Why I have always liked Bitcoin

Bitcoin's value in USD terms since 2014 (Source: here)

The conservative world of finance is replete with extremely intelligent people, including prominent central bankers, who will swear on their mothers' graves that Bitcoin is a hoax, a criminal enterprise, an asset without value, without future.

I beg to differ. I see a real need for an asset such as Bitcoin. And not for criminal purposes at all. Bitcoin has several really useful features.

First, it is an electronic, infinitely divisible asset, which makes it accessible to everyone and hence far more democratic than, say, conventional bonds and stocks.

Second, Bitcoin is created, distributed, traded, and stored using blockchain technology, which is fundamentally safer than conventional financial assets as far as counter-party and operational risks are concerned. Bitcoin can be traded without financial institutions as intermediaries, so the trades are not at risk of bank failure, while trading costs should be lower since banks don't take a cut.

Third, unlike other crypto currencies and particularly fiat currencies, Bitcoin is issued in a finite quantity, which will never exceed 21 million coins. This restriction on the supply guarantees that Bitcoin is never at risk of inflation. As such, Bitcoin shares some of the most attractive features of gold, albeit with far superior liquidity (meaning it is much easier to trade).

For more fundamental information on Bitcoin, see here.

My view is that Bitcoin should become more widely held with time and therefore become more liquid over time. This will gradually stabilise its price at which point more people will hold Bitcoin for the same reasons they hold conventional money, namely as a unit of account, store of value, and medium of exchange.

Recent developments lend support to the optimism about Bitcoin's future. The US government is advancing on multiple fronts with respect to regulation (see here). Regulation is crucial, because it induces confidence and enables large institutional investors, such as pension funds and insurance companies to participate in the market. Growing involvement of institutional investors obviously drives up the price of Bitcoin, which is fortunate if you own some, but the real importance of their involvement is that it reduces the biggest risk to Bitcoin, namely that it is outlawed by governments fearful of the threat it poses to monetary policy.

Private hedge funds have recently emerged to offer sophisticated actively managed crypto products - see an example here). There are also a growing number of Bitcoin-referencing exchange traded funds (ETFs) out there, which offer a cheaper way to invest than through actively managed funds (see here).

Personally, I find the potential of Bitcoin in emerging markets (EM) especially intriguing in light of the problems faced by EM policymakers due to fragility of their currencies. At the slightest sign of uncertainty, be it country-specific or global, investors ditch EM currencies in favour of Dollars or the Euro. These flight episodes can lead to serious hard currency shortages, even defaults. Even perfectly well-managed EM economies are not immune to contagion as investors stampede out of their markets.

This is why some EM policymakers are rightly considering the possibility of complementing or even replacing their fiat currencies with Bitcoin as legal tender. El Salvador and Central African Republic (CAR) have already done so. Bitcoin reduces reliance on US Dollars and Euros, which itself can reduce risk. For example, the US Dollar dropped 50% between 1969 and 1979 and these days there are also wider geopolitical risks to consider too. An increasingly nationalistic and insular US government could well exploit the might of the Dollar to bully smaller nations. Bitcoin avoids these risks, because Bitcoin not controlled by any government.

Having said that, Bitcoin is still held in relatively few hands with a predominance of speculative investors. Regulation is lagging behind. Crypto-currencies will therefore display volatility for some time yet.

Personally, I would never pay attention to anyone flogging Bitcoin as an investment idea, especially during such times when Bitcoin trades near its all-time highs. Amateur investors are targeted directly in the latter stages of rallies, when the big holders - the ones who caused the rally in the first place - look to off-load positions and take profits. This is why amateur investors so often end up holding the baby when prices falls, losing tons of money in the process, experiencing many sleepless nights, or worse.

Bitcoin's volatility is far from over, so if you want to play decide how much you can afford to lose and then invest when the price falls. During big market downturns, set three or four attractive levels to buy, say, 20%, 40%, and 60% below the top. Then wait. Make sure you actually buy when the targets are reached, which is much harder than it sounds, because when the market crashes everyone screams blue murder!

The basic mantra of investing is always the same: buy when it is cheap and sell when it is expensive! Remarkably, this is actually quite unusual behaviour in financial markets, where herd dynamics are extremely powerful. Market-makers are excellent at whipping the herd into proper frenzies, because stampeding herds increase trading volumes and therefore revenues. Amateurs are skinned twice, first when they sucked into the bubble too late and then again when they are spat out in the ensuing crash.

As for investing in general, I urge anyone other than the most seasoned professional investors to stick to a simple three-pronged strategy:

(1) Make sure you invest: Every second your money is idle, you get poorer, either because you forego returns or because inflation eats away at your cash.

(2) Diversify: Diversification is the closest you will ever get to safety in financial markets.

(3) Invest tax efficiently: Taxes can be punitive in many countries, so ignoring them can amount to financial suicide.

In reality, even this simple three-pronged investment strategy is far from easy to implement. For example, due to lack of knowledge and information very few people actually have the skills to implement (2) and (3) without which (1) can be quite risky.

For this reason, it is also a good idea to hire a professional investment manager. Sadly, investment managers are expensive and many will screw you over, especially if they work for banks. Remember the smartest criminals do not rob banks, they work for them.

Good advisors do not grow on trees. I would therefore invest very considerable time and effort in identifying a competent, trustworthy, and reasonably priced investment advisor. If he or she moves to another institution maybe you should move your assets too.

Once you have implemented the three-pronged strategy together with the aid of your trusted investment advisor, then you can begin to consider making stand-alone investments, such as named stocks, individual currencies, particular commodities, bonds issued by specific governments or companies, or, indeed, Bitcoin. Stand-alone investments are extremely risky, because they lack diversification. Amateur investors are always at a huge informational disadvantages vis-a-vis professionals, who spend their entire lives getting close to issuers, etc.

The odds that an amateur investor beats the market on a stand-alone investment is extremely slim. Other than through sheer luck, the amateur's best chance of winning on a stand-alone investment is to think long-term. Long-term thinking is the amateur's only edge over the professional, since professional investors tend to be ridiculously myopic. Assuming the long-term view is actually correct, the amateur will beat the market if he or she already holds a big position, when a rally starts, as Bitcoin has done on a number of occasions.

Bear in mind, though, that success in stand-alone long-term investments requires the investor is able to hold the investment through protracted market downturns, which in some cases can be longer than the investor is able to remain solvent. So never invest more than you can afford to lose!

The End