Seriously, what is Bitcoin?

Have you purchased bitcoin on a credit card? No? (Well done!) That was a question a journalist recently emailed me. Fortunately, I don’t know anyone who has purchased bitcoin on credit (or at least anyone who felt compelled to tell me) but there appears to be a “bit” of a craze going on now around cryptocurrencies.

To buy or not to buy?

With Bitcoin (and other cryptocurrencies) that is a popular question. As is typical of the internet-age, there is a cacophony of noise on bitcoin available. There are even new marketing schemes with self-styled bitcoin gurus offering their knowledge to a select group of individuals for $80/month. Please make it stop.

Recently, Bitcoin has experienced a tremendous increase in price, as well as some dramatic losses. So what’s all of the excitement about? Should you buy Bitcoin? (Hint: probably not)

I think it’s important to break Bitcoin (and any cryptocurrency) into buckets; first, there is the underlying blockchain technology that could be transformative and, second, there is the hype around cryptocurrencies as a speculative “investment” (similar to gold, Pokemon cards, tulip bulbs, etc.). Let’s cover a quick primer on bitcoin.

Seriously though, what is Bitcoin?

Bitcoin is a (semi) anonymous digital currency. It was designed to allow the secure transfer of money without the oversight of a government. It is not backed by any real asset, government, bank, or anything else. It is said that there is a finite supply of Bitcoin, not all of which has been “mined” yet. Bitcoin is “mined” using complex computer algorithms that essentially solve puzzles.

Side note: mining and maintaining bitcoin blockchain uses up a tremendous amount of energy, so for those of you interested in Environmental Social Governance (ESG) issues beware.

(Read more: What is ESG Investing?)

Once the puzzle has been solved, the code is recorded in the “blockchain” and that can be turned into bitcoin that can be spent at some retailers. Of course, by design, the bitcoin transactions are irreversible and there is nobody to complain to if your transaction doesn’t go well. This is similar to purchasing something in cash but does vary a bit from using a credit card or where you may be able to contest a transaction with your card issuer.

It may go without saying, but just in case, any transactions you try to make with bitcoin should only be made with reputable sellers. Caveat Emptor (Buyer Beware).

However, the real noise around Bitcoin (and other cryptocurrencies) right now is whether or not they are a “good investment”, or perhaps whether it is an investable asset at all. When contemplating whether to include bitcoin [or any holding as an investment] in a portfolio, we need to ask ourselves a few basic questions about the proposed investment.

First, is the investment expected to produce any cash flows?

While not all investments produce cash flows, cash flow is actually a big part of many investments returns. So you would be wise to evaluate whether or not you can expect to receive any regular cash flows from your investments.

Simply holding a dollar in your hand does not mean you will get more dollars in the future. Similarly, holding a bitcoin does not entitle you to more bitcoins in the future. You could put that dollar in a bank and potentially earn interest on it. Compare this to FDIC Insurance also protects your cash (up to $250,000), giving your savings a legal backstop in value.

If you purchase a U.S. government bond you could earn a predictable stream of interest payments. With a dividend paying stock you could have the dividend payments deposited back into your account (or reinvested to purchase additional stock). Stock dividends are not guaranteed, but we have some historical information available around their predictability.

How do cryptocurrencies compare? There are some companies offering to accept bitcoin deposits and pay interest on them but they aren’t backed by any government or long-standing financial institution. There are no regulations around how bitcoin should be stored, protected from hackers, or how much these institutions must keep in reserve - all standards that traditional banks are held to.

For the vast majority of bitcoin owners, there are no future expected cash flows.

Second, Does The Ownership Of This Asset Entitle Us To Any Future Profits?

OK, so the next question we might explore around the ownership of an investment is whether we can expect to receive any profits back from the company (or asset) in the future. Or perhaps we expect the company to increase in profitability and thus drive the share price up. Can share or asset prices be driven too high? Absolutely. It happened during the dot.com bubble in 1995-2000 and the real estate bubble that ended in 2007.

But let’s back up and apply that standard to cryptocurrencies. Bitcoin is not a company and there is no underlying object of value, such as a house you rent or live in or pork bellies. Yes, as late as 2011 you could trade pork bellies and if you love bacon as much as I do...but I digress.

There is no inherent profit motivation in bitcoin, it’s a currency not a business. If you purchase Bitcoin now in the hopes that the price will rise, you are basically saying that you don’t think you’re the (pardon the phrase) “last sucker in.” Translation: Bitcoin is highly speculative.

Third, Does The Volatility Of The Investment Fit My Risk Profile?

As investors, we could be presented with a tremendous investment opportunity, but if it’s going to cause us major heartburn, it’s not worth it. An investment that causes the investor to lose sleep due to the ups and downs in the value of said investment is not a good fit for that investor. Or if a particular investment will significantly shift the overall risk of a portfolio, it’s not a good fit.

(Is your portfolio out of whack? Understand the why of rebalancing)

For some people, there may be room in their portfolio for an investment in a highly illiquid, speculative holding (like a cryptocurrency). For others, there simply isn’t.

Other questions to consider:

How liquid is this holding? (Can I easily sell it and get out?)

What are the costs of holding, buying and selling this holding?

When exploring a speculative purchase, can I afford to lose all of the money I have invested in it?

Is there future regulation on the horizon that might drastically reduce the appeal of this holding?

Does this holding align with my values around environmental, social and/or governance issues?

Am I primarily motivated to buy this holding by the “fear of missing out?”

How would increased regulation affect my holdings value? Is increased regulation likely?

How might competing products (in this case, other cryptocurrencies such as etherium, zcash, ripple, etc.) affect demand?

It’s certainly an interesting time for cryptocurrencies. The blockchain could have far reaching effects on how money moves throughout an increasingly global economy. Whether Bitcoin makes for a good investment is hard to say. Understanding the risks involved in any investment or speculative purchase is extremely important. A CERTIFIED FINANCIAL PLANNER ® Practitioner can help you figure out how your decisions align with your values and fit into your overall financial plan.

Want to know more about cryptocurrencies and the technology that undergirds them?

If you like podcasts check out this great one from the1A.org (which replaced The Dianne Rehm Show on WAMU-NPR)

If you prefer the written word check out this helpful article from New York Magazine.

Knowledge is power. Do you want to better understand investing so you can make more informed decisions?  Start here:

What Is An Asset And How Can I Get One? (Part 1)

What Is An Asset And How Can I Get One? (Part 2 Hedge Funds, Private Equity, Real Estate) 

The How and Why of Rebalancing