By Brad Thomason, CPA
This article was first posted to our sister-site, NoStockPortfolio.com, toward the end of 2017. For all of our older blogs (2015 to 2017) and a world of information about Alternative Investments, please give it a look. Thanks.
Since everyone else is talking about Bitcoin, I thought that maybe I should chime in, too. I’m not going to tell you if it’s a good thing or a bad thing, nor am I going to tell you where the price is headed. There are already enough people talking about those things. Which is itself sort of interesting since value judgments and speculative predictions are both opinion-based, and offer little in the way of fact. So for a change of pace, here are a couple of facts that you may not see mentioned in too many other places.
First fact: Bitcoin trades on an exchange. Which is not likely news to you, but the significance of that fact might not be as obvious as the fact itself. Anytime an asset trades on an exchange, whether it’s shares of XYZ Corp or a barrel of oil, there are certain universal factors which WILL affect its price movements, no matter what it is. That’s because exchanges act as a sort of Supply and Demand engine, where reliable patterns of human behavior repeat themselves over and over again, sometimes in very rapidly-moving cycles. Exchange-traded assets can change price quickly, both in the upward direction and the downward direction. This can happen even if the ownership of the asset is wide, and the number of persons trading is low: the market price is set by those who show up and act, not those who sit on the sidelines and hold.
So volatility is always on offer, and even expected when there’s a period of time in which market participants have competing views about actual value. These opinions play out in all markets. But the rapidity with which they can play out on an exchange market is such that the possibility becomes its own emergent characteristic, and something that thoughtful persons must consider if thorough analysis is the goal.
Second fact: The underlying value of Bitcoin is essentially impossible to assess at this point in history. Let me explain what I mean by way of comparison. If the price of oil starts to move a lot, market watchers develop a sense of whether or not it’s over-valued or under-valued by considering a couple of different things. First, they look at what one could do with a barrel of oil. What could it be made into, or how much power would it provide if converted to one or more types of fuel? Second, they consider the current price within the context of past prices. How does oil today stack up against the historic price ranges for oil?
You can’t do either one of those exercises with Bitcoin. Since it’s a currency, you can’t do the sort of utility studies you can with a physical commodity. And since it’s new, there’s no history to go check it against. As an academic matter, valuation of Bitcoin is a very interesting problem. We all would like to know what a Bitcoin is actually worth, but the primary tricks we use to answer that question when other assets are involved, aren’t available to us right now.
Which doesn’t mean that it’s worth nothing, by the way. Don’t confuse a measurement problem with a statement about reality. It took mathematicians hundreds of years to figure out how different celestial objects affected each others’ gravity fields. But the sustained head scratching from one generation of smart persons to the next had no effect on those stars and planets actually being up there in the heavens. Just because we don’t have a real good way to know what Bitcoin is worth at the level of intrinsic value, doesn’t mean that the value doesn’t exist.
The thing that makes a currency have any value at all is a tacit agreement among market participants that it does indeed have a value, signaled by their willingness to use it as a medium of exchange. This is the thing which the gold standard guys have never understood. Enough people agree that Bitcoin has value, so therefore, it does. That the agreement is not a physical thing does not make it any less real. This is an important point to understand, because while it does not protect Bitcoin from being subject to the pricing dynamics which can bear upon all exchange-traded assets, it probably does mean that it isn’t going away. At least not anytime soon.
Where the value of Bitcoin eventually settles is likely to play out over the next several months. Normally, volatility is somewhat reciprocal: that which moves up quickly often corrects quickly. Though it doesn’t have to, nor right away. Still, if we played out this scenario 100 times, we’d expect to see some significant price drops at least 51 times, based on the rate at which the prices have come up in the past few months. Maybe more than 51 times.
Whether or not to invest in Bitcoin would at this point have to be considered an opinion-based question. As I said at the beginning, that’s not my purpose here. Instead I would retreat to what is often my purpose in writing these posts: a reminder that if you are going to get involved with anything, a better understanding of what the thing is, is never a bad idea.
So while you consider the viewpoints of the various talking heads on this topic, take some time to think about the structural features mentioned here, and what they may imply about proper expectations for Bitcoin’s future and how or if that will have any impact on you.
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