Should I Buy Bitcoin?

"Should I buy bitcoin?"  Over the past few months this question has been asked directly to me or arisen in casual conversation with friends several times.  Each time I tried to keep the answer simple: no.  This said, I firmly believe that one should attempt to understand the phenomenon at hand before making important decisions, and while I have tried to do so myself, I've not felt comfortable delivering (nor do I think others would enjoy) the following exposition. 

NB: I am not a financial professional; the following is my own analysis and opinions; I do not own any bitcoin or other cryptocurrencies.  If you are a bullish on bitcoin or trying to get other people to buy into bitcoin, you can write me off right now.  Finally, if you are at all versed in foreign exchange or bitcoin you will likely find the following very boring.

What is bitcoin?

A simple search will tell you what you need to know, but basically bitcoin is a cryptocurrency, which is a fancy word for a currency with no physical form.  The fact that is has no physical form is irrelevant to its functioning.  For example, the monies associated with my credit card have no physical form, nor do the monies in my checking account until I convert them to physical dollars.  No matter, they all work fine and bitcoin theoretically does as well.  In fact, many places already accept bitcoin as valid payment.  It is highly probable that this trend will continue and some form of cryptocurrency will become stable and long-lasting, yet this likelihood does not mean that bitcoin itself will be the currency to stabilize (over a thousand cryptocurrencies currently exist and hundreds if not thousands have failed).

How is it made?

Bitcoin is "made" through mining, a process whereby your computer performs certain functions repetitively until it achieves a goal: a portion of a bitcoin.  The take-home here is that mining is how bitcoin creates scarcity.  Scarcity is vital to any currency achieving stability because if everyone made as much monies as they wanted, the monies would be worth less and less over time (as more and more enter circulation).  It is highly likely that you will not be able to adequately mine any bitcoin because the costs associated with establishing a "rig" are too high relative to the potential benefits.  In other words, most the bitcoin has been mined.  Thus we cannot reasonably produce any bitcoin and must buy it.

What does buying bitcoin mean?

When you buy bitcoin you are basically trading currency.  Many people trade currency; in fact, the Forex market (foreign exchange market) is the largest market in the world.  Trading currency means exchanging a brand of fiat money for another in hopes of being able to sell that latter currency at a later point for a gain.  It is, in essence, gambling.  Bitcoin is no different.  If you look here, you can see the exchange rate of various currencies and commodities; bitcoin is there as well.  What this means is that I could take a thousand US dollars and exchange it for X euros, Y bitcoin, or Z yen; in this example, X, Y, and Z all depend on the respective exchange rate.  The difference between these currencies is severe: euros and yen are tied to centralized governments (who control their own money supply--read: scarcity) while bitcoin is tied to a decentralized network of mining rigs.  Yet in spite of these differences, the currencies trade in the same manner, on an exchange.  To the market, they are interchangeable.  The take home here is that buying and selling bitcoin is the same as buying and selling euros.  If you are not willing to trade euros then why would you trade bitcoin?  The answer is clear: because you think there's money to be made.

Small note: Unlike a savings account and other fixed-income instruments like bonds, or even equities that pay a dividend, bitcoin (like all currencies) produces no value.  You will never end up with bitcoin+1 because of bitcoin.  You can only realize monetary gain through bitcoin (as with all currency and commodity speculation) if you sell for more than you bought. 

Is there money to be made?

Such a question is unanswerable without knowing the future, but we can look at the situation as objectively as possible.  To begin, let's look historically.  Here is a chart of bitcoin's progress over the entirety of its lifespan as a currency:

For those unfamiliar with stock charts, the X axis is time (~2012 to the present) and the Y axis is the value of a single bitcoin.  Yes, in early 2013 a single bitcoin was worth next to nothing while now, as of this writing, it is worth $11,300.  In retrospect, if one held bitcoins pretty much any time before 2017, one is feeling very good.  On the other hand, if one bought at the peak (roughly mid-December 2017) one would have paid ~$19,000 for a coin which is now worth $11,300.  That's nearly a 50% loss of value in around a month which means that if bitcoin is nothing else, it is volatile.  Volatility is a form of risk because I don't know when I may or may not need my money, and if it is tied up in a volatile asset it may be worth very little when I need it most.  So bitcoin is objectively extremely risky at this point in time.  How risky?  Well, here's a chart comparing bitcoin's rise to major historical financial bubbles:

Note that this chart ends in October and misses the fact that bitcoin went from $4,500 to $19,000 (!!!) in a couple months.  If this chart were to include this data and the blue line sky-rockets off the page, we can see that a bitcoin bubble it is vastly larger than any other financial bubble ever seen.  In other words, it's insanely risky.  It's riskier than buying beanie babies at their peak.  Here's another devastating historical comparison:

The nice aspect of this chart is that it shows how long it took the late-1990's "dot com" bubble (the blue line) to inflate and deflate: around four years to inflate and just over one year to deflate.  Bitcoin inflated at a much higher rate--in less than a year, meaning that if it were to pop it could deflate in a matter of months if not weeks.  Also note that the above chart was made when bitcoin was only at $4,000.  As mentioned above, it surged to $19,000 in less than four months.  This fact only highlights the point being made.

So the answer to the question "is there money to be made" is that there is, but only if you can sell your bitcoin for more than you bought it.  If you bought a month ago, you may never be able to recoup that money.  If you bought in 2016, you will likely make lots of money if you sell now.  If you buy now, who knows?  

I believe that if you are considering buying bitcoin you ought ask some simple questions:

1)  Why would I buy bitcoin and not euros or gold?

2)  If the answer is that I think there's money to be made, why do I think that?  Likely because others have made money.  But I am not them; they bought then and I am thinking about buying now.  

3)  In regards to buying now, do I have the ability to risk this money?  Bitcoin certainly is volatile (risky).  If I buy now, am I comfortable losing 50% of my money in a month? 75% in a couple months?  90% in a year?  This may not happen but I should be prepared for the worst and, if history is any indicator, the worst is very, very, possible for bitcoin.

4)  On a simpler level, am I capable of trading in currency and commodities?  Have I ever bought or sold mutual funds?  Have I ever actively traded stocks?  Am I familiar with the logistics of such endeavors?  Do I know the costs involved?  Many if not most financial entities and enterprises try and make it seem like it's super easy to trade stocks.  This is because they profit off every trade no matter your gain or loss.  In the world of finance, nothing is free and nothing is easy.  Bitcoin is no exception.  The difference is that trading in Apple or GE stocks may cost you 15-50% in a year, whereas trading in bitcoin may cost you 40-80% in a week. 

5)  What are my alternatives?  Buying bitcoin is equivalent to speculating on currency or commodity exchange.  What else could I be doing with this money?  Another way to think about this is: what do I want my money to do for me?  Presumably, you want it to make more money--you want an investment.  Bitcoin is not an investment any more than gold, silver, or foreign currencies are, and most folks asking about bitcoin aren't hoarding gold bars.  I think the best definition of an investment came from the famed Benjamin Graham who in 1934 wrote:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Bitcoin promises absolutely no safety of principal (your money) and makes no claims towards return.  What it does offer you is a high-risk high-reward type speculation.  And given that most of the people asking about it now are doing so without thorough analysis, I fear that the current bubble will take many an unsuspecting person's savings down with it.  I write this in hope that a cursory analysis helps some avoid the temptation at hand or, at the very least, aids in being informed on a developing world.

Cover image woodcut "Greed (from The Seven Deadly Sins)" by James Todd; image courtesy of The Annex Galleries