Bitcoin: Lucky Bet or Savvy Investment?

There is no doubt that Bitcoin and other crypto-currencies have soared in value and popularity, far beyond the expectations of all but their most optimistic fans. Does this mean Bitcoin and the like are good investments? I will argue they are not investments at all. What about the claims that they are a new store of value? Likewise, I will argue they are also not truly a store of value. And finally, could they be a new means of exchange? I highly doubt it.

What is an Investment:

Think of an investment as a swimming pool. If you buy a stock, you own a percentage of the pool. Revenue is like water being pumped in and expenses are like water being drained out. The resulting change in water level is the profit or loss. The overall amount of water in the pool is the value of the company of which you own a share. Some pool managers realize that the pool is nearly full, yet they don't want to expand the pool. As a result they give out water in buckets to their shareholders as dividends. Other pools are rapidly expanded in size, with expectations of more water being delivered in the future. Of course, this means the water level, or profit, falls. But that it all right, because as water continues to flow in, that percentage of pool ownership can hold more water.

These pools would be analogous to growth stocks. As you can see, the value of the pool is completely based on how much water you will end up owning into the future, either as distributed buckets, rising water levels (retained earnings), or future water in the expanding pool.

Maybe the investment is not in a company through stocks or bonds but instead in something like gold. Here, the pool is growing in size by a very small amount each year through mining. If this was the only thing going on, the water level would drop every year as the pool gets bigger and the same amount of water remains in the pool. However, purchases of gold for jewelry, technology, medical equipment, coins, and speculation is like a constant flow of water into the pool.

With stock, ownership of the pool would be like owning a percentage of the pool. If the pool expands, then your potential for owning more water expands too. With a commodity like gold, it is more like having a square foot of the pool, if the pool expanded because of a gold find that doubled the supply of gold, all things being equal, the water in your section of the pool would drop to half it’s previous level because your share doesn’t expand with the new find.

Gambling:

Continuing the analogy, gambling would be like throwing a bunch of buckets of water into a pool and betting to see who gets to take home the mutually accrued water. The amount that goes in is what goes out. For every drop won, someone else lost.

Ponzi Schemes:

Imagine I make a pool and start telling people the pool will begin rising dramatically. A few people believe me and deliver me buckets of water in exchange for a share of the new pool. I throw those buckets of water into my pool and lo and behold: the water is now rising! More people take notice of the rising pool and come with more buckets in exchange for a share of the rising pool. I throw these buckets, too, into the pool. The more it rises, the more people want a piece of it, and the more people come with buckets. This broadly sketches the outlines of a Ponzi scheme, or Bitcoin, and is similar to the gambling example. The money paid in is what is available for later pay out. It is ‘zero sum’ because there is no outside revenue stream delivering value. In contrast, everyone can make money owning Ford stock, if Ford is profitable, because the owners of the stock receive those accumulated profits. This is markedly not true at a poker table or a roulette wheel, nor so with a Ponzi scheme. The money lost by one person is gained by another.

Imagine some of the pool’s owners decide they want to cash-out and take their share of the water in the pool. Maybe the water isn’t rising as fast as before or there have been wild fluctuations in the height of the water and the owners are getting nervous. Who knows. This can cause a chain reaction in the other direction. If I own 1% of the pool and pull out the water in my section, sure, I get my water back, but the water level in everyone’s section has dropped as a result. Some of them might want to take their water, too, seeing this drop. This causes further drops for everyone’s water level. What often results is a ‘flash crash’, where panicked selling collapses the value of pool shares as all of the water drains back out. Who wins? Those who happened to cash out at the right time. Who loses? Those who timed it wrong. No value was created here, just transferred. Can you make money at this? Sure, you can also make money as a professional gambler. What any of those professional gamblers will tell you is that you have to have an exit strategy. When are you going to cash out your chips, your water share, your Bitcoin, or your wildly speculated Gamestop stock? If you don’t have a good exit plan, you will be one of the ones left high and dry.

