Bitcoin seems to be all that anyone’s talking about lately…I thought I’d share my thoughts about it, and how to approach something like Bitcoin when investing. (Now, I am not personally against Bitcoin in any way, I think many aspects of the technology are groundbreaking and will no doubt play a large role in the future of banking and financial technology. This post is strictly to explore cryptocurrency as an investment and I would welcome any information in the comments that would help me to learn and see anything I may be missing.)
Okay so, first thing I wanted to touch on is that Bitcoin is what’s called a non-productive asset. This is the most glaring problem with Bitcoin as an investor, and that is, it does not produce or generate anything of value, which leads to several issues. Say for example you bought a farm, a rental property, or a business, these are productive assets, they PRODUCE something over the course of their useful life, and that something is ultimately CASH. A farm produces crops which can be sold for cash, rental properties provide housing which produces cash flow to the owner through rent, a business produces products or services which provide value to customers who in turn use cash to pay for those good or services. The thing to remember here is cash flow is THE MOST IMPORTANT thing in investing. Because without it, we can’t know what to pay for an asset. Why is that important? Well because ultimately that is what investing is, paying cash today for an asset that will give you more cash over time then what you paid up front.
The thing to remember here is cash flow is THE MOST IMPORTANT thing in investing. Because without it, we can’t know what to pay for an asset.
Now let’s look at non-productive assets. Let’s look at gold for example, if you bought gold right at the beginning of human civilization, like when they were building the pyramids and calculated the return, the compound rate would be in the tenth’s of a percent. And at the end of your investment time horizon all you would have, is that same amount of gold as when you started. Whereas with something like a business, if it was productive, you would now own something substantially larger which would have grown through the power of compounding. And if you owned something like a rental property or a farm, you could have reinvested the cash flow into other properties, and ended up with many more properties than when you started.
2. Non-productive assets are virtually impossible to value. The first question you need to ask yourself when investing in something is “Can you understand it?” Do you know the market for the asset you’re investing in? For example, what sort of rent can I get for the rental property? How much cash will this business put back into my pocket? How much yield will I get per acre from my farm? The answers to these questions will tell you what you should pay for the asset and what sort of return you can expect. With Bitcoin, and other non-productive assets, it’s impossible to do this. Because Bitcoin doesn’t yield anything, you can’t know if the price you’re paying is a good price, and what sort of return you can expect. It’s impossible. This means you need someone to buy it from you, who’s more excited about it than you, and who thinks they’ll have someone else come along to buy from them and so on…This is a serious problem, because what happens when the pool of people who are buying it because they want to sell it to someone else, stops growing?
Think about it, what if, when you are buying your rental property, and say the seller is asking $100,000, but you have no idea about what rent could be, how do you know if $100,000 is a good amount to pay? If the rent is $10,000 a year, then a 10% return to start could be a good investment, but if the rent is only $1,000? well now it’s a different story. See how important it is to know the cashflow number?
“If you’re at the card table, and you don’t know who the sucker is, it’s probably you…”
As investors we want to stack up wins, this is how compounding can really work its magic. Losses kill our overall return. It’s far better to have 10 years of say 15% returns, instead of 9 years of 20% returns and the 10th years take a huge loss. Warren Buffett’s first rule of investing is to not lose money, and it should be the same for us. Check out the example below of the power of stacking up wins!
History is riddled with examples of non productive assets that made a few rich because they were early, and made many more poor because they were late.
Back in the 1920’s, there was a phenomenon called the “Florida Land Boom” where people got into this crazed frenzy about land in Florida. The prices kept going up and up and no one really knew why. It led to lots of crazy decisions being made like builders overbuilding, homeowners wildly over extending themselves, and all the newspapers jumped in as well, adding fuel to the greed. This left many people bankrupt, whole communities virtually abandoned, and also left a few people very wealthy. However, it mostly left lots of people much poorer because of the rampant speculation and not having any real value underlying their investments, (a.k.a. cashflow.) I see a lot of the same parallels with Bitcoin and other cryptocurrencies. In a lot of ways, it all sounds very familiar.
3. Government Oversight And Other Regulation:
A lot of people think Bitcoin is untouchable, and that governments can’t regulate it, and it’s basically this wild untameable thing. I would urge caution in taking this approach, because when we look at history for parallel examples, one sticks out in particular. In 1933, US President Theodore Roosevelt signed into law something called “Executive Order 6102.” This outlawed private citizens from owning physical gold. The government’s reasoning for the order was that the hard times of the Great Depression had caused hoarding of gold, stalling economic growth and making the depression worse.
So I share this not because of the exact reasoning behind the banning, but because if the governments of the world decide Bitcoin is somehow a threat, they can easily outlaw it and cause a lot of harm to anyone involved. Other regulation to think about before investing are legal hurdles cryptocurrencies need to overcome, social acceptance hurdles, and safety and technology hurdles. It seems there is a news story every other week about hacking and Bitcoin.
So I say all this to help you be aware of some of the things to think about when investing in non-productive assets like these. Now saying all this, it doesn’t mean you can’t make money with Bitcoin. This leads to my last point…
How to make money with Bitcoin:
Bitcoin’s volatility, which most people can’t stomach, can be a huge advantage for traders. But you must understand, trading is not a passive activity, and is most definitely not the right fit for everyone. I personally trade as part of my overall portfolio, but I mostly trade options, which I’ll get into in another post.
But, as a small percentage of your overall portfolio, if you have the time, knowledge and a certain temperament and interest that not everyone has, volatility is most definitely the friend of the trader. If you know what you’re doing, you can do very well. But that’s not what I find fits my temperament the best, I get much more excited about options because that’s where I find I have an ‘edge’, and having an edge is key when trading.
So, to recap, 1. Bitcoin is a non-productive asset, which poses many issues to the long term investor. 2. Non-productive assets are all but impossible to value, this is dangerous because we need cashflow to tell us what to pay. And 3. Risks from government oversight and regulation. You can make money through trading, but know yourself and what you can handle.