I took a bite out of Bitcoin and here is what I learnt

Fed up with the incessant chatter from my colleagues and friends  about the shiny new yellow digital gold aka Bitcoin and how one is  living under a rock if not yet invested in the latest digital asset , I decided to mine deeper into this topic. The digital currency Bitcoin had just breached the $16,000 mark and the best way to test the digital gold was to acquire some of the shiny metal for myself. But before doing that I had to understand the basics. Here is what I learnt from investing in Bitcoin.

Lets get to the basics. So what exactly is Bitcoin?

Bitcoin is a  global cryptocurrency for the digital era – “crypto” is a reference to cryptography which is part of the technology. It is the first decentralized  digital currency which works across international borders and doesn’t need to be backed by banks or governments. It is not owned by a single person or institution but by a global peer to peer decentralized network. In other words you don’t need Visa or Amex or a bank as a trusted intermediary.

In fact Bitcoin is one among thousands of cryptocurrencies – 1384 digital currencies to be precise, as on January 7 and growing. Due to the nature of its algorithm the supply of Bitcoins is limited to 21 million coins, other digital currencies have different limits.

What is so valuable about Bitcoin/cryptocurrencies?

Rather than a currency, bitcoin is being viewed more like an asset, with the hope of reaping great returns in the future. Fundamentally bitcoins derive their value just like anything else does, because people want them. Bitcoin too follows the basic rules of supply and demand.

Bitcoin derives its value from the fact that despite lack of government backing, it has built an ecosystem in which people are willing to trade it and place a value on it. In fact people perceive it to be more valuable than regular currencies – due to lack of control or censorship or intermediary. It cannot be controlled by one entity and has no single point of failure.

Bitcoin and other cryptocurrencies  are  built on the blockchain technology  – a continuously growing list of records called blocks, which are linked in a chain (hence Blockchain) and secured using cryptography. Each block typically contains a hash pointer as a link to a previous block, a timestamp and transaction data. By design, blockchains are inherently resistant to modification of the data. It is a public ledger containing all the transaction data from anyone who uses bitcoin.

What is blockchain. What is  so different?

Blockchain is an ingenious brainchild of a person or group of people known by the pseudonym,  Satoshi Nakamoto.

By allowing digital information to be distributed but not copied, blockchain technology created the backbone of a new type of internet. Originally devised for the digital currency Bitcoin, the tech community is now finding other potential uses for the technology including insurance,  healthcare,  real estate,   media, cybersecurity,  IOT and many more.

Imagine a spreadsheet that is duplicated thousands of times across a network of computers. Then imagine that this network is designed to regularly update this spreadsheet and everyone has the exact same copy at all times – you now have a basic understanding of the Blockchain.

Information held on a blockchain exists as a shared — and continually reconciled — database. Blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone on the internet.

“The traditional way of sharing documents with collaboration is to send a document to another recipient, and ask them to make revisions to it. The problem with that scenario is that you need to wait until receiving a return copy before you can see or make other changes because you are locked out of editing it until the other person is done with it. That’s how databases work today.

Consider  Google Docs, both parties have access to the same document at the same time, and the single version of that document is always visible to both of them. Similar thing happens in Blockchain as opposed  to traditional ledgers.

If two banks need to update their account balances, they have to spend time and energy to synchronize and coordinate. Money is held by the sender until it is received by the beneficiary. With Blockchain there is a single ledger and not two different databases.

But is it legal to invest in Bitcoin?

Trading and usage of Bitcoin is legal in the United states. The IRS views Bitcoin and other digital currencies as similar to stocks and bonds and federal tax laws dictate that buyers and sellers should treat it as such. Many countries have put out notices mentioning that Bitcoin and other digital currencies are not officially sanctioned and that users could be at risk. Bitcoin is outright illegal in Iceland and South Korea is actively considering a ban.

The worlds largest Bitcoin exchange is  Coinbase, a startup that has raised more than $200 million from a number of top tier venture capital firms.

You can trade four leading cryptocurrencies on Coinbase – Bitcoin, Bitcoin cash, Etherium and Litecoin.

With Coinbase, you must first give the app permission to connect to your bank account or credit card. As with other stock trading applications, you pay a fee (credit card – 3.99%, bank account – 1.49%)  for each transaction, buying and selling. Transaction through credit card happens in a few minutes but transaction through the bank takes a week to settle.

I bought the digital coins on a friday and it did not show in my account till friday of the next week. If the price plummets then, you are out of luck. Folks who bought via bank purchase on December 17 at the peak of $20K would see the prices drop to less than $16K by the time Bitcoins got credited to their account.

3 months price chart of Bitcoin showing the all time high and closing prices for 2017.

What cryptocurrency did I buy?

I downloaded the coinbase app on my iphone and within minutes was able to set up my account. Credit card registration is rather quick, but to add the bank account coinbase will send two transactions to your bank and ask you to validate the same. Overall in less than ten minutes I was all set and ready to trade.

