Bitcoin, Da Vinci, and FOMO (Fear of Missing Out)

December 6, 2017

Written by Nathan Erickson, CFA®, CAIA, Partner and Chief Investment Officer

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If you have opened a Wall Street Journal or turned on a financial news network in the last few weeks, you’ve likely heard about the recent price movements in Bitcoin. Pricing has gone parabolic. While Bitcoin is so volatile that it is difficult to obtain accurate data, as of the writing of this commentary Bitcoin’s price has gone from just under $1,000 per coin at the beginning of the year to almost $14,000 per coin, an increase of nearly 1,300%.

 

Bitcoin’s meteoric rise in price has not only drawn the attention of the financial media and Twitter users everywhere, but recently both the Federal Reserve and the White House have commented that they are monitoring Bitcoin closely. For some people, a drastic change in price in a short period of time can lead to a variety of challenging questions: “What if I invested $10,000 or $100,000 in Bitcoin a year ago?”, “If it keeps going up, should I buy Bitcoin now?”, and “What if all the people I know make money in Bitcoin and I don’t?”

A common acronym to describe the feelings driving these questions is FOMO, which stands for Fear of Missing Out. Historically, whenever human beings allow emotion to be part of a financial decision the outcomes are rarely favorable. FOMO can cause investors to buy at the top of markets after watching an investment increase in value for several years and hearing about the great performance experienced by friends and neighbors. Another emotional response is loss aversion, where investors sell at the bottom of markets because they just can’t take any more losses. Rather than allowing emotions to drive decisions, investors should examine the evidence, remain objective, and act rationally. Let us attempt to do this with Bitcoin.

Bitcoin was created in 2009 and, while the word “coin” implies tangible currency, it exists only in digital form. You cannot hold a Bitcoin. The appeal of Bitcoin is that it allows for transactions to take place through the use of a public ledger, called a blockchain. Each transaction adds to the blockchain, creating a permanent record of the use of each Bitcoin. In our traditional monetary system, we exchange notes, backed by the Federal Reserve, as verification of a transaction. A purchase at a store requires currency to change hands. Blockchain technology eliminates the need for notes, because the transaction record is stored and publicly available. Bitcoin is also appealing because it allows for anonymous peer-to-peer transactions without the influence of any sort of regulatory body.

Bitcoin is not the only form of digital currency or “cryptocurrency”. The website www.coinmarketcap.com lists more than 1,300 cryptocurrencies, representing nearly $300 billion in value. Bitcoin represents half that value at just over $160 billion. By comparison, Bitcoin’s current value is greater than Boeing ($152B), Walt Disney ($151B), IBM ($143B), McDonalds ($135B) and many other Fortune 500 companies.

While the current value of Bitcoin may be similar to a large public company, the drivers of value are very different. Companies create products or offer services and generate profits, which can be analyzed to determine a fair value for the equity of the company. Bitcoin doesn’t have profits or cash flows, making it extremely difficult to determine a value. The same can be said of traditional currencies like the U.S. dollar or the Euro, except that traditional currencies have a central bank whose role is to provide price stability by controlling the supply of money. Without a central bank, pricing becomes arbitrary and potentially unstable.

The challenges of Bitcoin make it difficult to classify. If there are no cash flows or assets to value, it can’t really be considered an investment. Without price stability, it is hard to consider it a currency. You can’t have a currency that will buy you three loaves of bread one day and only one loaf the very next day. In addition, there is a finite supply of Bitcoin, unlike paper currency which theoretically has an infinite supply. As a result, the closest comparison to Bitcoin would be some sort of collectible, like gold, except that you can’t actually hold Bitcoin which makes it far less secure as a store of value.

Based on the evidence, we find it hard to have a rational, objective reason for investing in Bitcoin. That may not solve our FOMO problem however. What we won’t do in this commentary is tell you whether you should or should not buy Bitcoin. What we will do is tell you that buying Bitcoin or any other cryptocurrency is not an investment decision, and we will provide a framework to help evaluate the decision.

If supply is limited and pricing is arbitrary, then Bitcoin’s value is whatever the next person is willing to pay for it. We are at a point in the economic cycle where examples of this valuation method occur frequently. Several weeks ago, a long-lost Leonardo Da Vinci painting called “Saviour of the World” sold for $450 million at Christie’s auction. Like Bitcoin, the painting is limited in supply (only 1), and the pricing is completely arbitrary. In 1958, it sold for $125; in 2005, it sold for $10,000; in 2013, it sold for $80 million; and in 2014, it sold for $127.5 million. There is no way of determining which of these prices are the right price for the painting. It is worth whatever someone is willing to pay for it.

When buying tangible collectibles, arbitrary pricing can be overcome by the desire to own something. Whether it is art, a classic car, or a baseball card, we can often justify an arbitrary price with the fact that we want to own that thing so we can look at it, use it, share it with others, or pass it down to future generations. No one is buying Bitcoin with that intent. Those who are buying today are simply hoping to sell it to someone else at a higher price. Without a mechanism for valuation or stabilization, it represents an extremely risky and speculative purchase. Bitcoin’s characteristics disqualify it as an investment and therefore, as your advisors, we will not recommend purchasing Bitcoin as part of a portfolio. However, if the fear of missing out leads to a personal decision to buy Bitcoin, we will happily join in the hope that at some point in the future it can be sold to someone else for a higher price.