What I Learned Researching Bitcoin

Bitcoin is the most talked and asked about financial topic right now. It’s enfuego. The main reason is because of its unprecedented appreciation as seen below:

Bitcoin Price Since 2014

By gawd it’s launching into outer space. As of this writing it is +850% year-to-date. Being the boring investment CFA guy in my group of friends I continually get asked about it. Also, once my mom asks about something it’s definitely mainstream (sorry mom!). After attempting a deep dive this is what I learned:

What Is Bitcoin?

It’s a “peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” That’s from the bitcoin white paper (authoritative report/proposal). The word to encompass this is cryptocurrency: a digital form of cash/currency. Traditionally a currency has three characteristics:

  1. Store of value- able to save it without it losing its value
  2. Medium of exchange- use it to buy and sell instead of bartering
  3. Unit of account- provides common base for prices

Currently bitcoin does not meet the standards for a currency. It has wide price fluctuations, so it is not the best store of value. It drops over -20% in a day. It cannot be used for everyday purchases. Also, nothing today is quoted in how much it costs in bitcoin.

 

Okay…Who created this?

So funny story…No one knows. The bitcoin white paper was written by Satoshi Nakamoto back in 2009, but has never been publicly identified.

What is this blockchain thing?

Blockchain is a new way to settle transactions. Traditionally transactions involve a middleman who acts as a trusted partner for both buyer and seller. For example, when buying a stock you go through middleman (or a broker) and they find a seller for your transaction. Blockchain eliminates that middleman by using an open public ledger. This ledger is decentralized meaning no one person controls it. It is administered by independent programers who verify transactions and are rewarded by earning bitcoins. This process is called mining. Every transaction is recorded on this public ledger and allows for trusted peer-to-peer transactions over the internet.

Why does that matter?

Advocates of blockchain say this is important because it is decentralized and no one person or government can control it. Also, it creates the possibility for creating trustworthy and efficient transactions over the internet without having to use a middleman. Many people are more in favor of the blockchain technology than a particular cryptocurrency.

I heard about this other one called Ethereum?

“Ethereum is different than Bitcoin in that it allows for smart contracts which can be described as highly programmable digital money. Imagine automatically sending money from one person to another but only when a certain set of conditions are met. With Ethereum, a piece of code could automatically transfer the home ownership to the buyer and the funds to the seller after a deal is agreed upon without needing a third party to execute on their behalf.” That is straight from Linda Xie at https://blog.coinbase.com/a-beginners-guide-to-ethereum-46dd486ceecf . Ethereum is gaining popularity as a main cryptocurrency because it solved some of Bitcoin’s issues around transactions.

Why are financial people calling it a bubble?

Financial people are freaking out by calling it a bubble and speculation because they can’t value it and does not fit traditional investing models. Speculation is when you are basing your investment decision solely on the market price of an asset. You are gambling that someone else is going to pay more for it. There is nothing wrong with speculation!! It keeps the gears of innovation turning. Also, risk is exchanged in the marketplace. This is part of a healthy economy. Amazon was highly speculative in the beginning, but because of internet stock speculation it was able to get its start. However, bitcoin doesn’t fit into traditional investing models because it has no revenues, profits, cash flows, or assets; therefore, no one is quite sure what the price should be. Some argue that it has some value as it gains popularity. Here are a few ways to try and value it:

http://marginalrevolution.com/marginalrevolution/2017/11/bitcoin-just-bubble.html

http://aswathdamodaran.blogspot.com/2017/10/bitcoin-backlash-back-to-drawing-board.html 

Issues

  1. Bitcoins have been routinely stolen from exchanges because of programming faults. How can something become trusted if it is commonly stolen out of your account?
  2. It has wide price fluctuations. For example, it has lost over -20% on six separate occasions
  3. New and unproven technology. I don’t understand the underlying technology, but some people are extremely excited about its applications. Also, this is similar to the dot-com euphoria. Huge appreciation in internet stocks from capital pouring in bid up prices, but more importantly laid the foundation for today’s internet. Will the same cycle happen again?

Well the real reason why I’m asking is should I buy some?

Woah woah woah! Let’s not get personal here! But if you are thinking about buying some here are a few things to consider:

  1. Can you handle the crazy price swings? When you see it down -25% are you going to sell? If so, then you probably cannot handle the risk (or volatility, which is a fancy investment word for price fluctuations)
  2. Are you okay with losing your entire investment? This asset could go to zero and you need to be comfortable with that. If you are going to participate, please for the love of god do not put a large part of your savings into this. Your retirement should not be based on speculation.
  3. Whats your plan? Write down on paper what you think will happen (finance people call this an investment thesis) and then create a few predetermined rules. If it rises to $10,000, then I will sell. If this event happens, then I will do this action. Try and think through the possibilities and have a plan!

If you can handle all of that, then look for a trusted bitcoin exchange.

Take Away

The great and worst thing about investing is that anyone can do it along side professionals. Imagine if that was possible in boxing, NASCAR, or the NFL! But in investing you can express your own views on the future by buying and selling assets. Bitcoin is the first asset that has reached high speculation without being embraced by Wall Street or financial institutions. Slowly firms are starting to implement blockchain technology and bitcoin. What happens next is anyone’s guess. Place your bets accordingly!

Sources:

http://investorfieldguide.com/hashpower/  (This is the best source I’ve found if you want your own deep dive)

https://bitcoin.org/bitcoin.pdf 

http://thereformedbroker.com/2017/10/18/an-evening-in-wonderland/ 

http://www.imf.org/external/pubs/ft/fandd/2012/09/basics.htm 

https://medium.freecodecamp.org/smart-contracts-for-dummies-a1ba1e0b9575

https://medium.freecodecamp.org/explain-bitcoin-like-im-five-73b4257ac833

https://www.ft.com/content/1c034898-d50f-11e7-a303-9060cb1e5f44 

Disclaimer: This should not be considered investment advice. Do not buy or sell anything based on the above! But you already know that…hopefully.

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