A Bitcoin Toss

Let’s take a look at the pros and cons of bitcoin. Financology has to date not paid much attention to it, and what little attention it has paid has been mostly negative.

Longtime readers however know that our starting platform for portfolio construction has been the Global Market Portfolio, the portfolio collectively owned by the world’s savers and investors. The exact amount is a moving target, but bitcoin and other digital tokens have now reached a portion of the total global market capitalization of assets that can no longer be ignored. A position in bitcoin, and possibly other members of the asset class such as ether, can be justified purely on this basis. Whether it’s wise, however, remains an open question. We’ll try to look at both sides. For our purposes here, “bitcoin” will refer variously to bitcoin proper or the asset class of digital tokens or cryptocurrencies or blockchain-resident assets.

The cons are easy. These tokens have no intrinsic value. They entitle the holder to nothing. But they undeniably have market value. Where does it come from?

To answer that question, let’s turn to a thought experiment. Imagine you are a computer network whiz, with the technical skills of a Satoshi Nakamoto, the claimed creator of the original bitcoin. It’s not entirely hypothetical; there are many such people.

You copy the feat. You create a new digital coin with all of the attributes of the original. What is its market value?

At the outset, obviously none. No one has heard of it. Not only does it entitle the holder to nothing, but it has no history in the media or any investment performance record. In order to imbue it with market value, some marketing is required.

I ask the reader to turn this over in his mind for a while. It is self evident to me, but needs to be the same for you if the remainder of my reasoning is to make sense.

Once accepted, this premise leads to some fundamental conclusions about bitcoin. First of all, since this is how the original actually did arise, all of the same implications arise as well. The most fundamental of which is this:

Bitcoin derives its entire market value from marketing.

Without the media coverage, without the performance history, it’s worthless.

Another is that one of the central pillars of marketing, the limited supply claim, requires donning blinders to fully accept. While it may be that the potential supply of the original is finite, the potential supply of other, identical, things is not.

Its uniqueness is ephemeral. The supply of bitcoin may be limited, but the supply of things like it is infinite. The only thing that bitcoin has that a new equivalent wouldn’t have is the marketing machine.

To make the point more concrete, let’s compare it with other assets.

Where does a share of Apple common stock get its value? We could write volumes, but the gist of it is that, among other things, company takes a few dollars worth of raw materials and coverts them into devices that billions of people are willing to spend thousands on to use to communicate, inform, educate and entertain. A share of Apple stock is a share of equity in the business and entitles the owner to a share of the profits (a dividend), and should the company liquidate, a share of the assets after bond holders have been repaid.

Another, closer, analogy to bitcoin is gold. Where does it gets its value? It has intrinsic value … you can delight your sweetie with it. It is useful in electronics and medicine. It has a finite supply. We may move it above ground and then back below again, but the number of ounces of gold on earth hasn’t changed for eons. What about the supply of competitors? Even if we expand the field to other things that have a fixed supply on earth, namely the stable elements, there are only about one hundred. A recent article attempts to equate this with bitcoin – There Can (Probably) Be Only One Bitcoin – but a hundred is a little different than infinity. And none of those elements are or can be identical to gold. 

Bitcoin is marketed on the basis of the problems with man made money, but is a form of man made money itself. And because there have already existed forms of money that are not man made, it smacks of a solution in search of a problem. Its production also burns up massive quantities of physical energy, computational resources and human time.

Those are the main cons. Next up the pros.

We’ve already cited the most compelling reason for including bitcoin in an investment portfolio; it’s an appreciable part of the Global Market Portfolio, the portfolio presenting the minimum possible risk due to selection of assets.

Based on the insights from our thought experiment, we can also formulate some basis for evaluating its investment prospects: Assess the likely course of the marketing case.

One crucial aspect of the marketing case is its performance history. The more it goes up, the more compelling it is. The counterpoint is that the more it goes up, the more attractive it is for existing owners to sell. With its absence of fundamental value, the field of technical analysis is likely better suited to trading bitcoin and its brethren than almost anything else.

For instance the anticipation of spot bitcoin ETF approval was enough for traders to bid up bitcoin. The publicity was more important than the fact. Investor perception and psychology are known impacts on the value of most assets, but in the case of bitcoin, it’s the only impact.

If there is anything with a pretense to fundamentals, it’s competition. Bitcoin competes favorably with other man made forms of money. The uglier they grow the more attractive the alternatives. Yet less so compared to other stores of value like gold, other commodities and real estate. A major factor is the potential for other trendy investments to displace the media space now underlying bitcoin’s market value. As media turn their attention to bitcoin from other assets, its value is likely to increase. As they and the public become more fascinated with other things, its value is likely to decrease.

Keynes once wrote that investing is like judging a beauty contest. But one in which the object is not to choose the most attractive contestant, but to choose what others will find most attractive. And they are choosing based on what others will choose as well … ad infinitum. Investors who feel comfortable with investing his way should be comfortable with bitcoin.


3 thoughts on “A Bitcoin Toss

  1. Finster says:

    Besides the cited weakness, the linked article also errs in characterizing bitcoin as “digital gold”. That is purely a marketing device, and a false and misleading one at that. Digital gold is backed by gold:





    As the Forbes reference indicates, the most commonly used form of digital gold is gold ETFs.

  2. jk says:

    i don’t own crypto, nor do i intend to. but there is one use case that really makes sense to me: a [somewhat volatile] store of value and a means of transaction for people who don’t live in the dollar universe, and who may be subject to even more extreme inflation.
    the dollar has value not only because of demand in the u.s., but because there are $30trillion in eurodollar loans that need to be serviced with dollars. there is no such demand for a peso, rupee, yuan, ruble or [turkish] lira. furthermore, crypto allows for remittances to be transmitted at very low cost, for workers who wish to send funds to family back in the country from whence they came.
    as for bitcoin itself, it appears to be the best of a ragged bunch, and layers that have been built upon it, like the lightening network, enhance its usability. further, the fact that bitcoin is something of an object of religious devotion means that the float is even more limited than the ultimate theoretical supply. iirc about 80% of bitcoin extant does not trade: it is held by hodlers.

    1. Finster says:

      Thanks, JK. The light of day between the legitimate use case you cite and what most investors are using it for is a concern. I wonder how many people, consciously or otherwise, view it as digital gold. The term is widely used in the media and stories about it are routinely headed with a graphic of a gleaming golden coin.

      Gold itself along with silver also has a similar utility, so bitcoin is hardly unique. The dollar deprived may find handling physical money cumbersome, though if they can’t keep track of a few coins they may have the same trouble keeping track of a smartphone.

      Its volatility as a store of value likely owes to the lack of an anchor. Having no fundamental value, it invites speculators to use their imaginations. So they are susceptible to any narrative put before them. The only solid counterpoint is zero, and its market value makes it easy to dismiss, especially if it’s more emotionally comforting to believe you have an asset capable of huge gains.

      Dollars have value not only because of supply but demand. Demand is a function of people needing to acquire them because they are short, ie in debt. It’s possible to imagine that somewhere in the byzantine bitcoin ecosystem there might lurk an analogous mechanism.

      The main attraction is undeniably its record of appreciation. Volatility can also be an attractant … I’ve even made use of it myself to nab some small trading gains. Although you can justify an ongoing allocation on GMP theory, however, I have no confidence in long term return potential. Technology is notoriously susceptible to obsolescence, and it seems probable that once just about everyone is fully invested, some new alternative, whether another digital asset or something completely different, will be marketed as the Next Big Thing.