Why invest in ₿itcoin? A guide for the intelligent skeptic.October 23, 2022
Over the years i've had many questions from family & friends considering investing in Bitcoin. Each time the price starts rising, the more questions I get.
What i'm hoping to compile here is a guide for the intelligent skeptic, and yet uninitiated, which aims to answer the following questions:
- What is Bitcoin?
- Why does Bitcoin matter?
- Why should I invest in Bitcoin?
- What is Bitcoin's addressable market?
- What are the risks?
Since that time i've had numerous discussions with colleagues, friends and relatives trying to spark the same level of excitement that i've grown to have for bitcoin in them, with varying degrees of success.
Like many others, my first exposure to bitcoin came from hearing about it online via the bitcointalk forum
In October 2010, i saw a post on a random internet forum where someone was claiming to have discovered an algorithm that would allow them to generate bitcoins. In the post, a user, satoshi nakamoto described a process by which transactions could be verified without using a central authority.I remember thinking to myself, "that's really cool, but i don't fully understand how it works".
I had previously had a "don't invest in something you don't understand" rule when it comes to investing, so i ignored it and moved on.
Around year later, I was on the bitcointalk forum again to check on the status of bitcoin, and i saw a link to the bitcoin whitepaper. I read the whitepaper and was completely blown away; i'd never read anything so elegantly written in my entire life. I was convinced this was going to change the world. I bought my first bitcoin few weeks later from MtGox. I downloaded the bitcoin-qt wallet and let it run to sync with the blockchain but my coins i thought i had withdrawn from the MtGox purchase were no-where to be found...
I've since come to believe that the only way to truly understand an investment is to first become invested in it (starting with small amounts), which then gives you the financial incentive to better understand it.
Like many others in the bitcoin community, I didn't just stumble into it without a prepared mind. Years of un-learning classic economics (since a 2006 undergraduate degree in economics) had taught me that there was a different way of thinking about things like the inflation rate and long-term planning within an economy.
These books had the greatest impact on my thinking during that time:
- Ludwig-von Mises: A treatise on economics (link)
- James Davidson: The Sovereign Individual: Mastering the Transition to the Information Age Paperback – August 26, 1999(link)
In 2005, I had felt the pain first-hand of interacting with the online financial system, as an avid online-poker player having some (thankfully small) part of my online bank-roll seized when the U.S government froze assets in Netteller, which the preferred funding mechanism for online poker sites at the time.
When I first encountered bitcoin, I didn't hear about it in the context of online poker, but rather as a technological marvel that was the actualization of the information age (described in the Sovereign Individual).
The promise of a decentralized currency, repudiating the central banks and the centralization of the world's financial system was of course the most critical aspect of it, but the world-wide payments network, the possibility for the unbanked to participate in the global economy, the possibility for censorship-resistant free speech, etc. were all features that made it compelling. I should point out that I didn't know anyone in the bitcoin community at the time, so my thoughts on it were not influenced by others at the time.
In the following 6 year period, my thoughts were focused elsewhere, and I mostly ignored what was happening behind the scenes with bitcoin.
That would all change with the run-up of late 2017.
Bitcoin is a technology, and therein lies its potential value. Just like the internet itself, the technology is useful for a wide variety of things. Bitcoin as a currency is only the first, and quite possibly the least interesting. Just as the internet enabled new types of commerce (e-commerce), so too will Bitcoin enable new types of commerce (Bitcoin commerce).
This is why Bitcoin has such huge potential, and why it is different from all previous attempts at online currencies. Previous attempts failed, often miserably, because they tried to create new currencies. Bitcoin is not a currency, it is a technology. Just as the internet did not replace money, it replaced postal services as the primary means of sending information, Bitcoin is likely to replace the existing closed payment systems as the primary means of transferring value online.
The key to Bitcoin’s usefulness as a technology is that it is both decentralized and distributed. Decentralized means that no one controls it, and distributed means that no one owns it. While it was invented by a person (or persons) with the pseudonym Satoshi Nakamoto, its ownership and control is spread out across the world, and the software is open source, meaning that anyone can inspect the code and see exactly how it works.
This is critical for two reasons. First, it means that no one can control it or change it, because it is open source and available for anyone to inspect. Second, it means that there is no single point of failure. If someone tries to attack or shut down the network, they will not succeed because there are thousands of other computers on the network that will continue running the code.
The decentralized and distributed nature of Bitcoin means that it is impossible for anyone to manipulate the value of Bitcoin for their own ends. In particular, it is impossible for anyone to artificially inflate the number of Bitcoins in existence, because there is no central point at which new Bitcoins can be created.
Instead, new Bitcoins are created through a process called mining. In a process that is similar to a continuous raffle draw, mining nodes on the network are awarded Bitcoins every time they find the solution to a certain mathematical problem (and thereby create a new block). The difficulty of the problem is automatically adjusted so that, on average, a new block is created every ten minutes, no matter how many miners (and computers) are working on it. As a result, the number of Bitcoins in existence will never exceed 21 million, the total that is initially imposed by the rules of the Bitcoin protocol.
Bitcoin is the first system that allows for the transfer of value over the Internet that is completely distributed, without any central authority or trusted intermediary.
This allows Bitcoin to have built-in fraud and theft protection that no other payment system has ever had. Like most who first heard of Bitcoin, I initially dismissed it as an interesting experiment, but nothing that would ever be significantly adopted.
Why? Well, because I thought it would be easy to shut down. This is almost correct. Bitcoin is not easy to shut down, but it also is not easy to use.
Like a fax machine, you need both the sending and receiving sides of the system to be operational for it to work – so any attempt to shut down Bitcoin would have been like trying to kill the fax machine in the early 1990s. The Internet is far more powerful than the fax machine, and so it turns out Bitcoin is more powerful than I originally thought.
In fact, Bitcoin is a distributed, worldwide, decentralized information network masquerading as a digital currency.
It allows you to exchange money or assets between parties with no middleman. Without Bitcoin, this simply wasn't possible. And while it's true that all of us — the entire human race — now have access to this new technology, the truth is that 99% of us don't even realize this is happening. Most of us don't see what's coming, because we're too busy looking towards the past.
What we're seeing right now is the most disruptive technology since the Internet itself. And it's just getting started.
Is it money? An information network? An energy network? A new digital gold?
Bitcoin can be described as al of the above, but it's primary value in 2020, is as a store of value, which can be seen on these dimensions:
- Scarcity: Bitcoin supply is scarce, and asymptotically approaches 21 million coins. Achieving scarcity in digital form was Bitcoin's great technical breakthrough (building on decades of computer science research).
- Portability: Bitcoin is extremely portable, especially relative to gold. Arbitrary amounts of value can be held in a USB stick, or digitally transported across the globe in minutes.
- Fungibility: Any two Bitcoins are practically interchangeable, although each Bitcoin has a distinct history on the public ledger.
- Divisibility: Each Bitcoin can be divided into 100 million smaller units (called "satoshis").
- Durability: Bitcoins are durable and do not degrade over time.
- Broad Acceptability: Bitcoin’s primary weakness: it is far less broadly accepted than gold or US Dollars, although it has made impressive strides over the past decade.
If you're upset about how the banks are structured and the amount of control they have, bitcoin is a great alternative," he said. Palihapitiya said he is not as enamored with the other cryptocurrencies that are trying to compete with bitcoin.
"There's a real innovation in bitcoin," Palihapitiya said. "I'm not a huge believer in most of the other cryptocurrencies. I think they're silly."
He said he believes that the cryptocurrencies that survive will be the ones that deliver the most value. "If you're looking at this as a get-rich-quick scheme, you're going to be sorely disappointed," he said. "If you're looking at it as a way to create a new asset class, then you're going to get rich."
"If you're looking at it as a way to create a new asset class, then you're going to get rich." Chamath Palihapitiya
Palihapitiya said that he'd rather own bitcoin than the stock market. "I'd rather own bitcoin than the stock market," he said. "I'd rather own bitcoin than bonds. I'd rather own bitcoin than traditional commodities. I'd rather own bitcoin than most things that exist out there in the world today." When asked why, Palihapitiya said that most assets today are not correlated with anything. "They're just correlated with other assets," he said.
"Bitcoin is the only thing that you can look at and say it's correlated with nothing. It's a floating currency, and it's a good one. You can look at it as the new gold standard."
“We just had the awful realization that we were sitting on top of a $500 million ice cube that’s melting,” Saylor said. MicroStrategy has settled on bitcoin as the treasury alternative.
#Google is what happens when we pool information energy on a software network. Everyone understands this. #Bitcoin is what happens when we pool monetary energy on a software network. Few understand this. — Michael Saylor (@michael_saylor) October 24, 2020
In the west of China where there’s a lack of ultra-high-voltage (UHV) power lines Bitcoin mining may be one of the only suitable consumers of the excess hydro energy. Without UHV lines, much energy is lost to resistance during electrical transmission. Bitcoin mining can, in theory, transfer the equivalent value of the energy to the main cities in the east of China, avoiding loss due to resistance in the lines. If you think of a transaction over the blockchain network as the movement of stored energy it is frictionless and akin to sending an email.
This is just one example of how the bitcoin blockchain could be used to harness energy in a more efficient way. And it’s a good example of how the world of energy and the world of the blockchain are beginning to blend together.
One way to think abut the total addressable market for bitcoin is the sum of the amount of gold stored in the world and the amount of gold that is not, but could be, stored in the world. The latter is the market that Bitcoin can capture.
According to gold bar manufacturer Valcambi, the total amount of gold bars in the world is ~4.5M ounces or ~170,000 tons or ~1.3 billion troy ounces. Assuming that each Bitcoin could be substituted for 1/1,000,000 troy ounces of gold, this would give Bitcoin a total addressable market of 1.3 million troy ounces of gold, or ~$1.3B.
The total market cap of gold is much larger than the above market size, though, so there is a great deal of room for Bitcoin to grow. As an easy way to estimate the market size of gold, we can assume that the price per ounce of gold is $1,000 and that the price per bitcoin will also be $1,000, which is relatively conservative since the price of Bitcoin has historically been much higher than the price of gold. This would give an upper bound market size of $1.3T for both Bitcoin and gold.
As Nobel-laureate Robert Shiller observes:
"Gold is a bubble, but it's always been a bubble. It has some industrial uses, but basically it's like a fad that's lasted thousands of years." This is not an argument against gold (or Bitcoin) as a valuable monetary asset, but an astute insight into the bubble-like, reflexive nature of money.
However, Bitcoin's market size is not a fixed number. Even if Bitcoin captures 100% of gold's market and gold's market size remains constant, Bitcoin's market size would increase as more people start to use Bitcoin.
The most likely scenario is one of partial adoption, though, where Bitcoin captures a fraction of gold's market size and, as a result, Bitcoin's market size increases over time. For example, if Bitcoin captures 25% of gold's market, Bitcoin's market size would be ~$400B. This is still small relative to gold's market size but would still be enough to make Bitcoin the largest cryptocurrency by a significant margin, which is already the case.
The reason why Bitcoin's market size won't increase linearly with the number of people who adopt it is that Bitcoin's market cap is not a fixed number. If we assume that the price of Bitcoin is determined by the market cap divided by the supply, then as the number of people who own Bitcoin increases, the price per coin will also increase. This means that the market cap will increase at a slower rate than the number of people who adopt it.
The reason we know this is the case is that Bitcoin is the first of its kind as a digital asset, and we have no models for how it should behave. Consider the first person to ever jump off a cliff and discover the principle of gravity, or the first person to ever light a fire and discover the principle of combustion. These people could not have known the full extent of these principles, but they still acted on them. So it is with Bitcoin.
The price of Bitcoin will, in the long run, be the price that Bitcoin can support through mining. If Bitcoin becomes more widely accepted as a store of value and the demand for Bitcoin rises, then the cost of mining will rise and miners will be incentivized to add more mining capacity to the network. More mining capacity means more people will be working in the Bitcoin ecosystem, more products and services will be built on top of Bitcoin, and more people will hold Bitcoin.
