May 122014
 

Bitcoin in Your Investment Portfolio

Is Bitcoin in your investment portfolio a good idea? Bitcoin is a technology that enables a public, peer to peer ledger decentralized over an entire network. Huh? Well yes, that’s what Bitcoin is, in a nutshell, even though the main stream media would have you believe it’s some kind of a weird speculative currency with no intrinsic value. If you are evaluating Bitcoin as an addition to your investment portfolio, it is very important to first understand what Bitcoin is and how it might fit into your portfolio.

Warren Buffett, arguably the greatest investor of the last century, has called Bitcoin a ‘mirage’ and has said “…the idea that it has some huge intrinsic value is just a joke in my view” and goes on to compare Bitcoin to check/money order. No, seriously. If you’re interested in the more juicy details, read this Forbes piece on Warren Buffett vs. Marc Andreessen. Mark Andressen likes to compare Bitcoin to the internet in the early 90s – something with the potential to change the world. So who’s right?

Time for disclosures first – I am not an investment adviser and really, you shouldn’t be reading my blog for any investment advice. I run a blog about Bitcoin, so it shouldn’t be surprising that I see a bright future in Bitcoin. Make your own mind up whether Bitcoin is good or bad for you. And yes, I am long Bitcoin.

Also, getting the obvious out of the way, unless you’re really really savvy as an investor or technologist, pay off your debts first before venturing into Bitcoin. And oh for your own sake don’t try to ‘invest’ your rent and food money into this. Also, this guide is for medium to long term investments in Bitcoin, not trading advice (no, I don’t care what triangle is formed on the top of the chart and your prediction for tomorrow’s price movement).

Understanding Bitcoin as a Technology

If you’re going to look at Bitcoin as a medium to long term investment, it is imperative to first understand what Bitcoin is. Is it just a faster money order as Buffett believes, or is it something more?

Well, in short, it is much much more. Calling Bitcoin a faster money order would be like calling the World Wide Web a faster postal service – you’re missing the point entirely. Simply as a technology, Bitcoin has shown it is possible to maintain a completely decentralized database in sync across all the peers without requiring any central trust. This is revolutionary in itself, and solves an old computer science problem of Byzantine Generals Problem. The first and most obvious use of Bitcoin has been as a currency, which makes it possible to transfer money from Nicaragua to Nigeria in a matter of minutes without paying any fees (the optional network fees is less than 5 cents) and without waiting for any clearing houses. This is big because now you don’t require permission from the big payment agencies of the world to get paid, and don’t need to pay their cut to move some digital bytes around (ask Wikileaks if you think all the big payment processors want to go out of their way to serve your interests).

However, Bitcoin as a technology can be used for everything from asset registries to entire stock markets. Markets created in the Bitcoin environment are global and decentralized, and the entire network agrees on whether a transaction took place or not – there’s no case of a fraud (there has never ever been a ‘counterfeit’ Bitcoin) in the protocol (If you think MtGox showed that the Bitcoin protocol is ‘hacked’, you should close this article immediately and go back to reading New York Times). With smart contracts implemented on the blockchain, sky is the limit to where this technology can lead us.

Understanding Bitcoin as an Investment

It’s not always possible to make money even if you correctly predict the next technological revolution. Buffett himself gives a very good example of how there were over a 100 car companies at the turn of the last century and even if you foresaw the car technology taking over, it’s unlikely you would have made a lot of money. Same with the technology industry in the 90s – only a few survived. Even if you believe in Bitcoin’s underlying technology, it might not be the right investment vehicle for you.

If you do plan on putting your money into Bitcoin, ask yourself if you’re willing to experience extreme volatility. In a matter of weeks, Bitcoin fell from $32 to $5, then rose to $266 a few months ago and promptly fell to $60. Then went up to $1000 and now a hovers around the $450 mark. If this is too much to stomach, consider investing in MCD and KO instead (and since you ask, no Bitcoin doesn’t give you dividends).

The investment potential for Bitcoin is purely the possibility of capital gains – how much can one Bitcoin be worth. The worth of a Bitcoin is very tricky to calculate, however. Currently, these are some factors that give Bitcoin its value –

  • Store of Value: Venezuela has a 57% official inflation rate. Capital controls prevent easy conversion of this currency into something that would hold its value over the long term. Bitcoin is one of the alternatives that’s often discussed. Of course, beware of random Wall Street price targets.
  • Medium of Exchange: If you hire a graphic designer from Nigeria for your website, it is almost impossible for you to pay him (there’s no PayPal in Nigeria). Bitcoin solves this problem in an instant. As it spreads across the world, more and more people will start accepting and using Bitcoin for their services. This obviously provides it with value.
  • Transfer Protocol: This is the part Warren Buffet was talking about – as a transfer protocol, Bitcoin can move money from the UK to Kenya in under an hour and at almost no cost. Remittances is a very big international market, exceeding $400 billion. Cost is important because banks now charge an average of more than 12% for African remittances, a ridiculously high amount in today’s day and age.
  • Protocols on the Bitcoin Blockchain: There are several projects that implement a protocol layer on top of the Bitcoin blockchain and can provide additional services, from colored coins to Mastercoin to Counterparty. These allow the creation of secondary markets (such as permacredits for the permaculture industry). All these additional protocol layers provide Bitcoin with a value, as they cannot exist independent of Bitcoin.
  • Speculation: Everything from globalized decentralized stock markets to fully autonomous corporations buying and selling from each other instead of from humans, can be thought of as potential use cases of Bitcoin in the future. This gives it a lot of speculative value as well.

Competition

Bitcoin is an open source technology and as such, anyone can copy the Bitcoin code and create a clone. There are several hundred of these right now. So far, however, none of the Bitcoin copycats (all the altcoins) seem close to dethroning Bitcoin. It has the network effects built in and a great developer support, merchant adoption and community already built-in and it would be hard to replace, even if we see a world with multiple crypto currencies operating simultaneously.

That being said, altcoins can be a potential threat to Bitcoin’s dominance. It’s not true that any new feature that might be created by an altcoin can be incorporated into Bitcoin because of the dynamics of open-source projects and the difficulty in changing the core protocol. Only time will tell if an altcoin can ever be a genuine threat to Bitcoin’s dominance.

It wouldn’t be a bad idea to have Bitcoin in your investment portfolio, provided you understand Bitcoin and believe in the technology. Consider investing x% of your investment portfolio in Bitcoin, for a potential high-risk high-return strategy.

Photo Credit: Thomas

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