If you've been watching bitcoin prices lately, you already know they've made a record-setting run. As of this writing, a single bitcoin is valued at almost $1,300, more than an ounce of gold. To put things in perspective, bitcoin values were in the $300 -- $400 range for much of 2015.
SEE ALSO: Betting on Bitcoin
Those who invested in bitcoins years ago are likely rejoicing. But, should you join them? Continue reading to learn more about bitcoin, how the currency works, and why this investment might be one to skip despite its high returns.
What is Bitcoin?
Generally speaking, bitcoin is a crypto-currency used by online firms and big businesses worldwide. One of the biggest advantages of bitcoins is that the currency can cross borders easily -- facilitating international trade.
For the purposes of investing, bitcoins are similar to any other currency (or commodity) investment. This means, when it comes to your investment return, bitcoins face the same uphill battle as investing in:
- agricultural products
- fine art
In other words, at any given time, bitcoins are worth whatever the market says they're worth. While this isn't a problem in itself, investing in bitcoins does pose some specific challenges. As sexy as investing in bitcoins sounds -- and despite the recent run-up in price -- there are at least two fundamental problems with investing in bitcoins right now:
PROBLEM #1: YOU LOSE MONEY AFTER INFLATION (NEGATIVE REAL RETURNS)
When you invest in bitcoins (or gold, or oil, or other commodities, or any other currency, or fine art), you are betting the farm on price appreciation alone. Or rather, you're betting that the price of bitcoins will go up compared with the U.S. dollar. What this means is, bitcoins are 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 dividends. Either way, a stock generates cash -- ultimately enriching those who own shares.
The same is true for bonds. Bonds spit out cash (usually twice a year). With a bond, you (usually) get back your original investment, plus interest.
The same applies to real estate. Rental property can appreciate (or depreciate) in price. But, either way, rental property exists with the goal of generating cash for the investors -- cash above and beyond the costs to maintain the property.
Unfortunately, that's not the case for bitcoins, gold, "Forex," commodities or fine art. These sorts of investments do not generate cash. Instead, investors can only hope they rise in value with the price of inflation.
Despite their volatility, commodities do not outpace inflation. And that's before fees!
Unfortunately, you are likely looking at a negative real return after expenses with an investment like bitcoins. Why? Because it costs money to get into bitcoins. You must "buy" them, and you won't be able to buy bitcoins at their value. You'll have to pay a little extra; otherwise, the person selling you the bitcoins (or gold, etc.) has no incentive to do so.
Not only must your investment appreciate at the rate of inflation, but 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!
On average, economies grow. A growing economy can raise the demand for goods and services. This can cause prices for said goods and services to increase. Moreover, entities issuing currency usually "print" more currency. This devalues that currency, requiring more of the same currency to be required for the same good or service.
These two factors - a growing economy and the printing of more money - can cause inflation. Therefore, an investment in currency, by its nature, should not be able to grow with inflation. So, not only does your investment in currency lose money because of inflation, but your investment also loses from the bid/ask spread - the price of buying into a different currency.
In short, bitcoins and similar investments are at a big disadvantage when it comes to generating an investment return. Bitcoins don't generate cash like stocks, bonds and rental real estate do -- and they have the added challenge of never even being able to keep up with inflation!
PROBLEM #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 bitcoins are no exception. Mean reversion itself isn't a bad thing, but it's still worth noting when it comes to investing in bitcoins, specifically.
As mentioned and shown in the graph above, commodities provide an investment return at 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 bitcoins, 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," says Jon Luskin, MBA, CFP®, of www.UncleDMoney.com. "Commodities can see even larger swings in value than stocks -- making successful investing in bitcoin almost impossible."
Pro Tip: Invest Only as Much Money as You Can Stand to Lose
Try thinking of investing in bitcoins 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 with 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 bitcoins 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.
See Also: Why Commodities Are Bad Investments
Taylor Schulte, CFPÂ® is founder and CEO of Define Financial, a San Diego-based fee-only financial planning firm. Schulte is passionate about helping clients accumulate wealth and plan for retirement. Schulte was recently honored with the 2015 Five Star Wealth Manager Award and the 2015 Metro Mover award for outstanding contributions to his profession.
Copyright 2017 The Kiplinger Washington Editors