If the number of people holding Bitcoin declines, then miners will have more incentive to sell their Bitcoin to people who are buying it. The price will have to drop. So, if the price is going up, then Bitcoin is gaining value and becoming more widely accepted, and if the price is going down, then Bitcoin is losing value and becoming less widely accepted.
Bitcoin has the potential to be substantially more valuable than it is today. Its price in ten years, assuming it succeeds, could be 10,000 times what it is today. And it could be 100 times more valuable than it is today.
Like any investment with great upside potential, bitcoin has numerous risks, any of which may prove to be fatal. That being said, many of these risks have been identified from day one and have not yet created any fatal impediments to its growth.
- Volatility: Bitcoin has been (and continues to be) quite volatile relative to US Dollars. There is risk that this volatility limits adoption or prevents investors from considering Bitcoin as a credible store of value. For better or worse, this volatility may be inherent to the process of Bitcoin adoption as natural swings in investor confidence (as faced by any early-stage upstart) are reflected in Bitcoin prices. Bitcoin’s bubble-like adoption process exacerbates this effect. As Bitcoin matures and becomes more broadly accepted as a monetary asset akin to gold, investor confidence and Bitcoin prices should stabilize.
- Regulation: Regulation is a challenge for Bitcoin. It is likely that governments will regulate Bitcoin and the Bitcoin network more strictly. One mitigating factor is that Bitcoin is a global, decentralized network like the Internet, which is difficult to control for any single government.
- Technical Risk: The Bitcoin codebase and network have been battle-tested for over a decade, but it continues to evolve and there remain some open questions about how the system might behave in the long run (for example, when the Bitcoin supply approaches its asymptote and miners must be compensated primarily with transaction fees rather than block rewards).
- Competitive Risk: For example, Bitcoin is a relatively new and largely untested technology. While the system has been operational since 2009, it has only recently become the focus of significant media attention. Important questions regarding the security of Bitcoin and the protection of user's privacy, as well as the viability of the network and its ability to scale, remain unanswered. There is a lack of uniformity in Bitcoin's implementation and the resolution of Bitcoin's problems could take a considerable amount of time.
- Unknown Unknowns: We must acknowledge that a digital monetary asset such as Bitcoin has never existed before and as such, we simply can't know all of the risks that will asail it apriori.
Q: Should I wait to buy bitcoin until i understand it?
A: Absolutely not. Bitcoin, and crypto-curencies in general are incredibly complex making it nearly impossible to get to any level of sophistication around them in a short period of time. A good first step is to read the Bitcoin whitepaper and then just go through the process of investing (acquiring, securing) bitcoin in a paper or hardware wallet.
Note: You won't really understand bitcoin by just purchasing it on an exchange like Coinbase, because they handle all the private keys for you.
Q: How much bitcoin should i buy at first?
**A: The amount you are comfortable with to risk going to Zero. **Try to understand what the amount you invest is based on. If you are in a risk adverse environment, you may want to start with a small amount. If you are in a risk tolerant environment, you may want to invest a large amount.
Q: Where should i buy bitcoin?
A: I recommend buying your first bitcoin on an app like Cashapp (by Square).
There are also many crypto exchanges, but my favorites are Coinbase, Gemini and GDAX.
Q: Where should i store my bitcoin?
A: You should store your bitcoin in a secure place. I would recommend a paper or hardware wallet like Ledger. This is the only way to truly 'own' your Bitcoin and will allow you to understand some of the inner workings of the Bitcoin protocol.
Q: Isn't it already too late to invest?
A: It's never too late to invest in Bitcoin. In the end, when investing in Bitcoin, success is a function of time in the market, regardless of when one starts. There's many early adopters that have already sold out, and there will be many lateadopters that will hold for decades into the future.
Q: Do i need to buy a 'whole' bitcoin to get started?
A: No. You can purchase fractions of bitcoins.
Q: Isn't Bitcoin an energy hog and environmentally un-friendly?
A: No. Bitcoin is actually one of the most efficient methods ever created for incentivizing the production of low cost energy. More here.