Store of Value?

People have compared Bitcoin to gold, but as explained earlier, the gold “pool” does have outsides streams of value entering in. We see these as myriads of differing manufacturers purchase it as a raw material. Furthermore, that pool is not showing any real signs of being a speculative bubble. Cryptos definitely contain the classic signs such as, media hype, massive inflows of retail investors, price decoupling from net present value of future earnings, crazy volatility, and FOMO purchases.

Next, the wild swings in value are not ideal for a store of value. A store of value would ideally be less volatile.

Bitcoin cannot be called an investment, since it generates $0 in earnings, nor is it a commodity like gold because it has no use in any products. Might it store value over time? Maybe, but there are no fundamental reasons for it to do so, unlike a real investment.

New Means of Payment:

Despite using more electricity than all of the Netherlands, the Bitcoin network can only process a puny 7 transactions per second. Compare this to Visa, which can perform 65,000 transactions per second. If that wasn’t enough, the cost per transaction is enormous, and is currently around $30. Some people think they are paying with Bitcoin when they use Bitcoin cards offered by various exchanges. Instead, the exchange is acting like a bank and only clearing batch transactions as necessary. In case you are wondering, these exchanges are nowhere near as safe as a bank or credit card company, both of which have high security along with fraud and theft protection free of charge.

Currently, advocates seem to be speaking out of both sides of their mouths. If Bitcoin is a good store of value because it is expected to appreciate in value, this make it a bad means of payment. Why would someone want to pay for something with money that, if held for longer, would be worth more in the future? Everyone know the stories about people who bought pizza for a few Bitcoins. Obviously they should never have done that, since their Bitcoins would have been more valuable if held. Maybe it will stabilize? I agree, someday it might find its price. At that point it be used as a payment alternative to USD in very select circumstances.

Objection: You say I am going to get hosed, but I am up 800% right now. Sounds like you are jealous that you didn’t get in early enough.

Answer: It is all on paper until you cash out. That is awesome you are up so much, but if you don’t have an exit strategy, sooner or later that could all disappear. One option is to sell off your initial investment. Let’s say you bought $10,000 worth of Bitcoin and now it is worth $80,000. If you take your initial investment off of the table, you are now ‘playing with house chips’; you created a loss floor and the rest can spike or crash without touching your initial “investment”.

Of course I wish I got in when Bitcoin and others were still cheap. I also wish I had got in on the Dot com boom and somehow sold at the very peak. I wish I got in early and sold out at the perfect time before the 2008 crash. I wish I were in 1600’s Netherlands for the tulip bubble and magically knew when to time that one, too. Realistically, I know the smartest people in the world are far more likely to time bubbles correctly than I am. Therefore, since such bubbles are more like betting that investing, I am not interested in entering in a zero sum game with them.

If you were sitting at a poker table with a bunch of professional gamblers and found out you were up 800%, what would you do? Personally, I would at least cash out some of my chips, maybe all of them. I know that in the long run they will likely be the winners, and my early success was likely just luck of the draw.

Objection: The dollar is being used as a store of value, but it is also without value by your definition.

Answer: I agree the dollar is a terrible store of value. It is a means of exchange. If you want a store of value, buy an income-producing asset, land, or goods that will appreciate over time.

Answer: Dollars, like Bitcoin, have a value set by the market and can be traded for real goods and services. In this respect, they do have value, as evidenced by their acceptance as a trade for products.

Objection: You have it all wrong. Blockchain will change the world. You don’t understand the technology.

Answer: I agree that blockchain is a great technology with many good uses. Personally, I think that in 20 years real estate, contracts, auto titles, and other things will all be blockchain verified. That doesn’t mean Bitcoin is going to be valuable. That doesn’t even mean Bitcoin will ever even be used to pay for such things.

Answer: If the technology doesn’t create a revenue stream that pools in Bitcoin, then how will this make Bitcoin more valuable?