Why Holding Bitcoin is Pure Speculation

The surging price of bitcoin grabs a lot of attention. But it also raises questions about the nature of money and currency. What gives a currency its value?

The Elements of Money and Currency

Money is a medium of exchange. In a way, money is fiction; everything depends on people believing in its value. If enough people agree, anything can potentially be used as money—people have been known to use seashells, salt, grain, and even giant stone disks. Each of these options have drawbacks, of course. Seashells can weather and break. Grain can rot. Giant stone disks are hard to tote around in your pocket. Coins and paper money help solve these problems.

Currency is any widely-circulating form of money. The dollar, pound, and yen are state currencies. Gold is often considered a currency. Bitcoin, ripple, ethereum, and other alt-coins could also be considered currencies. You can exchange modern currencies in physical form, as you do with cash, or in electronic form, via credit cards, payment apps, or cryptocurrencies.

But what constitutes a useful currency? What attributes do we want for the currency we use every day? First and foremost, you need general acceptance. People must agree to accept the currency as payment. This agreement can come through legal means (when the government declares it legal tender), or through organic means (when people decide on their own, like with bitcoin).

Second, you want price stability. You need a reasonable sense of what your money will buy tomorrow, next month, and next year.

If you have hyperinflation, you have no faith in your currency’s purchasing power. Your incentive is to spend or exchange your currency as fast as possible. Many emerging countries (Yugoslavia, North Korea, Zimbabwe) have experienced currency hyperinflation.

If you have deflation, everyone’s incentive is to hoard the currency. If there is no incentive to spend or invest, economic growth stalls. Along with the Great Depression, the United States saw several deflationary periods in the 19th century such as the panics of 1837 and 1873.

A Real-World Experiment

I recall an interesting story that helps illustrate the difference between useful and ineffective currencies. The podcast Planet Money did an episode called Libertarian Summer Camp about a festival for government skeptics. For a few days, festival-goers were completely self-sufficient—they sold food and beer without licenses, traded goods, and discussed abolishing the IRS. They also engaged in a small-scale economic experiment, conducting daily business using silver and gold instead of the U.S. dollar.

It was clear that as everyday currencies, precious metals have some drawbacks. First, it’s hard to pay in small increments. If you want an omelet for breakfast, you need to measure out little shavings of silver. You need to carry around a scale, and unless you trust everyone you’re doing business with, you may have to test each bit of metal for purity. Paper money and electronic payments like credit cards and cryptocurrencies solve this physical problem.

But there’s another big drawback—the prices are volatile. This month, an omelet might cost 0.22oz of silver, but next month, it could be 30% more. Today it’s one price, but tomorrow, who knows? So how did the libertarians solve the volatility problem? They used their smartphones to look up the price of silver (in dollars, of course).

This is a silly anecdote, but the point is that price stability is extremely important for a useful currency. Because precious metals don’t have price stability, people need a stable reference currency (like USD) to decide what to pay. Not knowing what your money will buy tomorrow is not a good quality in a currency.

Mechanism for Price Stability

For decades, the U.S. dollar has exhibited strong price stability compared to other currencies. If you hold dollars, you aren’t worried about day-to-day volatility in your purchasing power. If you save money for a car, you have faith you’ll be able to afford it when it comes time to buy. You aren’t worried the car will cost $15,000 today, $20,000 tomorrow, and $5,000 a few weeks later.

The dollar’s price stability is aided by the central bank through monetary policy. To combat inflation, the Fed decreases the money supply. To combat deflation, the Fed increases it.

With gold, silver, and bitcoin, there is no central bank. If you distrust the government, the lack of a central bank may be a selling-point. But it doesn’t do much for price stability. If you own ten bitcoins or a pound of gold, what can you expect to buy with them next year? What about tomorrow? The lack of a mechanism for price stability is a major disadvantage. Without price stability, gold and Bitcoin are not effective as modern currencies.

Bitcoin and Source of Value

Bitcoin has no intrinsic value. You can’t eat it, use it to build things, or even look at it. It’s a virtual currency that exists in a virtual space—a decentralized ledger called blockchain. Its price is determined entirely by the market, and there is no government or central bank that can influence it. If people want to exchange bitcoin for $10 each, they can. If they exchange it for $1M each, so be it.

