Question: I’ve seen Bitcoin in the news a lot lately because it has gone up in value. Is this something we should consider as part of my investment plan?
As you might have guessed, the answer isn’t a simple yes or no. If that’s what you wanted, you shouldn’t be even considering throwing money at it, for any intelligent discussion will be highly nuanced. Anyone who suggests otherwise is a liar or a fool. If you aren’t willing to explore the nuances, there is no answer for you. Today, I’m going to explore some common questions and debunk some myths and misunderstandings about Bitcoin.
What is Bitcoin?
Bitcoin is a digital payment system known as a “cryptocurrency” that was released in 2009. Unlike most currencies such as the U.S. dollar that are centralized, Bitcoin is a peer-to-peer network powered by users without any middlemen or even a central authority. For those who want to understand all the details, there are plenty of resources on the Internet, so I’m going to focus on key points that are related to the question I’ll be tackling. Bitcoin is not the only cryptocurrency, but it is the most well-known. While I will be focusing on Bitcoin,, most of what I’ll be saying rings even more true of alternatives. Further, it’s important to distinguish the technology behind Bitcoin (blockchain) from Bitcoin itself. All Bitcoin uses blockchain, but not all blockchain is Bitcoin. I’ll be focusing my discussion on Bitcoin, so be careful not to assume that what I say about Bitcoin is also true of blockchain technology.
Is Bitcoin a good investment?
Bitcoin is not an investment. It is a speculation that Bitcoin may one day become 1) a reliable medium of exchange, 2) a reliable store of value, and 3) widely used. More on this below. Just because you can put money into something doesn’t classify it as an investment. Lotto tickets and other forms of gambling aren’t investments either.
Bitcoin experts say that ________.
Who says that? Who is a Bitcoin expert anyway? The overwhelming majority of information on Bitcoin is being put out by people who are have a lot to gain by Bitcoin going to the moon. This is called a “conflict of interest.” If you don’t understand the source of the information and what the author has to gain, then be wary of what is said.
Isn’t Bitcoin just like other money?
No, it isn’t. We have some degree of faith in national currencies because they are essentially based on the productivity of citizens, fiscal health of the country and stability of the government. If not the “full faith and credit” of the country that issued it, what or who is Bitcoin backed by? We can complain that the purchasing power of the U.S. dollar erodes slightly each year due to inflation, yet the value is not all that volatile. A reliable currency is one that reliably stores value. Bitcoin is wildly volatile and thus is a speculation that resembles a non-essential commodity rather than a store of value like a currency should be. Bitcoin can’t create a demand for itself like the U.S. dollar can. The U.S. government can demand taxes be paid in dollars and demand that dollars must be accepted as payment for its debt. Further, few places accept Bitcoin as a form of payment, so it has not proven to be a reliable medium of exchange. In fact, Bitcoin can only be a reliable store of value if it becomes a reliable medium of exchange, so the whole premise is based on the speculation that Bitcoin will become a reliable medium of exchange. Can that happen? Will governments allow that to happen? More on that later…
But doesn’t the fact that Bitcoin is going up in value prove it meets these criteria?
Absolutely not! In fact, some merchants are dropping Bitcoin. It’s simply too volatile. Imagine that the price of one Bitcoin is $16,000. You paid $15,000 for a product and sold it for $16,000. The buyer gave you 1 Bitcoin. However, the price of Bitcoin drops by 10% over the next few hours, so now your 1 Bitcoin is worth $14,400. Now you lost money on the transaction. “Just wait, the price will go back up” is an unacceptable answer to many businesses with tight margins. They simply can’t afford to take the currency risk. Even buyers attempting to use Bitcoin could see their transactions not go through because the value of Bitcoin is guaranteed for a few hours, so if they don’t go through quickly, they may not be covered. Overall, the volatility just makes it incredibly difficult for either buyers or sellers to understand the true cost of their transactions, especially since there are also transaction fees that can make smaller purchases unreasonable. This also potentially causes bad customer experiences and arguments. Bitcoin can be a great speculation, but it needs to be good “money” in the sense that it stores value and is a reliable means of exchange.
Bitcoin has done better than the stock market, so they are telling me that Bitcoin is obviously a better investment.
