Beware of Bitcoin – Learn from Newton
“I can calculate the movement of the stars, but not the madness of men” – Sir Isaac Newton
In my conversations, bitcoin comes quite frequently in my discussion these days. Whether I am talking to my friends or family, everyone asks me if I invested in bitcoin and what exactly is bitcoin.
It is also there in media every day. Few examples are below:
If you search for the google trend of the word “Bitcoin”, you will see the explosive growth in interest in this crypto-currency. So, bitcoin is everywhere these days.
What is bitcoin and how is it different from normal currency?
Without going into much technical detail, bitcoin is a virtual currency that uses complicated computations to generate the bitcoin. It is virtual as of now as there is no physical bitcoin. It is different from the normal currency in below aspects:
- Normal currency has backing of central bank entrusted by the government (for example USD is backed by sovereign US guarantee). Bitcoin is not backed by any government. A normal currency derives its value from the credibility of the government that backs it. Bitcoin derive their value simply from how much the next person is willing to pay.
- Value of currencies move (for example USD vs INR) as per rate on inflation, interest rate, credibility of government and supply and demand factors. Value of bitcoin depends mainly on supply and demand factor.
- As the economies grow, the country can increase the supply of money. Furthermore, central banks increase or decrease supply of money to adjust inflation and growth in a country. Supply of bitcoin is limited as I read only 21 million bitcoins can be in circulation. With a cap on supply, value of bitcoins is far more vulnerable to changes in demands, that at times may be purely speculation.
Is bitcoin a bubble?
Bubble is “used to refer to a good or fortunate situation that is isolated from reality or unlikely to last”. Few months ago, I read a book Memoirs Extraordinary Popular Delusions and the Madness of Crowds (available for free on Kindle). This book gives details of various bubbles in history. I will mention two of them, the south-sea bubble (famous scientist Newton is believed to have lost a fortune in this bubble) and Tulip mania. The human mind is a rationalising machine. It tends to find a solid rationale for most things. Only in hindsight, we realize how irrational the whole thing was.
When you look at the chart of bitcoin price, you see the explosive growth in last few months and this gives some credence to an element of speculative forces creating a bubble-like scenario.
Does bitcoin deserve a place in your portfolio?
Any asset whose price solely depends on “greater fool theory” (finding a buyer who is willing to pay more) is dangerous for most portfolios. The world is full of investment opportunities and many of them will do very well. However, to earn a decent return, one doesn’t need to buy the most popular thing, if that particular option doesn’t make any sense. Bitcoin might be the next big thing and might even do well but for me, it is too risky. It is risk not only because it is too volatile but also because I can’t find a rational explanation for movement in its price. So, in my view, bitcoin doesn’t deserve a place in my core portfolio. Having said that, I don’t mind buying $25 worth of bitcoin, just for fun!
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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