but it looks like people are jumping on the Bitcoin bandwagon over euphoria about its future place in the world, even though predicting what that place will be is about as difficult a guess as you will ever make.


While the idea behind Bitcoin as a global currency may have some rather attractive features, there is one group among us that is vehemently opposed to it: government. Controlling the money supply and monetary policy is one of the most jealously guarded of governmental powers. We won’t discuss here whether it’s right or wrong, but its undeniable that governments all over the world don’t like it when they can’t control something. And so far they have not been able to control Bitcoin.


This means that Bitcoin faces some pretty tough opposition when it comes to being more widely used as a currency. Governments all over the world will fight it tooth and nail. When it comes to money, governments fight the most furiously. I wouldn’t want to get in front of that. So I don’t see it’s use as a currency increasing too much anytime soon.


This leads to why I don’t consider Bitcoin an “investment”. As I said earlier I discuss the difference between an investment and a speculation quite a bit in my books and in other posts, but let me just point out my 3 main criteria for making this distinction: an investment should have objective data to analyze, price changes should not be based mostly on random chance (luck), and the potential for reward should be reasonable given the level of risk.


Unfortunately Bitcoin fails at 2 out of 3 when it comes to my criteria. There is little-to-no data to analyze when it comes to determining Bitcoin’s true value, and since the price changes almost entirely on emotion, far too much luck is involved. This is why I consider Bitcoin to be a speculation, not an investment. If you buy Bitcoin, you are speculating its price will go up based on no real objective data. To speculate is to guess, which is another word for gamble.


Once again, I’m not saying you should not, or should, buy Bitcoin. I say over and over again in my books and blog posts: know what you are getting into before you buy anything. Knowing that Bitcoin is a speculation rather than investment tells you not to put your “investment” money into it. If you do decide to buy Bitcoin, and the thought has crossed my mind once or twice, only use your “play money” or money that you can afford to lose all of without it affecting your lifestyle or your future in the least.


Knowing the risks and rewards of everything is the key to being a financial success. Personally, I get nervous about buying anything when the price jumps 20-30% in a matter of days or even weeks. I’d feel a lot more comfortable making the Bitcoin gamble if the price would come back down to at least close to pre-bubble levels. I’ll talk more about asset bubbles later this month, but for now I’m keeping even my “gambling” money away from Bitcoin. Stay tuned; I don’t think the rollercoaster ride is anywhere near over.

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