Run from anyone who tells you this — they are either delusional or morons who are dangerously clueless about risk and investing. First, past returns are the last thing you look at when comparing places to put your money. Second, unless the risk is equal, comparing returns is stupid. There are thousands of investments that start off with risk characteristics similar to Bitcoin and end up worthless. Claiming Bitcoin is a good investment because it did well is like claiming that buying lotto tickets is a good idea because you see that one pays out big ever so often. People who claim Bitcoin was always such an obviously good investment have fallen victim to survivorship bias since they aren’t comparing it to the thousands of similar speculation opportunities that didn’t survive and thus are being overlooked. When they claim they “knew it all along,” they fall victim to the psychological trick our brains play on us known as hindsight bias. Does Bitcoin have any real intrinsic value? (No.) Does it produce earnings? (No.) Does it own physical or intellectual assets? (No.) Does it have numerous characteristics such as malleability and beauty, or does it have other uses such as in manufacturing that give it value outside of as a store of value like precious metals have? (No.) The market value of Bitcoin is simply what people are willing to pay for it. If it fails as a medium of exchange, are there other uses for it? (No.)
Bitcoin is safe/secure.
Is it? Bitcoin is difficult to secure. Nearly 4 million Bitcoins have apparently evaporated into thin air. Many exchanges have been guilty of money-laundering. Just Google “Bitcoin stolen” to see numerous examples of Bitcoin theft. Many Bitcoin exchanges have many glitches and have encountered many trading issues ranging from choppy trading and miscalculations to complete outages, leading many to wonder if Bitcoin exchanges are truly ready for the big time. Mt Gox, formerly the largest Bitcoin exchange, collapsed in 2014 after hackers stole over $487 million in Bitcoin. Back in 2014, the price of Bitcoin traded between $300 and $1,000. Today it is more than $16,000. Numerous other Bitcoin hacks have occurred, and when they do, there is no established way to resolve it like there is when your credit card is stolen.
What are you hearing from traders?
I talked to one trader who was in Chicago this week when the futures contract was released on the Chicago Board of Options Exchange, and he confirmed it’s a huge topic there. Everyone from his cab drivers to bell boys was talking about it. Many of the traders owned cryptocurrencies already at places like Coinbase and Kraken, but lamented that the sites have been completely frozen for days as they dealt with the huge surge in volume. That means they had no way of either buying or selling their Bitcoins. That is potentially a catastrophic problem! According to this trader, 40% of Bitcoin is held by Asian nationals (predominantly Japanese), 34% by Americans and the rest scattered throughout the world. What happens if an Asian government squashes Bitcoin? Naturally, its residents would sprint to sell their Bitcoin, causing huge selling volumes while Americans are potentially locked out of their accounts. Most exchanges don’t allow limit orders, and there is no guarantee the order would take place anyway on such a fledgling market.
Why didn’t my investment advisor recommend Bitcoin?
Elements of the answers to this question are contained in all the questions I’m covering. In summary, Bitcoin is not an investment, it is a speculation. That probably sounds like semantics to some, but for either wise investment advisors, or those just simply trying to avoid lawsuits, the difference could be the ability to keep one’s career or not. However, here are a few more thoughts. Investment advisors are reluctant to advise on speculations because of their extreme unpredictability, there is little opportunity to analyze them without inside information, and most clients simply do not understand the risks associated with speculations and assume they are much safer than they really are. The fact that people ask if they should be invested in Bitcoin instead of the stock market is indicative of the fact that people often have a dangerously inadequate ability to compare risk between destinations for their money and that even intelligent investors can get swept up in the euphoria of seemingly easy money. Another point is that your investment advisor likely has no advantage over you in speculation like he likely does in managing your core investments. What good is a team of highly trained and experienced investment pros and traders if everything is based on a speculation and there is nothing to fall back on if that speculation doesn’t work out? There simply isn’t enough to analyze and manage with such a speculation. There is no strong investment case to be made, so unless you are an ultra-high net worth investor who has allocated some funds to high-risk speculations, your advisor is likely unable to recommend something like this to you in the first place.
But I heard Bitcoin has value because it can be “mined” and because it is scarce. Doesn’t that matter?
Scarcity doesn’t matter if it doesn’t become a reliable means of exchange. If the only intrinsic value Bitcoin has comes from the effort it takes to mine it, Bitcoin can be manipulated. The fact that Bitcoin is decentralized is pitched as a good thing, and while it does have its benefits, there are drawbacks as well. If a malevolent government or organization sets out to control a significant portion of the mining capacity, it could manipulate Bitcoin.
But I’ve made a lot of money on Bitcoin. Have you? Unless you’ve sold it, you’ve made nothing off it. Your gains are paper gains that are different than the paper gains you get when you buy a quality stock. If Bitcoin blew up, it could go to zero. If the stock market crashed, most of your quality stocks will probably still be doing business as usual and they still have assets. Further, when people decide to start taking profits from Bitcoin, the price will drop further and faster depending on how many people decide to do this. Remember, there is nothing behind the price of Bitcoin. If you think the stock market, which is backed by real assets and earnings, can fall fast, how much faster can something fall that has no real assets or earnings behind it?
