Bitcoinmania

12/14/2017 11:35 am ET

You can’t browse a financial website or tune in to financial news without being inundated with analysis and opinions on bitcoin. The bitcoin frenzy is everywhere, and people don’t want to get left behind as many clamor to participate in the 21st century gold rush and become the next bitcoin millionaire.

The question being asked is “Should I invest in bitcoin?” In my view that is the wrong question. The appropriate question is “Should I speculate in bitcoin?” The difference between investing and speculating is dramatic and worth clarifying.

Warren Buffett’s mentor (and The Father of Value Investing), Benjamin Graham, along with David Dodd, attempted a precise definition of investing and speculation in the seminal work Security Analysis (1934). “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Since Graham and Dodd penned those words in the midst of the Great Depression, the lines have become blurred and the term “investor” is now being applied to anyone who participates in the financial markets.

None other than Vanguard Group founder Jack Bogle advises people to “avoid bitcoin like the plague.” Like Graham and Dodd, Bogle bases his opinion on the simple fact that bitcoin, like gold, has no underlying rate of return. Stocks have earnings, and dividends and bonds pay interest. Bitcoin and gold produce no stream of cash flows or earnings. They really produce nothing except the hope that you will be able to sell your position to someone for more than you paid for it – the greater fool theory.

Rather than the Gold Rush of 1849, I think a better analogy to the current market for bitcoin is “Tulipmania” experienced in the Dutch Republic in the 1630s. During this period, a single tulip bulb sold for multiples of what a skilled laborer could earn in a year, despite the fact that these bulbs had no earning power.

Last weekend, University of Chicago Professor Richard Thaler received the Nobel Prize in economics for his work in behavioral finance. The premise of behavioral finance is that human beings aren’t rational profit maximizing machines, but often succumb to behavioral biases. One of the most common behavioral finance biases is recency bias, or the observation that we tend to overweight our most recent experiences and underweight experiences from the more distant past. In essence, many of the bitcoin speculators watch the market price of bitcoin rise and assume it is going to continue into the indefinite future.

In addition, there is the “FOMO phenomenon” at work in any mania (fear of missing out). There is something about seeing others get rich quickly that brings out the greed in all of us. And that’s more than a little dangerous to our financial health. We would be wise to heed Warren Buffett’s advice to “be greedy when others are fearful and fearful when others are greedy.

Many of these speculators would be wise to be reminded of perhaps the most recent market bubble that occurred in residential real estate in 2007-8. Many speculators leveraged and purchased multiple homes with the intention of flipping them as the price rose. The popping of that real estate bubble precipitated the financial crisis.

Coming full circle connecting bitcoin and the real estate market is the most alarming financial headline I have seen in many years. Yesterday, MSN Money reported that “People are taking out mortgages to buy bitcoin as price soars.” My advice would be to not mortgage your homes and instead buy a couple of tulip bulbs, as the price has come down dramatically over the past 400 years. Then you can at least have something else to look at when you need a break from the parade of madness that financial markets produce from time to time. This particular wild ride is best experienced as a spectator, not as a speculator.

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