It seems these days that we cannot travel in any personal or professional circles without being bombarded with questions about Bitcoin. The astronomical returns being reported are enough to make your head spin. Many investment firms have jumped into the frenzy as they seek to take advantage of opportunities they perceive may benefit themselves and investors.
Before discussing its appeal, it is important to understand Bitcoin and the reasons for its skyrocketing interest by investors. First created in 2009 in the depth of the financial crisis, Bitcoin is a type of cryptocurrency or digital coin. Thus, it has no tangible value. A maximum of 21 million Bitcoins can be issued thus capping their supply. Rather than being funneled through the banking system, transfers of Bitcoins are processed directly from peer-to-peer through a decentralized ledger called Blockchain that uses cryptography to verify and secure transactions as well as control the supply of units.
Proponents of Bitcoin cite these two features, finite supply and a de-centralized transaction platform, as reasons they view it as a superior alternative to the traditional banking system. Many supporters have compared Bitcoin to gold due to its limited supply, unlike any of the major fiat currencies. Like gold, Bitcoins are “mined” by individuals or networks who verify transactions on the Blockchain and are compensated with percentages of Bitcoin for their efforts. This process requires significant computational power and coding expertise, and it can be a very profitable endeavor. The security of this system represents a major concern of potential Bitcoin users. However, Blockchain is actually designed to discourage hackers by making it more valuable to contribute to the chain than to break it.
While Bitcoin is the first and most hyped, cryptocurrencies now number more than 1,200 with Ethereum being the second most notable. Bitcoin currently represents more than 50% of the total market of cryptocurrencies. As of December 2017, total market capitalization of cryptocurrencies exceeded $600 billion, propelled by the value of one Bitcoin as it skyrocketed from $1,000 to $12,800 during 2017.
Supporters of cryptocurrencies argue that it will be a major form of currency in the future, meaning it will be common for individuals to use these digital coins as a store of value and as a medium of exchange. Right now, though, Bitcoin and other cryptocurrencies are primarily being used as speculative trading vehicles, as the outrageous price fluctuations make it nearly impossible for them to function as actual currency. In fact, the most widespread use of Bitcoins is reportedly by criminals attempting to launder their money.
Because there is currently very little practical utility for Bitcoin or any other cryptocurrency, we believe it is impossible to value it as an actual investment. Therefore, its rapid rise is likely the result of pure speculation and a rampant “fear of missing out” on huge returns. This is only exacerbated by media stories of people making millions seemingly overnight. However, it is important to understand that few people have actually struck it rich during the massive rally. There are some interesting facts that tell the story. According to a white paper published by OppenheimerFunds, as of December 11, 2017, 54% of addresses own less than .001 Bitcoins or an average of $3, only .6% of investors own more than 10 Bitcoins, and 50% of bitcoin trading is transacted in Asian currencies. The largest owners of Bitcoins are early investors as well as successful "miners".
During our 40 years in practice, we have witnessed several "bubbles". The technology bubble of the late 1990s is the most recent example when companies that added a .com after their name experienced exponential increases in their stock price. Recently, a company formerly named Long Island Iced Tea changed its name to Long Island Blockchain and the stock soared as much as 500% in pre-market trading and "settled" back to 275% when the market opened. In economic history, the closest analogy may be the Tulip Mania that swept the Netherlands in the 1600's where prices of newly imported bulbs of fashionable tulips rose to dizzying heights only to plunge in 1637.
Isaac Newton, one of the smartest people to ever live, got swept up in the speculative mania known as the South Sea Company bubble in 1720 and lost a fortune. Reflecting on his experience, the physicist exclaimed that he “could calculate the motions of the heavenly bodies but not the madness of men".
As we have shared with most of you, when evaluating any investment, it is essential to remove the emotion and evaluate it on its merits. While we don't pretend to know the future of cryptocurrencies, we do know that based on their mind boggling gains, they will most likely experience a spectacular collapse.
Clifford L. Caplan, CFP®, AIF®
Stephen W. Caplan
This article is intended for educational purposes only and is not a recommendation for or against cryptocurrency. It is merely used to illustrate a point. Make sure to conduct your own due diligence with all investments.
In the News: Cliff has been quoted in three separate articles in U.S. News and World Report including "7 Mistakes to Avoid with Dollar Cost Averaging" on November 7th,"4 Things to Consider Before Investing in Bonds" on December 6th and "Should you own Nontraditional Bond Funds" on December 8th.
Announcement: For the 7th time, Cliff is honored to have been named a Five Star Wealth Manager in Boston. Our new profile will appear in the February edition of Boston Magazine.
*2018 Five Star Wealth Manager Award, created by Five Star Professional. Presented in 11/2018 based on data gathered within 12 months preceding the issue date. 2,819 Boston area advisors were considered, 532 advisors were recognized. Advisors pay a fee to hold out marketing materials. Not indicative of advisor’s future performance. Your experience may vary. For more information, please visit www.fivestarprofessional.com.