Dreaming Of Becoming A Bitcoin Billionaire? Ask These 5 Simple Questions First

The only thing more contentious than politics today is Bitcoin.

Ask the Twitterverse whether Bitcoin is a good investment and you’ll get too very different answers. First, the early adopters love to tell everybody when they first bought (or mined) Bitcoin. If they bought it any time earlier than a few minutes ago, they’ve probably made a fortune.

Then there are the value investors who see Bitcoin as nothing more than “artificial gold,� as Charlie Munger describes the cryptocurrency. In his view, Bitcoin is nothing more than “total insanity.�

Rather than try to convince anybody of one view or the other (although I’d never bet against Charlie Munger), here are some questions to consider before you starting buying Bitcoin.

1. Bitcoin is capped at 21 million, but does that justify its price?

Bitcoin is famously capped at 21 million. Unlike U.S. dollars, which the Treasury can print at will, there is a fixed limit on the number of Bitcoins that can be mined. Many argue that this hard limit justifies the price, particularly as the government prints more money in response to Covid.

Bitcoin isn’t the only asset with limits. In 2007 the same argument was made about land as real estate prices soared. That didn’t keep prices from crashing. It also didn’t keep Bitcoin from crashing in 2017.

Further, Litecoin is capped at 84 million, yet it doesn’t trade anywhere near 25% of the price of Bitcoin. As I type these words, Bitcoin is trading at about $35,000. Litecoin sits at less than $165. If a fixed number of Bitcoin makes it so valuable, why is Litecoin being left behind? More fundamentally, consider whether you can reasonable derive a fair value of Bitcoin based on the 21 million cap. I can’t, but maybe you can.

2. Institutional investors have joined the Bitcoin party, but does that make it a good buy?

Many point to institutional investors buying bitcoin as a justification for its current price. As an example, Michael Saylor, founder and CEO of MicroStrategy (NASDAQ: MSTR) has bet the future of the company on Bitcoin. His company even borrowed $650 million on a 5-year bond to sink more into the cryptocurrency.

The question a potential buyer of Bitcoin should ask is, “so what?� Institutional investors make bad investment decisions all the time. The point here isn’t that companies like MicroStrategy have made a mistake investing in Bitcoin (although I think they have). The point is that one shouldn’t look starry eyed as some institutional investors move into Bitcoin. If anything, all it has done is rise the price (bad for would-be investors). What it won’t do is sustain unreasonable prices in the long-run.

3. Will Bitcoin save us from the government’s monetary policy?

The government is borrowing a ton of money to respond to COVID. While the Treasury’s printing press hasn’t resulted in significant inflation of goods and services (yet), it has sent asset prices soaring. It also calls into question the future value of fiat money, as many like to describe it.

It’s certainly true that as interest rates fall, asset values rise. One could even argue we are seeing that with Bitcoin. We are certainly seeing it with stock prices. It’s an interesting time right now with monetary policy, and one wonders just how much our government can borrow without consequences. But how do you take that fact and translate it into a meaningful price for Bitcoin or any other cryptocurrency?

Countless people have been sounding the monetary policy alarm for decades. Before Bitcoin, it was what gold sellers used to sell gold. Insurance companies use fear to sell annuities. Today the same argument is being used to tout Bitcoin. It’s not that the underlying concern is misplaced. It’s that the concern can’t possibly justify the nearly doubling of Bitcoin’s price in 30 days.

4. Does the “network effect� support Bitcoin’s price?

Some argue that the network effect propels Bitcoin’s price upward. Bitcoin was the first cryptocurrency, it enjoyed early adoption, and as more people buy bitcoin, it becomes more valuable. It’s one explanation for why other cryptos, like Litecoin, haven’t seen their prices soar.

A potential buyer of Bitcoin should question this argument. The network effect is where the utility of something goes up as more people adopt and use it. It can apply to messaging apps or social media platforms. But does it really apply to Bitcoin?

It might if Bitcoin were used as a currency, but that’s not the case. It’s certainly true that as more people and institutions buy Bitcoin, the price goes up. But does the increase its utility? Does Bitcoin become more useful as more people buy it? If so, what exactly is the use that’s improving?

Some might argue that it becomes a better store of value. More buyers certainly increases the liquidity of Bitcoin. If that’s the new definition of network effect, however, I wonder if it’s lost all meaning. Regardless, it’s certainly not the network effect as applied to a social media platform. Moreover, one could make the same argument about any asset that enters bubble territory.

5. Can you handle the volatility?

Finally, those considering buying Bitcoin should ask if they can handle the volatility. There are really two questions to consider here.

The first obvious question is whether you can handle the volatility. Can you hold on to Bitcoin even if it drops by 50%? That’s an important question to ask with any investment. It’s particularly important with Bitcoin.

The second question is more fundamental—what does the volatility tell us about Bitcoin as an asset? While some volatility is to be expected with any liquid asset, Bitcoin takes volatility to the extreme. Two days ago it fell 17% below $30,000. Today it’s above $35,000. That suggests that the price may be divorced from reality, even for those who think Bitcoin is a sound investment.

If you do decide to buy Bitcoin, don’t bet the farm.

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