What are financial advisors to make of Bitcoin? A quick Google search reveals descriptions of Bitcoin ranging from “scam,” “speculative bubble,” “investment mania,” and “money laundering scheme,” to “the currency of the future.”
On a more factual basis, here’s what we do know about Bitcoin: It opened on Aug. 11, 2010 at $0.06 per coin. By Dec. 11, 2017, Bitcoins were selling for $17,549.66. As of Jan. 9, 2018, they were trading at $14,789.
Do these prices make Bitcoin a speculative bubble? That is, a market in which investors are paying increasingly higher prices based solely on the belief that other investors will pay even higher prices. Considering that Bitcoin itself has no inherent value, it’s easy to see why some folks believe the Bitcoin market is pure speculation.
(While some Bitcoin advocates are quick to point out that the same could be said of U.S. paper money, they overlook the fact that sellers are required by law to accept U.S. dollars, regardless of the value of the paper they are printed on.)
I find it ironic that the Bitcoin market emerged less than 10 years after the last speculative market crash in 2001, when the dot-com stock bubble burst, and the Nasdaq fell some 52% to 1,950 from 4,069.
A popular joke that captured the speculative mania of that time went like this. One tech investor ran into another tech investor walking his dog on Nob Hill in San Francisco. The dog walker asked: “What do you think of my new $1 million dog?” The other investor replied: “That’s ridiculous. That dog isn’t worth $1 million.” “Sure he is,” the other investor replied. “I traded two $500,000 cats for him.”
The not so funny truth is that many, if not most, of today’s Bitcoin “investors,” aren’t old enough to have a clear memory of the dot-com market, nor are they likely to have read much about the history of other speculative investment markets, either.
In times like these, it’s important for all of us to remember how speculative markets occur, how they work, and what their inevitable outcomes are. Toward that end, here are some speculative investment market moments, courtesy of Investopedia.com, that are enlightening.
The classic business school example of a speculative market is the “tulip mania” during the 1630s, in Holland (now the Netherlands). Following the importation (from Turkey) of the first tulips, the Dutch aristocracy went on a tulip bulb buying frenzy.
Aided by Dutch banks’ virtually unlimited lending, the price of a single tulip bulb soared to the equivalent of $1 million in today’s dollars. However, to restore some sanity into their economy, the Dutch government outlawed lending on tulip bulbs, the market for them collapsed, leaving many Dutch aristocrats with very expensive gardens.
The South Sea Bubble isn’t as well known, but it’s equally as instructive. In 1711, Great Britain formed the South Sea Company to reap trading profits from South America, as the East India Company had done with India. Based purely on hype from the company, its stock became hugely popular, increasing over eight-fold by 1720, as “the” investment to be in. When trading prospects with South American countries proved far less than expected, the company collapsed and many investors lost their money.
Then there was the Japanese real estate and stock market bubble of the 1980s. Fueled by government stimulus programs, Japanese stocks and urban real estate started to rise in value, which ignited speculation for continued increases. Within the next three years, prices tripled to unrealistic levels, and when the bubble burst in 1990, it took the Japanese economy a decade to recover.
The takeaway here is that sound investing is based on actual value behind an investment. Simply counting on someone to pay a higher price than you did is called “the greater fool theory” for a reason.