By now, most investors have heard of Bitcoins, a virtual currency that is “minted” by computers. According to recent reports, there are about 11 million Bitcoins in circulation worth roughly $140 apiece at current valuations.
Of course, those valuations are subject to change. A Bitcoin was worth around $30 a month ago … and if you believe the critics, it could be worth that again very soon. Maybe less.
So what’s the score? Should you dabble in this 21st-century currency, either for profits or for a hedge? Or should you steer clear until the inevitable bubble bursts?
My two Bitcoins of advice: Avoid this false asset class like the plague. Virtual currency generally has a poor track record, and Bitcoin investments in particular seem to be the playground of opportunists and speculators.
A Bitcoin Primer
It’s hard for some people to understand Bitcoins, because you can’t touch one. Bitcoins are actually encrypted files that are transferred securely between computers or smartphones. There are no physical coins.
Odd, right? Well, welcome to the 21st century.
The best rundown of what a Bitcoin is comes from Brad Plumer at The Washington Post. He writes the following five-sentence summary:
Bitcoins are a virtual currency in which new coins are created by a slow, complex computer process known as “mining.” Once a person acquires a Bitcoin, he or she can trade it online to anyone who will accept it as payment for goods or services. Right now, a single Bitcoin is worth about $140 in U.S. dollars, though that value fluctuates. There are 11 million Bitcoins now in existence, and once 22 million have been created, all mining will effectively cease. The currency isn’t regulated by any central bank.
Here’s also a helpful 1:30 video from Now This News.
Perhaps the most important point in all of this is that most people are not using Bitcoins for actual transactions at this moment. They are buying the digital currency because it’s rising in value and they are hoping to make some money.
And many people have indeed made money. Check this chart:
What gives? Well, the supply is inflexible. As the story does, the brains behind Bitcoin have planned a hard cap of 22 million on the number of Bitcoins that will ever be in circulation. This makes the idea thrilling to central bank opponents who decry quantitative easing, currency devaluation and the like. How can bitcoin do anything but retain value without someone like Helicopter Ben mucking it up?
Of course, central bank supporters will point out that inflexible currencies have their own particular brand of trouble … including the massive volatility that has characterized bitcoin as of late, making Bitcoins purely speculative and hardly a practical currency for goods and services.
While U.S. Treasury officials are watching closely, there is nothing illegal about Bitcoin. Bitcoins are considered “virtual currency” that is shared digitally. But more than 1,000 merchants in the real world have begun to accept the currency, including dentists, bars and even a political candidate accepting Bitcoin donations. That could change the game as Bitcoin increasingly moves into the real world.
Big Risks of Bitcoin
So is buying some Bitcoin a good idea?
For spending, clearly not. It’s just not practical as an alternative currency for 99.9% of transactions.
Furthermore, the parabolic rise in prices affects the amount of transactions being made. Why spend a Bitcoin worth $50 today when it’ll be worth $100 in a few weeks? Why not just hoard it and never spend? That behavior coupled with a small supply means that the currency properties of Bitcoins are severely limited.
So if not a true currency, what about Bitcoins as a speculative investment?
Some equate Bitcoin to gold. The world has a limited supply of gold, and it is slowly extracting that supply from the ground. Theoretically gold can be used as an alternative currency and is seen by some as a favorable alternative to fiat currency like the U.S. dollar.
Volatility in the gold market, like the Bitcoin market, is common thanks in part to these underlying characteristics. But the portability of Bitcoins and the ease of transactions without a middle man make many see it as a very favorable alternative to gold.
Unfortunately, gold has a long global history as a cultural touchstone. It also has a diverse and broad network of buyers and sellers, and no viable alternative that can pop up.
There’s also the added bonus that gold is gold – you can touch it and prove you have it. Not so with Bitcoin.
Consider this recent hack of Instawallet, a Bitcoin site that has halted operations due to concerns about fraud.
And of course, don’t forget the above chart. As Felix Salmon writes, any chart like this “is bound to end in tears at some point.” That kind of parabolic run is never sustainable.
My advice: Don’t buy a top in Bitcoin right now. It’s simply too hot and too fashionable a trade — whatever the underlying reasons are.
Will Bitcoin Last?
I’m not a big fan of Bitcoins. But I understand why it’s around, and think it may actually last.
Some decry Bitcoins as “an obscure digital currency — used mostly for running drugs and laundering money for dictators.” But that’s a low blow. After all, Virginia has toyed with creating its own currency because there are enough hard-money advocates out there.
It doesn’t matter if you or I disagree with them. I strongly disagree with Ron Paul and the “end the Fed” crowd, but that doesn’t mean his books won’t sell or that he can’t garner a wide following among people who agree with him.
My problem with Bitcoin right now is that the currency is like a collectible that has branched out from a small, loyal group and into a mainstream moment. Think Beanie Babies, which were avidly collected by thousands of diehards. At their peak, some hard-to-get dolls sold for $50 or $100 or even more. That frenzy led to speculators and profit-hunting.
Now you can buy them at a thrift store for less than a buck.
Surely there were folks who simply liked Beanie Babies, and surely there are still some who collect them or just cuddle with them in 2013. But as an “asset class?” Well, Beanie Babies had their moment. And that moment passed.
As one commentator puts it, Bitcoin is the “Harlem Shake of currency.” In a matter of time the fad will fade and it will be just another quirky pop culture moment for trivia games.
The value of Bitcoin will inevitably crash and burn. The chinks in the armor have already started to appear. But there will always be a small and loyal group that will believe in the product.
Just don’t expect to see people at the grocery store using Bitcoins … any sooner than you’d expect to see them paying for beans with Beanie Babies.
- Felix Salmon has a nice piece worth reading on “The Bitcoin Bubble and the Future of Currency.” (Medium)
- And a rebuttal from a Bitcoin fan who thinks Felix is being unfair. (Unqualified Reservations)
- Check out a small list of merchants who take Bitcoin as currency here. (BitPay)
- Talk about Bitcoin regulation by the Treasury. (New Scientist)
- Why Bitcoin is legal. (Extreme Tech)
- Get updates on Bitcoin pricing here. (Bitcoincharts.com)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP.