Should I Get in on the Bit-Coin Boom?

by Patrick Gleeson, Ph. D., Registered Investment Adv ; Updated December 30, 2017
Should I Get in on the Bitcoin Boom?

Getting in on the Bitcoin boom certainly is tempting, particularly if you've got enough money to survive a future Bitcoin crash. The Winklevoss twins, who started Facebook with Mark Zuckerberg, invested $11 million in the Bitcoin market in 2013. By late 2017 their investment was reported to be worth over a billion. But that's only half the story. Before you put everything you own (or even a lesser amount) in this cryptocurrency, consider the risk. It's greater than you might think. You may want to consider the history of market crashes carefully before proceeding.

Market Crashes 1: Tulipmania

Late in the 16th century, a previously unknown flower in Holland was introduced from Turkey: the tulip. It became very popular. Then, a disease infected the tulip stock. This reduced the available supply, which in accordance with the law of supply and demand, increased the value of the surviving tulips. The same disease also caused a wonderful mutation of these surviving flowers: They no longer were simply yellow or orange, but were streaked with dramatic flamelike bursts of other colors. Everyone wanted these enhanced tulips and the herd of eager buyers drove their prices higher. In response to this increased demand for flowers in limited supply, financiers began an official tulip bulb futures exchange where eager buyers could invest in (or you prefer, "bet on") the future value of the bulbs. Another way of looking at this is that investors were attaching values to bulbs that did not yet exist. Tulip bulbs had become financial instruments!

At the height of the tulip boom, a single bulb cost more than a house. Ordinary tradespersons became wealthy overnight. Everyone wanted in on this marvelous quick path to extreme wealth, and many of them borrowed against everything they owned.

But didn't investors know that no reasonable person could possibly think a tulip bulb was worth more than a house? They did, but also they were operating according to the market Theory of the Greater Fool: Any price, no matter how elevated or unsupported by data, is justified if the buyer paying that price believes there is someone else – the greater fool of the theory – who will pay even more.

And then came the crash. As it accelerated and deepened, everyone who'd invested tried to sell out before the market got even worse. The same immutable law of supply and demand that had driven prices to preposterous heights now operated with a vengeance in the other direction. Within a few days you could buy a tulip bulb for the price of an onion. The heaviest investors lost everything. Families were ruined and businesses that had survived for generations were gone forever. In following centuries, as you already well know, tulip bulbs never reached these lofty prices again.

Market Crashes 2: The South Sea Bubble

The South Sea Bubble of the early 18th century was another boom and crash sequence that bankrupted thousands of investors. Unlike Tulipmania, the South Sea Bubble has no simple narrative of cause and effect. Like a lot of other crashes it's not entirely clear why the bubble began or why it lasted long after the rationale for it ended – although why it crashed is better known.

In brief, The South Sea Bubble centered on the the fortunes of a single company, the South Sea Company, an English firm that traded slaves, although with difficult political constraints that limited its profits. But as an unpopular war between Spain and England drew to a close, speculation arose that Spain and England's treaty agreement would remove these constraints, vastly increasing the company's slave-trading capacity and, hence, its profits. The company's stock began trading energetically, with guaranteed returns of six percent annually. The number of shares in play soon increased to a possibly fraudulent degree.

As it turned out, the treaty between the two countries didn't allow for an expansion of the slave trade. This should have begun a sharp decline in the company's share value. Instead, following an endorsement of the company by England's King George 1, the stock rose further in value. The company then began offering annual payouts of 100 percent interest. After all, how could the King be wrong? Share sales soared.

Here's where the story gets interesting. Instead of admitting defeat and retrenching as the basis for the company's wealth, the company's directors next proposed to somehow take over the England's national debt and to pay it off with a fantastically profitable expanded trading enterprise. This should have sent off warning bells because there was no basis for the claim. Instead, the stock increased by nearly a thousand percent in a few months.

And then, it crashed. All the energetic hoopla surrounding the South Sea Company's vastly expanded trading basis turned out to be based on fraudulent accounts of trades by a few trading ships that returned with modest profits or with no profits at all. The favorable publicity that had made investors eager to get in on the boom was manufactured largely on the basis of bribes to government ministers. It was all fiction.The promised 100 percent payout on South Sea Company stock never happened, the Company's stock price collapsed and, again, ordinary investors were ruined.

Market Crashes 3: The Crash of 1929

In the 1920s the U.S. stock market began a spectacular climb over several years, culminating in a boom that until late in 1929 made ordinary investors rich. At one point a few months before the actual crash, a prominent economist announced that the market had achieved an economic phenomenon previously unknown: A plateau that would continue indefinitely without any following decline. Already enthusiastic, investors put in more money further and further on margin – that is buying stock with money they really didn't have, but that they expected to have as the market further climbed.

The stock market, however, like markets generally, is profoundly cyclical. In 1929, the good times ceased rolling overnight and investors, deeply in debt to their brokers, soon declared bankruptcy, sweeping away their brokers as well in the general collapse.

Within a year, the collapse had widened to include every aspect of the U.S. economy, engendering America's Great Depression. Former high-flying stockbrokers were eking out a living selling apples on the street from a cart. Despite the creation of many government programs to to get the country back on its feet, the good times didn't roll again until World War II in the 194os.

The Psychology of Booms

The details of each of these booms (and following crashes) are unique, but all of them – and later booms that included the "Dot Com Boom" of the early 200os and the Subprime Housing Boom that ended in 2007 – have similar narrative arcs. They all began fairly reasonably with a rising market. At some point, however, the way investors feel about the market – what economists call investor "sentiment" – begins to overcome investors' reasonable caution and fear of losses. Subsequently, market evaluations that warn against unreasonable price rises are generally ignored, often after one or a few prominent "authorities" declare a market victory that promises to continue forever. Investors then swarm the market and the boom gathers energy.

In the following phase, which you might think of as the fantasy phase, the booming market gets seriously out of whack, as in the South Sea Bubble, where credulous investors bought stocks promising guaranteed 100 percent annual returns despite the near absence of underlying market activity. The unreasonableness of the guarantee would be immediately apparent to a sophomore in finance; but with a prevailing sentiment of fantastic optimism, data-based reasoning is generally ignored, or even scorned.

At some point common to every boom, "the little guy,'" joins the fray. Famously, in the Dot Com Boom a Shanghai rickshaw driver began his own investment fund and successfully sold its shares to his riders. In every boom comes a time that Alan Greenspan termed "irrational enthusiasm," which drives the market with scant reference to verifiable underlying data that could establish reasonable share values.

In every boom, the following crash swept away a large part of the economy, particularly the smaller investors who generally got in late and who couldn't afford to make these investments – often with borrowed money.

Yes, But ... (The Winklevoss Twins)

But isn't the Bitcoin situation different? When the Winklevoss twins began investing in 2013, many skeptical market professionals had already begun warning "the End is Nigh" - that disaster in the form of a profound market collapse was soon to follow. But what actually followed was a ten-fold increase in the value of Bitcoin. With that increase came a further deluge of "authoritative" warnings against investing in the Bitcoin market, some of them from government sources, such as Great Britain's Financial Conduct Authority, which predicted a total market collapse where investors would lose absolutely everything.

And still market goes on. As of the publication date of this piece, the Bitcoin market has a total value of over $170 billion, dwarfing the tech market's $2.4 billion value before the Dot Com collapse. With a capitalization this large, if a Bitcoin collapse does come, it's going to sweep away not only a lot of investors, but likely other financial institutions and even entire economies along with it. If it doesn't come – if the expansion continues forever – it will introduce a phenomenon often predicted in market booms but never before realized: Speculative investments that increase in value forever.

And in Sum....

Disappointingly, perhaps, this article can't advise you what to do if you're considering investing in Bitcoin or other cryptocurrency, because there's no predictable point where a given boom will collapse. The Bitcoin market could continue its remarkable expansion for years, or it could collapse tomorrow. If it goes on for years, you might invest, make a remarkable amount of money and then be wise enough to sell your investment before the collapse. (This is called "market timing" and is notoriously difficult to do). On the other hand, since an early collapse is just as likely as a later collapse, you might invest tomorrow, just in time to lose your entire investment.

One reasonable piece of advice often given by economists is that when you're making a speculative investment (really just another name for a bet) you shouldn't wager more than you can afford to lose. In the present instance with Bitcoins, how much can you afford to lose without feeling foolish or worse, finding yourself in a financial jam? Unless you're wealthy and/or blessed with a continuing generous income, that might not be very much.

References

About the Author

Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.

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