I heard Bitcoin is in a bubble.
It will definitely be called a bubble if it doesn’t become a reliable medium of exchange. Despite there being basically nothing behind Bitcoin besides the optimism that it will catch on, the value of Bitcoin is greater than the value of companies like AT&T, Procter & Gamble, Visa, Citigroup, Coca-Cola, etc. Let that sink in… It’s not a perfect comparison, since the market cap of these companies is really just the price investors are willing to pay for their future profits and not their total assets. Still, these companies have profits while Bitcoin doesn’t. Think of it this way… What’s the difference in AT&T trading at $30 versus it trading at $40? You could answer that in a variety of different ways and be correct, but all of them are essentially different ways of saying that a $40 price reflects greater optimism that future earnings and profitability will be higher than a $30 price reflects. Real numbers are behind both those prices — past, current and future projections of actual business that is being done. Now, what’s the difference in Bitcoin trading at $1 and $10, $1,000 and $2,000, or $15,000 and $16,000? The difference is how much faith you have that someone else will be willing to pay more for Bitcoin — that’s it. This phenomenon is explained by the greater fool theory, which essentially says it doesn’t matter what the value of something is as long as someone else is willing to pay more for it. The fact that something goes up in value doesn’t prove anything, and it especially doesn’t prove it was a good investment. In fact, it can be a foolish “investment” and thus the fact that the price goes higher can only prove that greater fools exist. Lastly, have you ever wondered what will happen when people start to take their profits? Do you truly believe the world is going the way of Bitcoin, or do you believe this is something you’ll put your money into for a while and then cash in your investment for dollars? If your answer is the latter, you better hope everyone else buying Bitcoins isn’t doing it for the same reasons, because that suggests there could be a rush to the exit one day. Again, there is just no way to predict the price of Bitcoin — you either believe you can get out in time, or you don’t. You either believe others will actually use Bitcoin, or you don’t. If you don’t believe others will accept it, you’ll be less inclined to accept it. Judging by the problems the still-developing exchanges have had with it, I’m not confident.
I heard some governments don’t like Bitcoin. Is this a problem?
It could be a small problem, or it could be the death of Bitcoin. Some countries have already banned Bitcoin, while others have a variety of attitudes toward it. Many are trying to create their own versions of it. China hasn’t banned the use of Bitcoin, but it has all but killed it by banning ICOs (initial coin offerings) and cryptocurrency exchanges. Governments probably couldn’t eliminate it, but they could certainly track down and punish users. This may be difficult since Bitcoin is pseudonymous, but it’s certainly not impossible. There is a record of your purchases. If a government wanted to track the purchases of a pseudonymous name, it could get on your scent pretty quickly. And if the other side of your “anonymous” transaction is government agent, you are toast.
Do you think Bitcoin could replace the U.S. dollar as the world’s reserve currency?
That would be chaotic in ways I’m not sure I can even fathom. Though it’s a mixed blessing, we benefit tremendously from being the world’s reserve currency. Governments will fear losing their ability to control money supply and fiscal policy, so I believe they will create their own cryptocurrecies or seek to put Bitcoin under their thumb. No doubt the SEC is keeping an eye on it, as is the Federal Reserve.
Isn’t the fact that Bitcoin futures began trading in December a positive sign for safety?
I have my doubts. The futures market is used to commodities that can be physically delivered, but it has grown to include a variety of financial instruments that have the ability to settle in cash. That’s often a good thing, but it can also be problematic. Bitcoin futures will always settle in cash, never actual Bitcoin. So Bitcoin is being treated like a commodity, only it’s not a commodity. It’s supposed to be a currency, yet it’s settled in a competing currency, which seems to me a vote of confidence that cash isn’t going anywhere anytime soon. Another problem with the cash settlement is that it makes the link between the asset (Bitcoin) and the futures contract a bit weaker, since there are other factors now involved in the price. A bar of gold is a bar of gold, but a Bitcoin isn’t quite so easy to define and it must pass through to dollars before you get your winnings or losses. Just because the futures market is regulated doesn’t necessarily do anything to address the fact that the underlying markets are unregulated. Some crypto markets are often a “wild west” wrought with every trading scam you can think of that the SEC has outlawed. Additionally, other types of cyber attacks can drive up transaction costs and randomly delay transactions. For example, attackers can jam one network with tiny transaction fees nobody wants to mine for and switch their mining muscle to another network where they get cheap and speedy transactions. Of course, they’d want to short the futures prior to making an attack. But the Chicago Mercantile Exchange (starting Dec 17) and the Chicago Board of Options Exchange (Dec. 10) are going to try to make a respectable product based on wild markets. The CME essentially picked four exchanges (which handle only 10% of Bitcoin volume worldwide) to produce their daily Bitcoin index for the futures to track, while the CBOE is using only one, Gemini, whose daily volume this year has averaged only $1,300,000. All five exchanges have taken steps to accept regulation and try to prevent money laundering, but that addressed only a fraction of the risk. Manipulators could still push around prices on just a few exchanges to reap profits from the futures.
