January 2, 2018

 

Dear Investor:

Given the astronomical gains last year, many clients have understandably asked if they should purchase some Bitcoin.

I would say no. Not because it’s a mania, a novelty, or a fad—though it certainly might be all of those things. I would say no for the same reasons I advised against buying companies like Pets.com in 1999. Not because it has no value, but because the value cannot be determined. I have no idea whether Bitcoin is worth $0 or $100,000 and if you cannot answer that question—at least within a range of 10%—buying the thing is just gambling, no different than playing roulette.

As Bitcoin trades at nearly $14,000, this advice must look woefully pedantic and stupid. After all, I said the same thing to a client when Bitcoin was trading at $7,000 and $10,000—and it’s doubled since then. What can the definition of stupid be if it’s not the leaving of a 100% gain on the table?

Pedantic or not, however, the discipline of being able to determine value is the most important thing. For every Bitcoin it causes you to miss, it helps you avoid hundreds of other passing worthless fancies, whether they be Beanie Babies, hoverboards, dotcom washouts or anything else.

The difference between investing and speculating is that the investor can make a determination of intrinsic value while the speculator cannot. And why can Bitcoin not be valued while a blue-chip stock or bond can? Simply because Bitcoin has no underlying yield or cash flows. If an asset lacks these features, it just cannot be valued. All methods of valuation used by successful investors, from Warren Buffett on down, approximate value based on the cash flows the asset produces. If it doesn’t produce any, good luck assessing the right price.

The same can be said for all currencies, not just the crypto kind. Naked yen and euros don’t produce yield or cash flows either, nor does the almighty dollar. To extract value, they must be invested in a bond or stock, or at least a Treasury bill or savings account. To make money on buying a raw currency, you need it to appreciate against the currency you used to buy it. And if you have no idea at what price that exchange should take place (and there’s no way to know because currency fluctuations are unknowable), you cannot take the gamble. Period.

I can tell you my estimate of the value of every asset in your account that I’ve ever purchased for you. It will only be an estimate, and it will sometimes be wrong. But more often that not, it will be approximately right. I would never be able to say the same for Bitcoin.

As with all parabolic price increases, there will be many who ignore this pedantry. A lucky few will strike it rich, as some have with Bitcoin. Most will not. By definition, a bubble is caused by the greatest number of buyers buying at the top. This is what creates the top and what ultimately bursts the bubble.

Buyers often harbor the illusion they can choose their selling point on the way down. In other words, why pay attention to value? Why not buy at $14,000 and just watch closely: as soon as it hits $13,000, you can sell and avoid big losses. But this ignores the way markets work. They are not local trains where you can get off at any stop along the way. They may appear to be local trains, as they pause at a few stops in a lazy fashion, but then—all of the sudden—they run express, like a haywire NYC subway. As any rider knows, it’s no fun to be trapped on the express train and see your stop zoom by.

Markets are actually auctions, where the next stop is only the price borne by the next bidder. When they go down, they can go down 50% in a flash. Hence, the phenomenon of “flash crashes,” as in 2010 when the Dow plunged 1,000 points in a nanosecond. Picture an art auction in reverse, where the buyer bids $10 million for a Renoir and the next bid comes in at $1 million. There was no opportunity to get off the train along the way at $9 million or $8 million or even $7 million. If no one yells “yes” until “Do I hear $1 million?” then that’s the new price. No more, no less.

If you want to buy a Bitcoin for fun or profit, go ahead. But understand: it’s not investing, it is speculating. You might as well visit Vegas and at least be guaranteed the free drinks. As the buyers of Pets.com learned in 2000, that which has no underlying cash flows can be valued at a billion dollars one minute—but at zero the next.

With best wishes for the coming quarter.