Should You Invest in Bitcoin?

Financial Planning | Investment Strategy

 Peter Lazaroff By: Peter Lazaroff

The frenzy around cryptocurrencies only goes up by the day. All the excitement drives everyone from experienced professionals to average investors to wonder: what should you do with Bitcoin?

If you’re one of those people asking that question (and many others around cryptocurrencies), this article might help.

That being said, this article should not be construed as either an endorsement or a rejection of cryptocurrency. There are also some important points we need to be very clear on before we dive into the details.

First, investing in cryptocurrencies or tokens is highly speculative and the market is largely unregulated. Anyone considering it should be prepared to lose their entire investment.

Second, Bitcoin and other cryptocurrencies use blockchain technology. I mention this early on because the merits of cryptocurrencies and the merits of blockchain technology are two totally different conversations. In this article, I’m only focusing on the cryptocurrency conversation.

Third, I’m not going to explain how either cryptocurrency or blockchain technology work. To responsibly explain these things would require an article that is four or five times longer than most readers are willing to tolerate – and that wouldn’t even leave me room to answer the most important question: should you invest in Bitcoin or any other cryptocurrency?

Required Reading for Bitcoin Education

There is a list of resources that, in aggregate, can provide you with a good understanding of cryptocurrencies and blockchain technology. I usually try not to discuss cryptocurrencies or blockchain technology with people who haven’t done this minimum level of reading.

I’ve included these resources throughout the post (so keep reading for links). You’ll also find the complete list of recommended resources to start learning about Bitcoin and blockchain technology at the bottom of this article.

It’s important to note that even if you read these resources, you won’t know for sure what will happen to Bitcoin the future. After spending months familiarizing myself with cryptocurrency and blockchain technology, I myself have no idea what the future holds for either. It’s too early to know.

This is partly because market predictions are hard, but also because the future value of cryptocurrencies depend on the adoption of their underlying applications and how society adapts to these trends.

For example, when public commercial use of the Internet began in 1989, I doubt anyone expected that we would all be carrying around a pocket-sized computer with internet access. Betting on the Internet in 1989 wasn’t straight forward because the winning companies and products didn’t even exist yet.

I’m not calling blockchain technology the next Internet, but identifying the winners of blockchain technology is as challenging today as declaring the winners of the Internet in 1989.

My Personal History with Cryptocurrency and Blockchain

I would never claim to be an expert on cryptocurrencies, so here is a little bit about my background within this realm:

My first experience with Bitcoin was in 2010, when a new client showed me his Bitcoin balance on his phone. I immediately did a Google search on Bitcoin to learn more and downloaded this paper from Satoshi Nakamoto, the creator of Bitcoin.

(If you want to have a serious discussion about Bitcoin, it can’t be done without reading this paper.)

I didn’t fully understand what I was reading, so I turned to more standard internet articles and decided to dismiss Bitcoin as a fad.

Even if it wasn’t, I viewed it simply as a “currency” at the time. Successful currency investing is next to impossible with a very poor risk-vs-reward profile. I’ve since evolved my position and now dislike referring to Bitcoin as a currency, but more on that in a moment.

Fast-forward to May 2017 when I attended a presentation on blockchain technology at the CFA Institute Annual Conference.

The presentation absolutely blew my mind and led me to read more about the technology as well as the ways in which governments, corporations, and financial institutions are working to incorporate the technology. This also sparked a renewed interest in Bitcoin and cryptocurrency in general.

The other cryptocurrency that stuck out to me as I learned more was Ethereum. This paper on Ethereum is the equivalent of Nakamoto’s paper for Bitcoin, and is another piece of required reading to have an intelligent conversation about cryptocurrency.

Bitcoin Is Not a Simple Conversation Topic

As I understood more about cryptocurrencies, I wanted to share this information in the context of my expertise as a financial advisor. Throughout the summer, I made multiple attempts to write an article on cryptocurrencies, but had a hard time keeping it to the 600 words that most people will tolerate and actually read. (For reference, the article to this point has been 769 words).

One of the things that made simplifying this topic a challenge was the many ways people define Bitcoin. It’s common to hear Bitcoin referred to as a “currency” in the traditional sense or a “store of value” like digital gold, but those definitions are too restrictive to the conversation.

The definition of cryptocurrencies is somewhat subjective, but a clear definition of cryptocurrency is crucial to debating its merits. For that reason, I’m going to say that cryptocurrencies are assets that exist to serve decentralized applications – a view that is expressed in this “required reading” article from Adam Ludwin.

Further complicating the discussion of cryptocurrencies is the insane number of coins that exist. There are well over 1,300 different cryptocurrencies available today. The two that interest me the most are Bitcoin and Ethereum, which both have entirely different purposes.

I believe the best resource for understanding these differences (as well as a host of other blockchain and cryptocurrency issues) is a podcast series called Hash Power. It’s another piece of required content to consume if you want to educate yourself on cryptocurrency.

Initially, the series was just three episodes (all require a listen). Recently, host Patrick O’Shaughnessy released additional episodes as “singles” that are also worthwhile.