Also, the wide public interest in Bitcoin is frightening. Anytime something becomes “obvious” and people fear being left out, the risk becomes exponentially higher, and the higher it goes, the more people will be tempted to get in. Institutions may largely stay away for a while due to the potential for counterparty risks and manipulation. When the Bitcoin futures started trading on Dec. 10, there did not appear to be much institutional volume, which is critical to the products being viable. By the morning of the 12th, there was about a $1,000 difference in the price of Bitcoins and the Bitcoins futures contract, a glorious chance for a risk-free arbitrage! (In such a “carry trade,” you would buy the Bitcoin and sell the futures contract so you would lock in the difference of the two as a profit with the contract expiring on Jan. 17.) But traders didn’t rush in to take the lucrative “free lunch” arbitrage opportunity. That inhibits liquidity and makes institutions shy away from trading at all. One problem is that the CBOE traded contract reflects prices of only one exchange (Gemini) that handles a very small portion of total volume of Bitcoin transactions. That means traders could try to skip back and forth between exchanges (pushing the price down on one and up on another) and create all kinds of pricing havoc overall and especially for Gemini if the extra selling caused problems. The risks of the “free lunch” trade are actually pretty high, and since millions in futures contracts have been bought, that could trigger major selling around contract expiration. It’s pretty normal for spreads to be higher on new products, but if the gap doesn’t disappear in time, I will take that as a bad omen. Traders need to be confident that the actual spot price on the settlement date will be reflected by the cash settled rate in the futures contract. Without this confidence, the market could become skewed against the shorts and in favor of the longs and Bitcoin futures could find themselves stuck in contango with few arbitrageurs willing to help flatten the curve as the futures contract approaches expiration. Too many longs tends to push the market up until something signals to the market that the bubble needs to pop.
So what’s the bottom line?
I’m not confident in Bitcoin’s ability to become a great medium of exchange and a dependable store of value, but my opinion is subject to change if information does. I do think the blockchain technology will be enormously impactful and cryptocurrencies will have a life after Bitcoin no matter what ultimately happens with Bitcoin. Still, there isn’t much fundamental analysis we can do on it. As I said before, there are no assets, earnings, etc. It all comes down to whether you believe enough other people believe in it and whether or not governments can or will squash it. So Bitcoin isn’t an investment, it’s a speculation. If the futures market develops nicely, Bitcoin could become a potential trading vehicle even if it’s not a great investment. Today, the market is too new and erratic and fraught with complications arising from the unregulated underlying markets and traders’ resulting lack of trust in it. In short, Bitcoin is not an investment–it’s a speculation. Many investors can afford to put a small amount of their net worth into speculative investments, but it should never be an amount so big that it would impact your future if you were to lose it all.
Other articles filed under Fort Worth CFP Team Posts
Part 2: Volatile Markets – How the Financial Media Helped Build Demand for Dangerous Products Based on the VIX
March 8, 2018 - To understand what happened in the markets the week of February 5, you need an understanding of the psychological forces behind what happened. The VIX isn't just an index that reflects what's going on with options. It's a psychological measure,...
March 7, 2018 - I’ve gotten a lot of questions about what happened with the markets the week of February 5. Many of the questions are on volatility and "the VIX." Explaining an event caused by many complicated tools can prove very difficult, especially...
February 15, 2018 - In 2009 with the emergence of Bitcoin, the legitimacy of cryptocurrency was scrutinized and hosted polarizing opinions on whether investing in this highly-complicated digital asset was really...well, an asset to begin with. At its birth, Bitcoin attracted more hobbyists than...
February 11, 2018 - Think of Options Like Insurance Options are essentially tradeable insurance contracts on stocks, indexes and some other investments. It helps to understand the concept of options if you keep in mind that options are insurance, but the terms are different....
February 6, 2018 - By now, you have probably seen the news that the stock market is taking a dip. There is a lot of information coming at us fast as we watch to see what happens next. We are here to answer a...