The Case for Investing in Cryptocurrencies: A More Rational AnalysisPosted on 2019-05-09
Two great investors, Charlie Munger and Warren Buffet have completely dismissed the value of investing in cryptocurrencies.
“I think the people who are professional traders that go into trading cryptocurrencies, it’s just disgusting. It’s like somebody else is trading turds and you decide, ‘I can’t be left out.’” — Charlie Munger
"If you buy something like bitcoin or some cryptocurrency, you don't have anything that is producing anything.. you’re just hoping the next guy pays more. And you only feel you'll find the next guy to pay more if he thinks he's going to find someone that's going to pay more..You aren't investing when you do that, you're speculating.” — Warren Buffet
Admittedly, there are lots of rash speculations within the cryptocurrency industry that have perhaps given birth to the distaste for cryptocurrencies in Buffet and Munger. This distaste may have caused them to misunderstand this brand new asset class altogether.
In this essay, I will make a case against Buffet and Munger, arguing that bitcoin, or certain cryptocurrencies in general, can be a good, rational investment instead of pure speculation, if you approach it the right way. (To minimize the risk of over-generalization, I will only talk about bitcoin in this essay as an example of cryptocurrencies; however, many lessons and principles apply to other cryptocurrencies as well.)
First, Bitcoin is not a company. It is not a stock. We cannot judge bitcoin with the same criterion we use to pick stocks. Bitcoin is a brand new asset class. If anything, it is a currency; however, unlike most other fiat currencies, Bitcoin has asymmetric growth potential, and that makes it a much more promising investment than its fiat counterpart. Let’s take a look at demand and supply, the two determinants a currency’s value and see how bitcoin and fiat differ:
The demand for fiat currency is difficult to predict and lacks growth potential. So many political factors are at play in determining the demand of a currency: international trade relations, internal regulations on companies, general economic trends with the country. I do not mean to generalize; the only point I want to make is that it is incredibly difficult to predict whether the demand for a particular currency will rise with certainty. Meanwhile, the demand of fiat currency lacks significant growth potential - it would be difficult to get 1 billion more people to start using the US dollars suddenly within the next ten years. On the other hand, the supply of fiat money is uncertain, the Federal Reserve can easily increase the supply of US dollars by billions, as they have done in 2008 - not saying that it was wrong, as moderate inflation can help the economy, but the point is, it is difficult to predict the supply of fiat money and the vast majority of fiat currencies are inflationary. Hence, unpredictable yet un-growing demand and unpredictable yet increasing supply, these two characteristics together make buying and holding a fiat currency a suboptimal investment option and make currency trading more of the realm of short-term traders.
On the other hand, bitcoin’s demand has a lot of growth potential and sees an upward growth trajectory. For starter, the global transmittance market is a 500 billion market, and bitcoin is looking to take over the majority of that market share for its low transaction fee.
“In India, the largest receiver of remittances in the world with 12 percent of the global remittance total, a recent partnership between bitcoin exchanges is projected to bring the fee down to 0.5 percent for remittances into the country.” (https://www.ccn.com/india-see-bitcoin-blockchain-remittance-new-partnership)
Each day passes by, more stores, restaurants, and venues ALL OVER THE world start to receive bitcoin. The demand for bitcoin transcends national borders. Let’s take a moment to think about it: for some person to adopt a new fiat currency, everyone around her must also adopt the same currency for it to have utility - and usually for that to happen, the government must get on board. Therefore unless there’s an economic collapse, the adoption of a fiat currency in favor of another is a long and arduous process. On the other hand, it’s not necessary for a whole country to adopt bitcoin before bitcoin brings utility to a person. Internet and globalization have made bitcoin more useful than ever. The internet allows buying goods and services across border. You can find venues that accept bitcoin all over the world. In addition, the communication technologies have matured enough to enable a rapidly growing population of remote work force, or digital nomads, who travel the world as they work whose demand for bitcoin lies in its universality and low remittance fee. Meanwhile, the supply of bitcoin is FIXED at 21 million eventually (96% of bitcoin will be issued by 2024). No entity can manually adjust the supply.
Therefore, while I do not intend to provide any financial advice, the rising demand and fixed supply lead to the increased price of bitcoin over the long haul. But by how much? Here’s a back-of-envelop calculation (inspired by Chapter 12 of "Cryptoassets: The Innovative Investor's Guide to Bitcoin and Beyond” by Chris Burniske and Jack Tatar) that you should not take TOO seriously, although it may help provide the tools for you to make your OWN estimation analysis:
The Bitcoin Value Demanded = Bitcoin Money Velocity * Bitcoin Supply * Bitcoin Price
Let’s say by 2022, bitcoin takes over 20% of the $500 billion global remittance market (in which it has a money velocity of 5, changing hands 5 times per year) and 10% of the $2.4 trillion global gold market (in which it has a money velocity of 1, meaning people hold it for the long term).
For the remittance market:
The bitcoin value demanded = 20 % * 500 billion = 100 billion
Bitcoin Supply = 21 million * 96% = 20.16 million
Bitcoin Price = (100 billion / 5) / 20.16 million = $ 992.063
For the digital gold market:
The bitcoin value demanded = 10% * $2.4 trillion
Bitcoin Price = (10% * $2.4 trillion / 1) / 20.16 million = $ 11904.7619
Note the price here is addictive because bitcoin must service the digital gold market AND the remittance market at the same time. EACH bitcoin must store enough value so that the TOTAL value for the two markets adds up. These two assumptions (that bitcoin takes over 20% the remittance market and 10% of the gold market) bring the bitcoin price to $ 12896.82.
Further adoption of bitcoin beyond these two use cases will only increase the price of bitcoin, and the addition is limitless - as long as they are new use cases for bitcoin, the demand will rise and the price will rise with it. Therefore, in the long run, the price of the bitcoin is doomed to grow; the question is how quickly and whether it will happen within your time span.
Therefore, Buffet may be wrong in that bitcoin has not created value. Its value, or utility, is THE reason why it will rise in price. Bitcoin is a delusion, but so are all paper currencies; papers do not carry intrinsic value, but because we believe in them collectively, they bring us great value. Bitcoin operates on the same principles.
By the way, as you perform these analysis and analyze your personal financial situation, you also have to take into account the opportunity cost. The same amount of money can also be put into an index fund and earn compounded benefits. In addition, while bitcoin has survived for 10 years without any major hack and its network grows more robust as each day goes by, it is still in its early stage and carries inherent risk. However, just as any investment, think carefully and rationally to maximize your financial freedom.