So you're thinking about investing in bitcoin? Don't
I’ve been watching this bitcoin situation for a few years, assuming it would just blow over.
But a collective insanity has sprouted around the new field of “cryptocurrencies”, causing an irrational gold rush worldwide. It has gotten to the point where a large number of financial stories – and questions in my inbox – ask whether or not to “invest” in BitCoin.
Let’s start with the answer: No. You should not invest in Bitcoin.
The reason why is that it’s not an investment; just as gold, tulip bulbs, Beanie Babies, and rare baseball cards are also not investments.
These are all things that people have bought in the past, driving them to absurd prices, not because they did anything useful or produced money or had social value, but solely because people thought they could sell them on to someone else for more money in the future.
When you make this kind of purchase – which you should never do – you are speculating. This is not a useful activity. You’re playing a psychological, win-lose battle against other humans with money as the sole objective. Even if you win money through dumb luck, you have lost time and energy, which means you have lost.
Investing means buying an asset that actually creates products, services or cashflow, such as a profitable business or a rentable piece of real estate, for an extended period of time. An investment is something that has intrinsic value – that is, it would be worth owning from a financial perspective, even if you could never sell it.
To answer why bitcoin has become so big, we need to separate the usefulness of the underlying technology called “blockchain” from the mania of people turning bitcoin into a big dumb lottery. Blockchain is simply a nifty software invention (which is open-source and free for anyone to use), whereas bitcoin is just one well-known way to use it.
Blockchain is a computer protocol that allows two people (or machines) to do transactions (sometimes anonymously) even if they don’t trust each other or the network between them. It can have monetary applications or in sharing files, but it’s not some instant trillionaire magic.
As a real-world comparison for blockchain and bitcoin, take this example from the blogger The Unassuming Banker:
Imagine that someone had found a cure for cancer and posted the step-by-step instructions on how to make it online, freely available for anyone to use.
Now imagine that the same person also created a product called Cancer-Pill using their own instructions, trade marked it, and started selling it to the highest bidders.
I think we can all agree a cure for cancer is immensely valuable to society (blockchain may or may not be, we still have to see), however, how much is a Cancer-Pill worth?
Our banker goes on to explain that the first Cancer-Pill (bitcoin) might initially see some great sales. Prices would rise, especially if supply was limited (just as an artificial supply limit is built into the bitcoin algorithm).
Bitcoin has become a bubble with the forces of human herd behavior, greed, and fear of missing out amplifying it
But since the formula is open and free, other companies quickly come out with their own cancer pills. Cancer-Away, CancerBgone, CancEthereum, and any other number of competitors would spring up. Anybody can make a pill, and it costs only a few cents per dose.
Yet imagine everybody starts bidding up Cancer-Pills to the point that they cost $17,000 each and fluctuate widely in price, seemingly for no reason. Newspapers start reporting on prices daily, triggering so many tales of instant riches that even your barber and your massage therapist are offering tips on how to invest in this new “asset class”.
Instead of seeing how ridiculous this is, more people start bidding up every new variety of pill (cryptocurrencies), until they are some of the most “valuable” things on the planet.
“Holy shit!” is the only reasonable reaction.
You’ve got bitcoin with a market value of $238bn, then Ethereum at $124bn, and so on.
The imaginary value of these valueless bits of computer data represents enough money to change the course of the human race, for example, eliminating poverty or replacing the world’s 800 gigawatts of coal power plants with solar generation.
Bitcoin (aka Cancer-Pills) has become an investment bubble, with the complementary forces of human herd behavior, greed, fear of missing out, and a lack of understanding of past financial bubbles amplifying it.
To better understand this mania, we need to look at why bitcoin was invented in the first place.
As the legend goes, in 2008 an anonymous developer published a white paper under the fake name Satoshi Nakamoto. The author was evidently a software and math person. But the paper also has some in-built ideology: the assumption that giving national governments the ability to monitor flows of money in the financial system and use it as a form of law enforcement is wrong.
This financial libertarian streak is at the core of bitcoin. You’ll hear echoes of that sentiment in all the pro-crypto blogs and podcasts.
The sensible-sounding ones will say: “Sure the G20 nations all have stable financial systems, but bitcoin is a lifesaver in places like Venezuela where the government can vaporize your wealth when you sleep.”
The harder-core pundits say: “Even the US Federal Reserve is a bunch ‘a’ crooks, stealing your money via inflation, and that nasty fiat currency they issue is nothing but toilet paper!”
It’s all the same stuff that people say about gold – another waste of human investment energy.
Government-issued currencies have value because they represent human trust and cooperation. There is no wealth and no trade without these two things, so you might as well go all in and trust people.
The other argument for bitcoin’s “value” is that there will only ever be 21m of them, and they will eventually replace all other world currencies, or at least become the “new gold”, so the fundamental value is either the entire world’s GDP or at least the total value of all gold, divided by 21m.
People who think that there’s even a tiny chance bitcoin could become a world currency say it is severely undervalued.
You could make the same argument about my fingernail clippings: they may have no intrinsic value, but they’re in limited supply so let’s use them as the new world currency.
Let’s get this straight: in order for bitcoin to be a real currency, it needs several things:
Easy and frictionless trading between people.
To be widely accepted as legal tender for all debts, public and private.
A stable value that does not fluctuate (otherwise it’s impossible to set prices).
Bitcoin has none of these things, and even safely storing it is difficult. Bitcoin exchanges such as Mt Gox in Japan, Bitfinex and various other wallets and exchanges have been hacked.
The second point is crucial. Bitcoin is only valuable if it truly becomes a critical world currency. In other words, if you truly need it to buy stuff, and thus you need to buy coins from some other person in order to conduct important bits of world commerce that you can’t do any other way. Right now, speculators are the only people driving up the price.
A speculative cult currency like bitcoin is only valuable when you cash it out to a real currency, like the US dollar, and use it to buy something useful like a nice house or a business. When the supply of foolish speculators dries up the value evaporates – often very quickly.
A currency should also not be artificially sparse. It needs to expand with the supply of goods and services in the world, otherwise we end up with deflation and hoarding. It helps to have the Federal Reserve system and other central banks guiding the system.
Finally, nothing becomes a good investment just because “it’s been going up in price lately”.
The world’s governments are not going to let everyone start trading money anonymously and evading taxes using bitcoin. If cryptocurrency does take off, it will be in a government-backed form, like a new “Fedcoin”. Full anonymity and government evasion will not be one of its features.
The cryptocurrency bubble is really a repetition of the past. This is a known bug in our operating system, and we have designed some parts of our society to protect us against it.
These days, stocks in the US are regulated by the Securities and Exchange Commission, precisely, because in the olden days, there were many stocks issued that were much like bitcoin, marketed to unsophisticated investors as a get-rich-quick scheme. The very definition of this investor is: “Being more willing to buy something the more its price goes up.”
Don’t be one of these fools.