Blockchain, the distributed database bitcoin uses, is a useful payment system. It is anonymous, secure, and fast. To use blockchain for payments, you can convert dollars to bitcoin. The seller can instantly convert it back. Payment companies like Coinbase and Stripe already do this. There is no need to hold the bitcoin for more than a few seconds, so you can avoid the volatility risk.

Coinbase promotes avoiding bitcoin volatility.

Many people confuse bitcoin (the currency) with blockchain (the database). Because blockchain is a great payment system, people say, bitcoin must be valuable. But what imbues bitcoin with a specific value? Why should we assume $10, $100, or $1M is “correct”?

Some people claim it’s supply and demand—because bitcoin has a finite supply, the price of bitcoin will simply increase with demand. But if we can use bitcoin for payments without holding it for more than an instant, where is the stable source of demand? Demand comes from people wanting to hold bitcoin, not just use it for payments.

Another concern is the growing number of “altcoins.” Here is a list of the top 100 cryptocurrencies, by market cap. The higher the market price of bitcoin goes, the greater the incentive to create and trade alternatives.

Why Hold Bitcoin Long Term?

For months, I’ve been asking cryptocurrency fans for answers to this question. What are the benefits of holding bitcoin, besides speculation? I hear plenty of good reasons for the merits of blockchain, but never the merits of bitcoin as a currency. As far as I can tell, the only reason to hold bitcoin for any length of time is the belief that its price will rise.

This is absolutely fine, if you want to speculate. If you think bitcoin will trade for $1M in five years, it might make sense to own some. But I wouldn’t bet the farm. It’s an asset with no intrinsic value, no physical form, and no mechanism for price stability. Blockchain gets well-deserved hype, but this does not mean Bitcoin has any predictable value. Maybe bitcoin will trade for $1M someday, but not for any reason other than human behavior.


Postscript

My inspiration for writing this piece was a concerning post last week from someone I’ve known a long time:

Late May Links

I’m working on a piece about Bitcoin, money, and the necessary qualities of an effective currency. But for now, here are some gems from the past few weeks:

Josh Brown on the inanity of cheering on a crash (“throwing spaghetti against the wall”).

Why Monish Pabrai regrets selling Ferrari.

Shane Parrish on seeking out disconfirming evidence.

Ben Carlson on barriers to entry in the investment business.

Robert St. George on information intensity in equity investing.

Karl Popper’s Skepticism

Karl Popper’s contributions to the philosophy of science and economics were invaluable. His way of thinking can also be useful for investors.

If an investment thesis relies on inductive reasoning, it may be a good probabilistic guess, but be skeptical. For example, consider a prediction like “Every time the economy does X, Y happens the following year. X just happened, therefore will happen this year.”

Why might this relationship not hold true in the future? Could this be a case of correlation, not causation? Consider the logic and assess probabilities, but don’t be persuaded with this type of evidence alone.

Investors should also remember the importance of falsification. If you find yourself persuaded by an investment idea, consider what could prove the logic wrong. If you hear a theory about a stock or market movement with a list of “reasons” supporting it, ask yourself what those reasons could be missing. Asking skeptical questions will help assess risk. As the saying goes, if it seems too good to be true, it probably is.

‘In so far as a scientific statement speaks about reality, it must be falsifiable; and in so far as it is not falsifiable, it does not speak about reality.’

Furthermore, don’t be persuaded by a theory that seems unfalsifiable. Don’t fall for a pundit’s prediction that, if the anticipated event fails to materialize, comes with a pre-programmed excuse.

‘Whenever a theory appears to you as the only possible one, take this as a sign that you have neither understood the theory nor the problem which it was intended to solve.’

Below is a short BBC video summarizing Popper’s ideas on the dangers of unfalsifiable theories:

Night of the Living Funds

This is part two in a series on active management. For part one, click here.

A few years ago, a friend asked my advice about an IRA. Her financial advisor had chosen the investments while she was in high school.

When I looked at the statement, I was appalled. The advisor had picked two variable annuities—a long/short fund and market neutral fund—both completely inappropriate for someone with a long time horizon. My back-of-the-envelope math showed these annuities had cost her more than 100% in gains, or about $15,000, compared to a S&P 500 index fund from Vanguard or Fidelity.

