Should you buy Bitcoin?

In my last video I told you about Bitcoin. What is it? Bitcoin is a relatively new thing called a cryptocurrency. Some people think that you can compare it to a traditional currency, or gold, while others describe it as a new asset class. Whatever it is, excitement about its potential for future adoption has lead to a rapid increase in price, which has a lot of people wondering if they should be buying in.

How Bitcoin is going to perform in the long-term is anyone’s guess. Without long-term data on Bitcoin, or any other cryptocurrency, it is not possible to make an evidence-based decision about investing in it.

Let’s look at Bitcoin from the perspective of it being a currency. Are currencies good investments? Traditional currencies do not have a positive expected return. In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that over the last 115 years, currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another.

Bitcoin has also drawn comparisons to gold. Unfortunately, that does not mean that you should buy bitcoin. The evidence for gold as an investment is not very good. Some people argue that gold is an inflation hedge, and that bitcoin could be the same. In a 2012 paper, Claude Erb and Campbell Harvey found that while gold has been an inflation hedge over the very, very long-term, “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

So if Bitcoin is a currency, it probably isn’t something that you want to invest in. The price volatility of currencies, and gold, does mean that while they do not have a positive expected return as a long-term asset, you may still be able to profit by trading them - buying low and selling high as the price fluctuates. Of course, the problem with trading currencies is that they are random and volatile, leading to extremely unreliable outcomes.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. Much like stocks and bonds currently serve public companies, Ludwin writes that cryptocurrencies are assets that serve decentralized applications. A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party.

While decentralization sounds like a good thing, there is a catch. By nature of being decentralized, decentralized applications are slower, more expensive, and less scalable. They also have worse user experience, and volatile and uncertain governance. When a service is completely decentralized, there is no customer service center. There is no help line. There is no way to get your bitcoin back if you lose it. In contrast, if you damage your US dollars in a fire, you can bring the scraps to the US government and they will try to identify the bills and reimburse you. That type of centralized service is lost with decentralization.

Ludwin explains that bitcoin isn’t best described as “Decentralized PayPal.” It does not compare to PayPal in terms of user experience or efficiency. It’s more honest to say it’s an extremely inefficient electronic payments network, but in exchange we get decentralization. The obvious question follows: who cares about decentralization enough to put up with a slow, inefficient, and inconvenient method of payments? The most obvious answer is people who want their transactions to remain anonymous and who do not want to be censored by, say, a government.

Based on Ludwin’s arguments for bitcoin as a separate asset class that serves a decentralized payments application, its value will be derived from the adoption of Bitcoin as a means of exchange. Buying bitcoin in hopes of benefitting from its widespread adoption, keeping in mind the very specific type of person that would value bitcoin enough to put up with its shortfalls, would be very speculative.

In an interview with Coin Telegraph, Eugene Fama, the father of modern finance, explained he believes that bitcoin only has value to the extent that people will accept it to settle payments. He explains that if people decide they don’t want to take it in transactions, it’s value is gone. When Fama’s interviewer tells him that bitcoin also derives value from its censorship resistance component, Fama says “I guess that for a drug dealer that has a lot more value. But otherwise, I don’t see the big value about that.” While Fama’s answer may seem flippant, it touches on the same point that both that Ludwin made - Bitcoin’s price depends on its adoption.

So why has bitcoin’s price seen such a sharp increase? It's safe to say that the future supply and demand of bitcoin are highly uncertain, but the expectations of future supply and demand are factored into the current price. Each time someone pays a little more to own a bitcoin, they are injecting their future expectations into the price. The recent rapid price increase is due to people’s expectations that bitcoin will be widely adopted in the future. The fact that the number of bitcoins can reach an upper limit is an often-used argument that bitcoin will retain its value over the long-term. That may be true in isolation, but the future supply of cryptocurrencies is a big unknown. New cryptocurrencies have emerged that attempt to improve on bitcoin's design, potentially reducing the demand for bitcoin as a payment system.

Bitcoin is either an inefficient currency in the early stages of adoption with plenty of disadvantages and one big advantage over traditional currencies, or its a new type of asset that serves a decentralized payments application. In either case, the long-term value of bitcoin will mainly be derived from from its adoption as a mainstream currency by the people who value decentralization enough to put up with all of the downsides.

There is no doubt that bitcoin is based on an exciting new technology with potentially widespread applications. Investing in bitcoin is a bet that this technology will meet or exceed the expectations that current market participants have for it. Just like I would be wary about investing in gold, an individual stock, or a specific currency, I would be very hesitant about buying bitcoin. And I’m not the only one thinking that way. Warren Buffett, one of the greatest investors in history, recently said "In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending,"

If you must buy bitcoin, keep in mind that its market capitalization is still less than 1/3rd of 1% of the global market capitalization of stocks. You might consider allocating bitcoin to your portfolio accordingly.