There’s no question that 2017 was the year of the bitcoin. In just 12 months, the digital currency rose from under $1,000 in price to nearly $20,000. Before its meteoric rise in value that year, most people had never heard of the digital currency and probably thought it was a gaming app you could download on a smartphone.
Now, however, it seems everyone is talking about bitcoin. You hear stories of people who threw away a hard drive years ago containing bitcoins, when the cryptocurrency was almost worthless. At one point last year, that junked-out hard drive would have been worth millions. Conversely, though, the currency had a dicult first quarter in 2018, falling 48 percent in value.
Just what is bitcoin? Bitcoin is an electronic currency. Without getting too far into the technical aspects, a bitcoin is created by a computer (or a bank of computers) completing an extremely complex algorithm in a process called “bitcoin mining.” The number of bitcoins that are created depends on how quickly the computer can complete this process — it is lengthy and takes a lot of computer processing power. Bitcoin mining is being done around the clock by people all over the world, and you could even do it yourself if you were so inclined — although there is a lot of technical know-how involved.
What makes bitcoin a unique currency is that it is decentralized and completely digital. There are no physical coins. There’s no central bank like the Federal Reserve or administrator like a commercial bank that controls how many bitcoins are created; no one is backing them up with gold or something of actual value. In fact, there’s no guarantee that the bitcoin you just bought or produced holds any value at all. The value is arbitrary, and it can change in the blink of an eye — which it does, constantly.
“You can’t value bitcoin because it’s not a value-producing asset.” — Warren Buffett
Emotional Decision Making
Certainly, bitcoin has gained a lot of popularity recently with its astronomical rise (and fall) in value. What has fueled this fame? Analysts could probably write master’s level theses on that question, so we won’t really get into that here.
But this is what we think: People become emotionally driven in their decision making. Many thought bitcoins would make them rich, and they didn’t even understand what they were buying. When this kind of thinking happens, we start to get into bubble territory, where prices are moving upward not for fundamental reasons but for emotional reasons.
And at some point, the fundamentals return.
So, if you want to try to make money in these bubbles, it’s a bit like musical chairs. You might hop in, ride the wave for a little bit and then get out before the music stops. But this isn’t being an investor — this is being a speculator.
And sometimes speculating is OK. But you must understand what you’re putting your money into, and you must be willing to lose all of the money that you put in. In the same vein, you also must be ready to potentially miss out on a lot of money. For example, you may have decided to pull out of bitcoin a week before it doubled in value. You just missed out on a lot of potential money because you sold too early. It can be nerve-wracking.
Importance of Fundamentals
Let’s take our bitcoin example and compare it with investing in an actual company — a tried-and-true company like Coca-Cola. This is a company that’s been around for a long time and makes products that people consume on a regular basis — soft drinks, bottled water, fitness drinks, etc.
Coca-Cola is more than 125 years old. The people who run the company bring in real revenue, they operate their business effectively, and most of the time, they generate a profit. They’ve been doing this for a while; they know the drill.
When you buy stock in Coca-Cola, you know what you’re getting into. You’re making a fundamental decision that is based on a lot of information. You’re coming into it with a certain degree of confidence that the company will do what it says it will do. Of course, there are no guarantees, but this is a fundamental investment that is based on logic, research, and high-quality information.
When it comes to bitcoin, it’s nearly impossible — no, it’s actually impossible — to get the same level of confidence as you would when investing in a company like Coca-Cola.
In other words, as an investor, you need to be careful. You are going to see many opportunities like bitcoin. Maybe it’s a “no-lose” business opportunity your brother-in-law is pitching to you; maybe it’s a penny stock tip you got at work hanging out by the water cooler; maybe it’s something you heard on a late-night infomercial. But remember, don’t get so emotionally sucked in that you become blind to the fundamentals. Know what you’re looking at. You should be saying to yourself, “Can I make a good decision to buy this based on sound information?”
Warren Buffett once said, “The market is there to serve you and not instruct you.” What he meant is that a smart investor doesn’t look at a price — say, for example, $11,000 for one bitcoin — and say, “Well, that must be what it’s worth.” He looks at what the actual value is according to his own fundamental research.
If he knows that the value of a bitcoin is $1,000, he will never buy it at $11,000 because it’s overpriced. He believes it will eventually fall to its real value of $1,000. At the same time, if he knows the value of a bitcoin is $30,000, he will buy a ton of them at $11,000 because he is confident that it will continue to rise in price, and then he can sell them at a profit.
But that is probably why a guy like Warren Buffett — an investor, not a speculator — has gone on record saying he doesn’t own bitcoins. He says he can’t determine what the value of a bitcoin truly is — it’s all speculation. If Buffett can’t determine the value, he doesn’t invest. He has to know the value of the investment before he invests, and if he can’t, he’s going to stay away. There are plenty of other more logical and predictable investments to consider.
So just be careful. If you feel as if you have a handle on things and you have some money to lose, speculation can be fine now and then — just as going to a casino might be fun every once in a while. But if it starts to consume you and you’re spending money that you can’t afford to lose, then it is becoming a problem. And that’s what speculation ultimately is — it’s glorified gambling.
Don’t get sucked in. Make sure you’re sticking with the fundamentals of investing before you start going out on a limb. Slow and steady is the way to financial freedom.
Be an investor. Don’t be a speculator.