Cryptocurrencies

Max Osbon - November 1, 2017

I get more questions about bitcoin and cryptocurrencies than any other finance topic. Everyone wants to know what to do with crypto. What’s your angle, how much is your allocation and which crypto is the most compelling? Here are some facts to help guide you:

The primer

Cryptocurrencies are technology-based currencies. Bitcoin and Etherium are the largest and most popular. Every transaction and every piece of ownership of a cryptocurrency is held in a shared ledger (aka blockchain) – there are copies of this ledger on every participant’s computer and it’s constantly being updated in real time. The “coins” are actually cryptographic keys that automatically scramble to keep them secret when transacting and unscramble when they arrive in your wallet. Different coins have different features that I won’t dive into here. It’s (sort-of) anonymous and it doesn’t require any central authority to make it operate. Cryptocurrencies wouldn’t be remotely possible without the internet – making it a truly unique 21st-century invention and something the world has never seen before. Click for a list of all cryptocurrencies with prices.

Investing and comparisons to gold

The properties that define bitcoin are governed by cryptographic methods and programming languages. Some worry that exponential growth in computing power will break the cryptographic security of bitcoin, instantly bringing the value to zero. Quantum computing would accelerate the breakdown of bitcoin’s security.

Durability is important. Cash wouldn’t be very useful if it was printed on tissue paper. By comparison, gold is unhackable. Theoretically, nuclear transmutation can turn lead into gold, but the fusion process required to do this is experimental, dangerous and enormously cost prohibitive.

Exponential math is not intuitive

Metcalfe’s law says that the value of a telecommunications network is proportional to the square of its users. This is true for social networks, and the same is true for bitcoin. A critical mass of crypto users is rapidly approaching and the value is exploding exponentially. Bitcoin is up 5x in 2017.

As the friction to use crypto lowers, you’ll likely see more adoption and an increase in crypto prices. Examples of lower friction are coffee shops seamlessly accepting crypto by installing an app onto their register, and Coinbase becoming a household name. There are even ads now for bitcoin based retirement accounts – that’s not a good idea – ask me if you want to know why. The lead article on Bloomberg (on 10/31) told us that the CME will be adding bitcoin futures contracts – introducing a method for professionals to trade bitcoin and other cryptocurrencies in active public markets.

Illegal activity

Crypto is used by criminals because it’s a useful tool for moving money without permission, signatures, banks, etc, although it’s no longer as fully anonymous as it used to be. It’s weightless and spaceless. Users can transport bitcoin in any quantity on a tiny computer chip, transact digitally at will or even store a particular value in their memory like remembering a password. Imagine declaring bitcoin with a customs agent when it’s held in your mind. It’s tempting to dismiss bitcoin due to its association with crime – it might fail because it’s banned outright or shunned by legitimate users. But before passing judgment, read the next paragraph about how this ability to move a digital asset is useful and practical for law-abiding citizens as well.

Perception is reality

People have started to perceive bitcoin as a safe alternative asset, like gold. That perception is powerful. Over the summer when the threat from North Korea to Japan became real, bitcoin prices surged as it was locally perceived as a safe asset. One way to view it as safe is to view it as the only international asset that’s easy to buy and that wouldn’t be affected by a local attack. Real estate, physical gold, cash and bank accounts could all be destroyed or paralyzed during a local crisis. Bitcoin stored in the cloud could be moved to another country on arrival.

What do tulip bulbs have to do with Bitcoin?

The Finance 101 lesson on market bubbles is the story of Tulip Mania during the Dutch Golden Age in 1637. As a refresher, tulips became a national symbol of wealth and speculation, driving bulb prices to levels 10x of what the average worker would make in a year. Speculators bid up prices in order to make a quick dollar and you made money as long as you weren’t the last buyer. It was a wonderful party until the speculative bubble burst and values collapsed.

Tulip Fever, the movie, came out this year. Bitcoin, which is essentially just an elegant new programming language, could be a bubble just like the tulip craze. Experts warn that crypto will “end in tears.” It’s hard to tell. Therefore, the amount to invest in crypto should be sized appropriately. Mark Cuban has something to say about that.

Is Mark Cuban Right?

Mark Cuban spent months publicly belittling bitcoin before announcing in August that he was putting $20million into a crypto currency hedge fund. It made headlines, however, Cuban’s net worth is $3.3Billion. Scale that down to a net worth of $1million and it’s like putting $6,000 into crypto – less than 1 percent of one’s net worth. Hardly headline worthy.

It’s a Call Option (a speculation)

The best thing a bitcoin investor can do is… be wealthy. That may sound silly, but it’s true. Wealthy individuals can afford to place real capital in speculative bets. The average wealthy investor is not going to care if they lose $6K in crypto because the potential return is so high and the loss is nearly invisible to them. It’s a purely speculative investment. Technology is usually a good place to look for speculations. AAPL stock, for example, had a total return of 650% over the last 10 years. AMZN is even higher with a return of 1,500% over the last 10 years.

To successfully invest in cryptocurrencies and other high-risk high-reward assets, you have to have at least one big win that significantly outweighs all of the small losses along the way. The investment journey is a long one – don’t rush it by buying up too much cryptocurrency because it’s performed well this year. We don’t hold any cryptocurrencies in Osbon Capital portfolios and we don’t currently have any plans to add it. Bitcoin and other cryptos are most useful as a minor speculative investment.

 –  Max Osbon

Research shows that only 1/3 of investors are currently comfortable with their investment portfolios. If you’re interested in a free performance review, click here.

 

 

 

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