Bitcoin was trading at around $16K and I refreshed the app multiple times hoping the price would fall, but it was the day of the digital coin bulls. I decided to bet on coins which had not appreciated as much as Bitcoin and also diversified by buying more than one type of cryptocurrency. Eventually I bought Bitcoin cash which was trading at $2400 per coin and Litecoin which was trading at around $310 . Keep in mind that you can buy fractional coins, so for example you can buy Bitcoin for $100.

One month price chart showing extremely volatility of Bitcoin, Bitcoin Cash and Litecoin.

I thought we were talking about Bitcoin. What is Litecoin now?

Litecoin is among the top 5 alternate cryptocurrency by market cap  and was created in 2011 by Chares Lee. Litecoin has a much faster transaction speed of 2.5 minutes as opposed to Bitcoin’s 9 minute per transaction. The fundamental technical difference is the cryptographic algorithms they use – Bitcoin uses SHA- 256 whereas Litecoin uses a comparatively new algorithm called Scrypt.

Bitcoin is referred to as the digital gold and Litecoin as the digital silver. Like other digital currencies supply of Litecoin is limited – fixed at 84 million litecoins. Bitcoin has a much lower supply at 21 million coins.

What then is Bitcoin cash?

Bitcoin cash is a crytocurrency which is a fork of Bitcoin and was created in August 2017. Bitcoin cash increases the size of the blocks from 1MB to 8MB. The goal of Bitcoin cash is to increase the number of transactions processed in order to complete with the transaction volumes that visa and paypal handle.

Why is the bitcoin craze?

It’s an investing frenzy, plain and simple.

Bitcoin cracked $1,000 on the first day of 2017 and crossed $20000 during the year before ending at close to $14,129. Other cryptocurrencies have seen similar spikes, though they trade for much less than bitcoin.

There’s a long list of factors people may point to in an attempt to explain this. Regulators have taken a wait and watch approach to bitcoin in certain markets. Dozens of new hedge funds have launched this year to trade cryptocurrencies like bitcoin. The Nasdaq and Chicago Mercantile Exchange have  let investors trade bitcoin futures, which may attract more professional investors.

Yet a key reason the price of bitcoin keeps going up is, well, because it keeps going up. Small investors have a fear of missing out on a chance to get rich quick. And when the value of your bitcoin doubles in a week, it’s easy to think you’re a genius. But you can also get seriously burned hoping that the prices will keep skyrocketing.

Some investors have compared the bitcoin hype to the dot-com bubble. Others, like Jamie Dimon of JPM Chase, has said it’s even “worse” than the Dutch tulip mania from the 1600s, considered one of the most famous bubbles ever.

Two weeks after my purchase Bitcoin cash was trading 4% higher and Litecoin has dropped by 17%,  total value of my holdings had decreased by a sobering 13%. Prices and total portfolio value as per above screen grab from Coinbase.

For the average investor, folks with mortgages, student loans, credit card debt or regular jobs they can’t afford to lose, bitcoins are highly risky — more akin to gambling than investing. Stay away unless you have the stomach for speculative investing and cash to lose without affecting your quality of living. But don’t take my word for it.

Jack Bogle- founder of Vanguard advised to avoid Bitcoin like a plague and he said: “Did I make myself clear? Bitcoin has no underlying rate of return. You know bonds have an interest coupon, stocks have earnings and dividends. There is nothing to support bitcoin except the hope that you will sell it to someone for more than you paid for it. Bitcoin may well go to $20,000, but that won’t prove I’m wrong. When it gets back to $100, we’ll talk.”

As way back as 2014, Warren Buffet said  “the idea that bitcoin has some huge intrinsic value is just a joke in my view.” Bitcoin is not backed by a company’s earnings, or the strength of a government and rule of law. There’s also no interest or dividends.

Charles Lee founder of Litecoin (LTC) warned late last year when the price of Litecoin doubled over the weekend – “ Sorry to spoil the party, but I need to reign in the excitement. Buying LTC is extremely risky and I expect to have a multi year bear market. If you cannot handle LTC dropping to $20, don’t buy”

Even my barber is thinking about investing in Bitcoin. That is surely a warning signal. Cryptocurrencies can fluctuate 20-30% in a single day. If you need the money during the next five years  do not speculate on Bitcoin.

There could be a better technology down the road which may reduce the value of Bitcoin, Hackers could get into the server and steal (yes it has happened!!), Digital exchanges like coinbase can go bust and you may loose all your money. Governments all over the world are watching this space closely and may bring about regulations, which may impact the value or may ban it altogether as the current mining ban in China.

So the list of potential risks are endless for a currency whose underlying value has not been established yet and cannot be used as a digital currency in a large scale currently due to the huge volatility in prices. You would not want to part with $10 in digital currency if you are not sure if your $10 will be worth $50 tomorrow . So in conclusion, if you planning to spend some money in Vegas, feel free to  buy some cryptocurrency instead. Or in other words speculate only the money which you can afford to lose. Good luck.

For more blogs on personal finance read Decoding the new tax code for 2018.

If you are aiming to achieve financial independence and travel the world send us a note and we will send you a FREE booklet on “How much do you need to achieve Financial Independence.”