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Investing in bitcoin and ethereum is all the rage these days. If you are new to bitcoin, here is an article that provides a lot of background information on this cryptocurrency. Many people are buying bitcoins and many more are wondering whether they are missing out on a great investment opportunity. In November 2016, bitcoins were trading at $740. Fast forward one year and they are now valued at over $8,170 (a 1,000% increase)! You might be wondering why it is going up in value. The initial rise of bitcoin’s value was due to its limited supply as well as fears about the long-term safety of fiat currencies, among other factors. But this rise in value has, in turn, generated additional demand as people saw a “hot investment”, further driving up the price of bitcoin.
When an investment goes up in value by over 1,000% in one year, are you thinking “bubble”? If not, you probably should. Unlike stocks that track real companies with real products, bitcoin doesn’t have any intrinsic value. As more and more people invest in bitcoin, the price goes up, which in turn attracts even more “investors” (or perhaps gamblers?). Eventually, early investors start cashing out on their gains and the price plummets. This has been happening all throughout bitcoin’s history. In fact, bitcoin has volatility seven times greater than gold, eight times greater than the S&P 500, and 18 times greater than the US dollar. Talk about a wild ride!
21st Century Tulip Mania?
In our view, bitcoins and other cryptocurrencies are not investments, as their price is largely driven by speculation. It is hard not to notice parallels between today’s cryptocurrency frenzy and the Dutch tulip mania of the 17th century. When tulips were infected with the breaking virus (which created colorful flame-like streaks on their petals), people started perceiving them as having increased value due to their more exotic look. As a result, the price of tulips quickly skyrocketed. As the price of tulips kept on going up, more and more people started “investing” in them. At one point, a single Viceroy tulip was selling for the price of five average houses! Eventually, the demand dropped and so did the price. By the time people came to their senses, many had lost their life fortunes. The same thing is happening now with bitcoins.
Below is a quick TED video about economic bubbles.
Greater Fool Theory
Before you invest in any asset, you should always ask yourself why it is going up (or down) in value. Is it because of increasing profits or dividends? Or is it strictly because more people are buying it, hoping that the price will continue to rise? When you make an investment, you are obviously expecting it to go up in value (unless you are shorting the investment in question). But if you can’t answer the question of why it is going up in value, then you don’t understand the investment. Unless you have a good idea of the intrinsic value of an asset, you won’t know the right time to sell it (the more an investment goes up in value, the harder it is to sell).
Play money
If you really want to join the bitcoin game, make sure you only invest money you can afford to lose. Your retirement money should not be invested in cryptocurrencies, as the price of bitcoin can drop dramatically at times. For example, in 2011 it dropped from $32 to just $2 (a 93% drop). In 2013, the price dropped again from $266 to $50 (an 81% drop). So if you’re going to invest in bitcoin, you better fasten your seatbelt.
When it comes to investing in cryptocurrencies, Warren Buffett’s words come to mind: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”
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