How does this kind of thing happen? Simple: the advisor was paid a commission. He received a fee for putting her in products which themselves charged high fees. He had little incentive to do the right thing for his client, and every incentive to choose a product that would earn him a fee.

Unfortunately, that’s why many overpriced products still exist. Commissions-based financial advisors and cheaply designed 401(k) plans routinely put unwitting investors into products that charge outrageous fees. If we didn’t have a system that encourages these products, they simply wouldn’t exist. They would be competed out of existence by superior, cheaper alternatives.

Meb Faber has an excellent post about certain index funds that charge inexplicably high fees. One example, the Rydex S&P 500 Fund C Shares (RYSYX), has an expense ratio of 2.31% and the gall to charge a 1% exit fee on top of that. By comparison, the equivalent fund from Vanguard (VFINX) charges 0.14%. The chart below shows the performance of this fund against the S&P 500 since its inception.

Rydex fund (white line), index (orange line). Data: Bloomberg
From its inception in 2006 until April 2017, the Rydex fund has underperformed its index by a cumulative 51%, and that’s before the 1% exit fee. Imagine what that would do to your retirement fund over time.

As outrageous as these fees are, it gets worse in many active funds. First, take the Sparrow Growth Fund (SGFFX). It’s an equity fund with an expense ratio of 2.45%, a 5.75% front load (entry fee), and a 1.00% back load (exit fee). If you buy this fund, you’re signing up for over 8% in fees even if you only hold it for a year.

There’s also the Saratoga Technology & Communications Portfolio (STPAX). It has an expense ratio of 2.24%, a 5.75% front load, and a 2.00% early withdrawal fee. If an advisor bought this for you, you may not be happy about the 7.99% in fees you’ll pay in the first year. If you want to sell, no worries, just pay an additional 2.00%.

If you were a fan of the technology sector, you could have instead purchased a NASDAQ 100 index fund like QQQ, which charges 0.20% and no load. The below chart shows the performance of these two funds since QQQ’s inception date, and doesn’t even account for the 5.75% front load.

Active fund (white line), index fund (orange line). Data: Bloomberg
This underperformance is not just due to bad stock picking: the active fund would be much more competitive if not for its high expense ratio.

What about those painful front-end load fees? Consider a hypothetical fund that outperforms the S&P 500 by 0.50% every year, but charges a 5% entry fee. The chart below illustrates your dollar underperformance if you invested $100,000 in this hypothetical fund:

If you bought the fund at the end of the year 2000, it would take more than ten years for that 50 basis points per year of outperformance to “catch up” to the 5% fee you paid initially. This also assumes you picked a fund that can consistently outperform after management fees, which is a serious hurdle.

Fighting off the Zombies

Many hyper-priced funds are small, but they still survive. The way some funds stay open is by obtaining investors through unusual means. Maybe a financial advisor gets paid a sales commission or a poorly structured retirement plan offers the fund as a 401(k) option. Maybe someone buys the fund, pays the high entry fee, and feels mentally “invested.” This is the sunk cost fallacy in action.

There are still some excellent active funds with reasonable fees, but many funds remain on the market when they shouldn’t. Fund companies know that high fees are a drag on performance, and it’s easy to see how funds fail to outperform their benchmarks if they charge fees of 1%, 2%, or above. They’re like the living dead; they limp along, dragging down the healthy in the process.

Joel Greenblatt on Investment Philosophy

Most investors have probably heard of Joel Greenblatt. He is a value investor with fantastic insights on analyzing special situations like mergers and spin-offs. I would recommend his books to anyone interested in investing or business.

The video below is a talk he gave at Google. The whole talk is worth watching, but I want to highlight a portion (11m:18s) where he discusses his investment philosophy and contrasts it to momentum investing.

Greenblatt explains that with momentum, it’s hard to know what to do when a trade isn’t working. He admits there’s plenty of evidence that it often works, but there are certain times it doesn’t work. If it’s not working at a given moment, it’s hard to tell if you should be patient or if the trade is too crowded. If your timing is wrong, it may not work, and there’s nothing fundamental to guide your decision.

This isn’t the case with a value approach. If Greenblatt is confident in his assessment of intrinsic value, he can be patient, and he won’t rely on price movements to dictate his decisions.