Should you invest in bitcoin? When an old school friend told me that he was thinking about quitting his plumbing job to become a full-time bitcoin trader, I thought it was about time to write an article on my understanding of this phenomenon.
Before we get into whether I think a series of 0s and 1s is worth $20,000, let’s have a little look at what bitcoin actually is.
At its simplest level, bitcoin is a currency i.e. a measure of economic value which can be exchanged for goods and services. It can be counted and there is a record of who owns what. But, unlike sovereign currencies (e.g. Australian dollars) which are issued and backed by the issuing nation, cryptocurrencies like bitcoin are not counted, backed or guaranteed by any central issuer. They are, by their very nature, decentralised and the records of who owns what are more like a ‘consensus view’ than an ‘issuer to consumer’ directive. You can find more about how it works by reading our beginner’s guide to bitcoin here.
Currencies or objects of value are not new. They have existed for as long as communities have exchanged goods. Think back to a small rural village BC. At a weekend gathering, a farmer meets with a blacksmith and exchanges a fattened lamb for a slashing knife. How do we know that the farmer no longer owns the lamb? Because there were many witnesses to the exchange and many of them decided to diligently record the details of the exchange on their ledger. There are now multiple independent records of who owns what, so it is almost impossible for anyone else to claim ownership of the lamb.
What is bitcoin used for?
To be an effective store of value, currency must be able to be exchanged for goods or services. One of the most high-profile companies to accept Bitcoin as payment was the computer giant Dell. Why Dell decided to accept payment in this manner is subject to debate, but their participation in the Bitcoin currency market gave a sense of stability and longevity to Bitcoin as a form of currency.
How to value bitcoin?
This question can be applied to any currency. Unlike a company which generates profits or a property that receives rent, currencies don’t provide a source of income. Ten dollars in your wallet today does not entitle you to any more dollars in the future. So the value of each currency is relative and I should not expect a positive return from simply holding cash (or any currency) unless I can predict when one currency will appreciate relative to another. That is, the value of one currency is relative to another currency. The market in which the currency is traded will determine the relative value of the currency.
The price of a Bitcoin is tied to supply and demand. Although the apparent interest in Bitcoin has exponentially exploded in the past 12 months, interest in it will likely reach an upper limit. This suggests that future demand for Bitcoins will reach an equilibrium of sorts and a less volatile dollar price for Bitcoin will ensue.
Will bitcoin mean the end for banks?
Unlikely, although it may change the way in which banks provide value in the currency exchange markets. If there are enough other willing participants to keep records of transactions, the role of banks as record keepers will change. I expect it will take many decades for sovereign currencies to cease being the dominant currency of choice.
Should we all invest in bitcoin now?
First let’s have a look at that statement. What does it mean to invest? To me it means to exchange your existing currency for the rights to future income and price increases of a particular asset. No issues so far. But the stumbling block with currencies, commodities or any asset that does not produce an income is that for every winner (one who profits from the transaction) there is a loser (one who loses from the transaction). Taken to the extreme, this question could be re-written “should we all quit our day jobs and play two-up for a living?”. Perhaps, but again for every winner there is a loser. You need an element of luck to succeed at two-up. Likewise, you need an element of being able to predict the future of the relative value of currencies to consistently profit from currency trading.
This isn’t to say that there’s not a long list of people who have made fantastic money out of buying Bitcoin. On the contrary. But as to whether it is suitable as an ‘investment’ will depend very much on each person’s own circumstances.
Personally, I have seen many charts of asset prices in my time in finance and the exponential (10,000%) increase in Bitcoin pricing over the past 3 years leads me to think that the potential for future upside is limited (but I have been wrong before).
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Disclaimer: This post has been prepared for general information purposes only. It is not specific advice to any particular person. You should consult an authorised Align Financial adviser before making financial decisions.
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