Is Bitcoin a Bubble?

I have no idea if Bitcoin is in a bubble or not. It will be really easy to say in hindsight, but it also depends on your definition of the word “bubble.”

Part of what makes something a bubble is that it isn’t easily identified. In my opinion, calling Bitcoin a bubble is too mainstream for the asset to actually be in one.

I like the way Cliff Asness defines a bubble: “The term should indicate a price that no reasonable future outcome can justify.”

In this case, there’s some probability that the masses adopt decentralized applications, and the impact on the value on crypto assets would be enormous. I have no idea what that probability should be, but I like the way Jason Zweig recently framed an investment in Bitcoin in terms of Pascal’s Wager: it’s either going to be worth a ton or nothing at all.

Another reason I hesitate to call Bitcoin a bubble is that bubbles tend to wreak havoc on the broader market or economy. For example, the dot-com bubble reduced household wealth by $6.2 trillion. The housing bubble cut way more than $8 trillion. (Both stats come from Morgan Housel.)

As of today, Bitcoin is worth $278 billion. In addition, 40% of the entire market is owned by just 1,000 people. If Bitcoin goes to zero, I don’t think that sends shockwaves through capital markets or the economy the way we would expect from a true bubble bursting.

In short, I’m more comfortable saying that Bitcoin is an incredibly volatile asset. A highly volatile asset like Bitcoin is susceptible to substantial losses. Bitcoin prices have already crashed at least 85% on three separate occasions. Whether we call it a bubble or not doesn’t really matter.

Should You Invest in Bitcoin?

As I said at the opening of a brief live interview last week, the best part about having a financial plan in place is that nowhere does my plan say I need to buy Bitcoin or any other cryptocurrency to meet all of my goals.

Your financial plan should likely be set up the same way: free from the requirement to invest in any asset that must go bonkers in order for you to create the wealth you need to reach your goals.

Behavioral finance helps explain some of our natural human biases that were once useful from an evolutionary perspective. But in today’s world, those same biases systematically lead to poor decision-making when it comes to our finances.

To me, watching Bitcoin’s price action has been like having a front row ticket to a massive human behavior experiment. At this very moment, I’m seeing a lot of fear of missing out (FOMO).

Living in the information age, it is easier than ever to see and hear what the rest of the world is experiencing. I’ve seen estimates that cryptocurrencies have created at least 10,000 millionaires in 2017 alone.

By that measure, it is minting more millionaires than the Facebook or Google IPOs. Add in the fact that people love get-rich-quick ideas and you have a recipe for silliness.

The most common reason people are inquiring about Bitcoin or other cryptocurrencies today is the rise in price. Here’s the thing: buying something because it has gone up in price is a poor investment thesis.

Developing a Good Process for Investment Decisions

I always joke that people spend more time researching the purchase of a kitchen appliance or car than they do their investments. If you are jumping into Bitcoin, Ethereum, Litecoin, Dash, Zcash, etc. without having done your homework, then you are not investing. You are gambling.

If you’re still thinking about investing in Bitcoin but haven’t yet read the resources I’ve shared with you here, stop. Go use this content. It’s critical if you want to make an informed decision with your investments.

It’s not completely impossible to perform some analysis on cryptocurrencies serving a decentralized application, but it requires a great deal of imagination and intimate understanding of technology (which is not just reading a lot of tech articles and being an early adopter of Apple products).

I write down the reasoning behind all of my investment decisions, which forces me to think carefully and clearly define my beliefs about a particular asset. It also keeps me honest in the future about my abilities as a predictor of the future.

Without performing this exercise, you are highly susceptible to hindsight bias.

If you get through the required content and still want to invest in cryptocurrency, here are some questions you should write down answers to:

  1. What are you trying to accomplish with your investment?
  2. What is your time horizon?
  3. How does this fit into your financial plan?
  4. What is your thesis for making an investment? How will you determine if you are right or wrong? Can you tolerate severe losses in the process (remember, Bitcoin has already fallen at least 85% on three separate occasions)?
  5. What are your expected range of outcomes and what probability would you assign to each scenario?
  6. How will your investment change your life in bullish scenario?
  7. How will this change your life if this investment goes to zero?

I can’t tell you with certainty, one way or the other, if you should invest in Bitcoin or any other cryptocurrencies. But using the resources listed below and going through these questions will position you to make a more informed decision.

When I think about adding an investment to my portfolio, I’m more concerned with implementing a bad idea than missing out on a good one. And as I said earlier, I have a thoughtfully crafted financial plan that has no mention of needing to buy cryptocurrencies in hope of earning 10x or 100x returns. For these reasons, I’m unlikely to own Bitcoin myself.

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice.  All investing involves risk. Past performance is no guarantee of future results.  Diversification does not ensure a profit or guarantee against a loss.  You should consult your own tax, legal and accounting advisors.

Related Posts

Peter Lazaroff, Chief Investment Officer, first took an interest in investing when his grandmother gave him a single share of Nike stock for his 13th birthday. Today, nearly 20 years later, his investment insights are highly sought after by local and national media. More »