Spring 2018

Beware of Bitcoin

David G. Hunter, CFA®, CAIA

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Towards the end of the 20th century, a devastating bubble began to form.  People quit their jobs to day-trade these markets full time.  Others took 2nd mortgages on their homes to leverage investments into  these growing markets.  Stories popped up everywhere of people retiring with millions of dollars after playing these markets for just a few short years. And as a new millennium dawned, the bubble finally burst, sending prices plummeting and leaving a wasteland of devastation in its wake.  I am speaking, of course, about Beanie Babies.

Most of us will remember those crazy times, where normally rationale adults suspended reality while lusting after those cute little stuffed toys.  People were being trampled at gift shops and malls. Some people were investing the entirety of their children’s college fund in plush toys and spending thousands of dollars for a single hand sized stuffed animal.

This Beanie Baby mania comes to mind when observing the current mania du jour: Bitcoin.

Let me explain why I consider Bitcoin as speculation, rather than a legitimate investment opportunity.

There is no quantifiable value. Almost everything people buy has a specific utility.  Food, gasoline, building supplies, medicine, and virtually every other good have some use from which people derive value.  Even art and music have a specific utility as they bring people aesthetic appeal and/or a desired emotional response (Beanie Babies would beat Bitcoin in this category).

Investment securities have value as ownership of companies (stocks) or a stream of interest payments (bonds).  In contrast, Bitcoin only derives its value from the willingness of people to accept it as payment for things with real value, i.e. perception.

Unlike other currencies, there is nothing supporting the price and no real underlying value or financial backing.  There are two key principals that keep fiat currencies, such as U.S. Dollar, grounded.

Purchasing power parity – This principal ensures that individuals cannot make significant risk-free profits just by exchanging currencies for goods. For example, we cannot make a profit by converting Dollars into Yen, buying Toyotas, shipping them back to the U.S. and selling them.  If this were possible, people would do this repeatedly, eventually causing the Yen to become more expensive and reach an equilibrium with the Dollar.

Interest rate parity – This principal says individuals cannot take out a loan in one currency, invest it in the risk-free rate of another currency, and earn a higher real rate of return.  Basically, the same outcome as above would occur.  People would capture this risk-free profit until the opportunity no longer existed.

What about Bitcoin? There is nothing to allow cross comparisons or to ground Bitcoin to other currencies.  Recently, we have seen crypto-currency “analysts” speculating that the value of Bitcoin should be equivalent to the value of gold.  Under this assumption, Bitcoin would have to reach around $500,000 per coin. After all Bitcoin is a finite commodity, right?

There are only 21 million Bitcoins that will ever exist. A finite commodity? Of course not.  This is an irrational argument that is fueling the Bitcoin mania.  Why can’t someone just create Bitcoin 2.0?  3.0? X.X?  Well, this is already happening and at the time of this writing, there are more than 1400 cryptocurrencies in existence!  Should each of them be valued just like gold?  Each new crypto currency would be worth 10.5 trillion dollars. Did we finally develop the proverbial money tree?

For the record, we are not predicting that the price of Bitcoin will soon fall dramatically.

We honestly don’t know what will happen in the next few years.  Perhaps there is plenty of room to run and people will continue to build massive amounts of wealth by speculating on these crypto-currencies.  But some people will also get rich going to Las Vegas or winning the lottery.  Many people got rich buying tech stocks in the 90’s, flipping houses during the last decade and even dealing in those fuzzy little Beanie Babies.  Just realize, purchasing Bitcoin is not an investment.  It is pure and simple speculation.

We understand that some people might like to speculate into Bitcoin with some “play money”.  But for the vast majority of your assets, it would be wise to stick with a long-term investment strategy. Unlike “get rich quick” schemes, long-term investment strategies with a patient and diversified approach have a proven track record and have been successful over various market cycles. Let other people catch the most recent mania, because the last thing you need in retirement is a warehouse full of Beanie Babies.

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