By Taylor Schulte
If you’ve been watching Bitcoin prices lately, you already know they’ve made quite a run. As of this writing, a single bitcoin is worth $831.91. To put things in perspective, Bitcoin values were in the $300 to $400 range for much of 2015.
Those who invested in Bitcoin years ago are likely rejoicing. But, should you join them? Continue reading to learn more about Bitcoin, how it works, and why this investment might be worth skipping despite its high returns.
What Is Bitcoin?
Generally speaking, Bitcoin is a open-source crypto-currency used by online firms and big businesses worldwide. One of the biggest advantages of Bitcoin is that the currency can cross borders easily, facilitating international trade.
For the purposes of investing, Bitcoin is similar to any other currency (or commodity) investment. This means, when it comes to your investment return, Bitcoin faces the same uphill battle as investing in:
- Gold
- Agricultural products
- Fine art
- Oil
In other words, at any given time, Bitcoin is worth whatever the market says it’s worth. While this isn’t a problem in itself, investing in Bitcoin does pose some specific challenges.
As sexy as investing in Bitcoin sounds — and despite the recent run-up in price — there are at least two fundamental problems with investing in Bitcoin right now.
Problem No. 1: You Lose Money After Inflation
When you invest in Bitcoin, you are betting the farm on price appreciation alone. Or rather, you’re betting that the price of Bitcoin will go up compared to the U.S. dollar. What this means is, Bitcoin is different from more conventional investments like stocks, bonds and real estate. That’s because conventional investments offer the chance to generate cash.
As an example, stocks are a slice of business ownership. Businesses exist to earn a profit. As an owner of that business, you are entitled to a slice of that profit.
That profit can either be re-invested into the business (to increase the value of the business) or paid to investors as a dividend. Either way, a stock generates cash — ultimately enriching those who own stock.
Unfortunately, that’s not the case for Bitcoin, gold, commodities or fine art. These sorts of investments do not generate cash. Instead, investors can only hope they increase with the rate of inflation.
And not only must your investment appreciate at the rate of inflation, it must also go above and beyond inflation to make up for the transaction costs. Trust me when I say this is rarely the case. Most commodities increase at the rate of inflation. Further, currency doesn’t increase in value at all — because that’s exactly what inflation is — a decrease in the value of currency!
Problem No. 2: Mean Reversion
Mean reversion is a fancy way of saying: “what goes up, must come down — and vice versa.”
All investments are subject to mean reversion, and Bitcoin is no exception. Mean reversion itself isn’t a bad thing, but it’s still worth noting when it comes to investing in Bitcoin specifically.
As you might know, commodities provide an investment return at the just about the rate of inflation — before fees. Moreover, commodities depend upon price appreciation alone to provide an investment return. This is because commodities do not generate cash.
So, if you are going to get an investment return from Bitcoin, you don’t want to be buying at a market top. However, recent run-ups in price suggest that it’s possible we are at the top of the Bitcoin market — or at least on the way.
“With investments like Bitcoin, you really have to get the timing right. The problem is that most people can’t even do that with stocks – getting the timing right. Commodities can see even larger swings in value than stocks – making successful investing in Bitcoin almost impossible,” says Jon Luskin of www.UncleDMoney.com.
Pro Tip: Invest as Much as You Can Stand to Lose
Try thinking of investing in Bitcoin as you would buying a lottery ticket. It only costs a dollar, but you could win big. However, as historically shown with commodities, the odds are good that you’re going to lose money compared to a low-cost diversified investment.
Most of the time, you’ll be a lot better off if you choose a long-term investment strategy that isn’t quite so volatile. You should also diversify as much as you can. This way, you won’t lose your shirt if one particular investment falls apart.
If you choose to throw your money into Bitcoin in spite of this advice, just know you’re doing so at your peril. The best thing you can do is limit your investment to an amount you can afford to lose, then brace yourself for a long and bumpy ride.
Taylor Schulte is CEO of Define Financial and the founder of StayWealthySanDiego.com and is passionate about helping people make smart decisions with their money. He can be reached at info@staywealthysandiego.com.