Financial Geekery

Bitcoin -- because I know you're going to ask

January 30, 2018

And why shouldn't you? Everyone's talking about it. There's the "investment guy" who's telling you how you should invest all your "dry powder" in it, and there's the historian who starts muttering about tulips every time Bitcoin comes up. So...what's the scoop? And what's this about tulips?

 

On the technology

 

If you're a tech geek, you probably already know the basics -- bitcoin is a cryptocurrency, a digital form of money that uses a technology called blockchains to allow digital transactions through a public ledger, effectively circumventing banks. It's no surprise that the idea gained a huge amount of traction after the global market meltdown of 2008.

 

If you're wondering "who runs Bitcoin", well, think Linux. It's a community effort, with all the potential havoc that entails -- including permanent forks of the code behind it, and hence, the bitcoin market itself. (And yes, "hard forks" have already happened.) Linux is hardly a failure story, though, as Linux-derived Android is by far the most popular OS around, according to NetMarketShare.com. (Priests of Torvalds, note that I'm not saying whether Android is Linux. It's Linux-based, at the least.)

 

Oh, and you may have heard that bitcoin mining will use all the world's energy by 2020. Not likely. It's estimated that bitcoin miners use as much energy as Denmark, or 1% of the US -- which is a problem! -- but bitcoin has a self-regulation system in place that will decrease energy usage over time. Not to mention the fact that as of January 2018, there are approximately 16.8MM Bitcoins in existence out of a (current) hard cap of 20.7MM, and the rewards for mining bitcoin will drop steadily such that mining activities will likely fall dramatically within a decade or two. 

 

Whatever you think of Bitcoin, blockchain tech definitely has some meat on its bones. It's not just bitcoin speculators that are throwing money at it -- Vanguard is already spinning up an application that will use it to replicate market index information, and bank consortia (couldn't pass up a chance to say "consortia") are working on tech that will greatly improve the efficiency of bank transactions. Evolutionary, rather than revolutionary, but we'll see what the future holds.


Should I invest in Bitcoin (or Ethereum or any other cryptocurrency)?

 

Good question. In theory, though, it should be simple: does it fit with your investment policy? If not, you need to create one first, and then come back and ask the question again. 

 

No, I'm serious. I'll do a bigger writeup on investment policy statements next week, but for now, just know that an investment policy is a systematic way of figuring out what you should invest in. It takes your goals into account, and your risk tolerance, and your time and skills (or your financial advisor's), and best practices, and due diligence. It's a framework that balances rigidity with flexibility in a way that's personal for you. It reminds you of what you know to be true, about money, the world, and you, to help you make good decisions in precisely such situations as these.

 

An investment policy often outlines your asset allocation: how much cash should you have in savings, and how much should you have invested in stocks, bonds, domestic or international securities, large-company or small-company equities, real estate, commodities, etc. In that case, you can simply ask the question: what kind of asset is Bitcoin?

 

Unfortunately, the answer is unclear. You could say it's a form of currency...but unlike every other currency, it isn't backed by the full faith and credit of any government. You could say it's a commodity, but commodities by definition are physical goods, which is what separates them from stocks and bonds. You could say that it's a collectible, which puts it in the tricky-to-evaluate column along with rare art, but it changes hands an order of magnitude more quickly than any collectible out there.

 

Ultimately, you really have to say "none of the above". No asset class can be closely matched to Bitcoin, and there's no good data to indicate what the value of Bitcoin "should" be. There are no dividends or interest, as in the case of stocks or bonds, nor an underlying physical use as in the case of lumber (gold is an article unto itself). 

 

Let's remind ourselves of times in the past when an investment has become untethered from reality. Tulips are the first, most famous example, from 17th-century Europe. At one point, according to a book by Charles Mackay in the 19th century, 1635 saw a sale of 40 tulip bulbs for 100,000 florins (or Dutch guilders, and you Princess Bride fans are suddenly having a flash of realization, aren't you?). That's approximately $1.4MM US dollars. Needless to say, when that bubble burst, a lot of "wealth" simply vaporized.

 

Lest you think people have gotten smarter, the 20th and 21st centuries saw their share of bubbles. An ounce of gold fell from $1900 in 2012 to $1100 in 2015. Median sales price of homes in Vegas went from $300,000 in 2007 to $130,000 in 2009. A share of Enron stock was $90 in 2000 and cratered to $0.21 in 2001. The list goes on and on and on -- sometimes the market value of something is, to put it succinctly, wrong. (We'll talk about what that means regarding efficient market theory another day.)

 

So does that mean the Investment Nazi says "no Bitcoin for you"? Not necessarily. If you have that gambler's itch, you can set aside part of your portfolio and call it "speculation". Perhaps you have 5% set aside in general for "Vegas money", with no more than 1% of your portfolio in any given single investment. So it might be 95% diversified stocks, bonds, and real estate, and 1% each of investments you just think might take off, like Tesla or Bitcoin (or gold or energy companies or tulips). (NoteI'm not making a recommendation for or against buying Tesla or Bitcoin or gold or energy companies or tulips. It's just a hypothetical. Keep your shirts on, SEC.) Once one of those 1% assets grows beyond a threshold, say 2%, you sell off back to 1%. (And if it falls to 0.5%, you buy back to 1% or perhaps consider replacing it entirely.) This allows you to capture growth in a methodical, systematic way, without potentially torpedoing your portfolio. Will it outperform a portfolio that's 100% non-speculative? Maybe. The odds are against it, but you could roll a winner. 

 

The point here is: before you decide to jump on a bandwagon, create a system. Once you have a framework for making this kind of decision, it becomes much easier -- and much less prone to blowing up your financial future!

 

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