Bitcoin: A mania or an investment opportunity of a lifetime?

bitcoin

30 Jan Bitcoin: A mania or an investment opportunity of a lifetime?

In the early 17th century, there was one commodity in high demand among the rich and the powerful in the Netherlands – tulips!

Rich people from Amsterdam paid the most exorbitant prices for rare tulips. According to one account (1), in the 1620s, a tulip connoisseur was offered 12,000 guilders, which was about the price of a decent townhouse in Amsterdam at the time, in exchange for ten bulbs of the extremely rare Semper Augustus – the most coveted tulip variety. He declined the offer and kept his tulips!

When word got out during the early 1630s, that tulip bulbs were being sold for ever-increasing prices, more and more speculators piled into the market. Tulips were being used as a form of currency. In fact, properties were sold for handfuls of bulbs. By the late 1630s, it was deemed to be ‘proof of bad taste in any man of fortune to be without a collection of them’. As people heard stories of acquaintances making unheard-of profits simply by buying and selling tulip bulbs, they decided to get in on the act – and prices skyrocketed.

Then suddenly, in February 1637, the tulip market collapsed without warning! This was because most speculators could no longer afford to buy even the cheapest bulbs. Demand disappeared, and flowers tumbled to a tenth of their former value. Many faced the prospect of financial catastrophe.

The Dutch tulip craze is one of the very first examples of financial mania and a cautionary tale for all investors today. You’ve probably heard about how many people are making money out of investing in Bitcoin. And like many of us, you may be tempted to get in on the action.

Bitcoin is one of the many digital currencies that have gained a lot of media attention in the past year. Traditional currencies like the Pound and Dollar rely on government backing, central bank regulation and a network of banks to hold deposits on our behalf. Bitcoin is based on a very different idea. There are no middlemen. No government backing. No central bank regulation. Instead, records are kept on multiple computer networks. The digital money is kept in a digital wallet on a website that stores and keeps track how the money is spent.

Stories abound on the internet of people who have apparently become overnight millionaires after investing in Bitcoin. So, is this an attractive investment opportunity for long-term investors? We don’t think so. And here’s why:

  • Firstly, one quality that separates investing from speculating is that investing backs established asset classes that are underpinned by long-term economic and commercial activities. When we invest in stocks, we’re investing in some of the most successful companies in the world, that generate earnings through their products and services. With bonds, we’re lending money to these companies and to governments, who generate revenue through tax receipts. Bitcoin, on the other hand, has no ‘earnings’ and isn’t based on any underlying economic activity. Its value is largely based on speculation and sentiment. It isn’t therefore an ‘investment’ in the traditional sense.
  • Secondly, we question the stability of Bitcoin as a viable currency. For a currency to be effective as a medium of exchange, its price must be stable over time. Imagine if you bought a pint of lager for £4 on Friday night, only to be told the next day that the same pint is worth £7? If the price of lager were to fluctuate like this daily, you simply wouldn’t know how much it would set you back until you got to the pub. Surely, your faith in the financial system would be shaken by this experience? Most people wouldn’t trust such a currency. The value of Bitcoin has fluctuated widely since it started. Just two years ago, it traded for around $390. By 16th of December 2017, one Bitcoin was worth a whopping $19,343! This is equivalent to a rise of 4,860%! But by the 21st January 2018, it had fallen back to $11,186, a nose dive of 42.17% (2). Don’t be fooled; it goes both ways – the value is volatile and can plummet as quickly as it goes up.
  • Finally, a central idea behind Bitcoin is that it’s held on an anonymous basis and its free from government regulation and control. This also makes it a very good tool for criminals. A recent study found that 55% of transactions using Bitcoin are to do with illegal activities, such as malware ransoms, drugs, arms and assassinations! It’s estimated that about $1billion of malware ransoms were paid in Bitcoin in 2016!

It’s impossible to predict what the future holds; Bitcoin (and other digital currencies) may end up as major currency and an asset class. We simply don’t know. But there’s a lot we can learn from history. Based on what we’ve seen so far, the Bitcoin frenzy has a lot of parallels with Tulipomania.

(1) Mike Dash (1999) Tulipomania: The Story of the World’s Most Coveted Flower and the Extraordinary Passions It Aroused

(2) Data taken from website: https://www.cryptocompare.com