An Investor’s Guide To Bitcoin
Bitcoin was the fastest investment in history to go from zero to $1 trillion in market value. And it did it without a CEO or board of well-paid executives steering the ship. So what exactly is Bitcoin and how does it work? We’ll break it down for you in this guide – and explain why you might want some in your investment portfolio.
How did Bitcoin start?
I’ll never forget the scene when Lehman Brothers, the giant investment bank, collapsed on September 15, 2008. Back then I worked in Canary Wharf (London) in a junior finance role at HSBC. Everyone was panicked. The industry mood was grim. Would our jobs be the next ones to go?
Lehman and other big banks invested heavily in subprime mortgages and mortgage-backed securities. And when the US housing market started to topple over, those investments quickly went bad. That caused major damage to the economy, and the public began to lose trust in the financial system as a result.
But around that time, one group of computer coders were hard at work – trying to build a new financial system. On October 31, 2008, just six weeks after Lehman’s fall, Satoshi Nakamoto emailed them the Bitcoin Whitepaper. The nine-page PDF laid out the concept of bitcoin and cryptocurrency.
What is Bitcoin?
Bitcoin two things:
- A blockchain or “ledger” that securely processes and stores transaction records (Bitcoin with a big “B”).
- A digital currency that you can send across said blockchain (bitcoin with a small “b”).
Satoshi’s paper introduced it as a “peer-to-peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution.” In other words, bitcoin is electronic money that doesn’t need a bank or credit card company to make it work. You can ping it to any corner of the world, in any amount, and it won’t affect the fees or time taken to send it. Compare that with the international banking system, where middlemen take their cut and funds can take days to travel.
What else makes Bitcoin interesting?
First, it’s scarce. Investors view bitcoin as digital gold. Like gold, bitcoin has a limited supply. But unlike gold, we can mathematically predict when that supply will run dry (in the year 2140). There will only ever be 21 million coins and around 92% of them have already been minted. So unlike fiat currencies, bitcoin can’t be debased (printed) by central banks.
Second, it’s safer than Fort Knox. I’ll explain why it’s so secure later, but for now, just know that it’s pretty much impossible to hack. You can store funds on the blockchain that only you can access. And because only you can access it, there’s no counterparty risk.
Third, you can be your own bank. According to the World Bank, about 1.4 billion adults don’t have a bank account. But anyone can create their own wallet to send, receive, and store bitcoin. So unlike with banks, you can have 100% control over your financial destiny. And Bitcoin is open for business on weekends, too.
How does Bitcoin work?
If I send money from my bank account to yours, our banks will talk to each other – they’ll debit my account and credit yours in their records. They’ll also run security checks to make sure the money arrives safe and sound. But Bitcoin takes a different approach: instead of banks updating their records after transactions, miners update the blockchain.
Let’s say I send some bitcoin (BTC) to your wallet. That transaction (and about 2,000 others) is grouped into a block, which is locked by an insanely complex cryptographic puzzle. Miners will compete to solve that puzzle with bitcoin mining software that they run on powerful computers.
Now, the first miner to crack the puzzle earns the privilege of attaching that block of transactions to the blockchain. That miner also earns bitcoin (which is how new coins are made) along with all the transaction fees of the block. This process is called proof-of-work (PoW) and it’s what keeps the blockchain going – with each block taking about ten minutes to confirm.
How secure is Bitcoin?
Once our transaction gets added to the blockchain, it’s already super secure. At this point, an attacker would need more than half the computer power of the whole Bitcoin network to wind back the blockchain and reverse it. Sure, a “51% attack” is possible in theory, but it’s never actually happened. And I doubt it ever will happen: it would be far too expensive for the attacker to get hold of that much computer power. Not to mention developers watch the network like hawks, so they’d kick that thief off the network pronto.
One block is secure, but two blocks are more secure. That’s because each block buries the previous block deeper into the blockchain. After six blocks, it’s buried so deep that it’s mathematically impossible to get out. Our transaction is now embedded in the blockchain forever and will never be undone.
How fast is it?
Each block can only hold one up to megabyte of data, which doesn’t leave much space for transactions – Bitcoin only does about five per second. But slower speed is the tradeoff for superior security.
Smaller blocks mean there’s more demand for block space, which bids up transaction fees. Since miners earn those fees, smaller block sizes create bigger incentives for them to mine, which means more mining competition (and mining power). The higher the network’s mining power (or hash rate), the harder it is for an attacker to outmuscle the network. So while Bitcoin isn’t the fastest blockchain around, it is the most secure.
Notice in the chart below how the hash rate (orange) keeps trending up over time. The older Bitcoin gets, the more secure it will be.
How much do bitcoin transactions cost?
As for transaction fees (orange, chart below), you’re usually looking at between 50 cents to $2 a pop. Mind you, those can go up dramatically in crypto bull markets when there’s greater demand for bitcoin transactions. But remember, that’s regardless of the size or geography of the transaction. So for transferring big amounts over big distances, Bitcoin is extremely cheap, secure, and efficient.
You could also use the Lightning Network for much quicker and cheaper bitcoin transactions. This is essentially a separate payment system that plugs into the Bitcoin blockchain to get the traffic moving faster.
What about mining and the environment?
Bitcoin mining consumes tons of electricity. The Cambridge Bitcoin Electricity Consumption Index puts it at around 140 terawatt-hours per year, which is on par with gold mining. That said, gold mining has many other adverse effects on the environment, which isn’t the case with bitcoin. Toxic waste, acid mine drainage, and the destruction of land are all bad spillovers of the gold mining process. Not to mention, transporting bars of gold uses way more energy than pinging coins across the blockchain.
Unlike oil drillers, gold miners, and the like, the location of resources doesn’t decide where bitcoin miners do business. That means they can choose where they operate – i.e. off-grid locations where electricity is cheap, clean, and abundant. According to the latest Bitcoin Mining Council survey, about 58.5% of bitcoin mining comes from sustainable energy.
That number should tick up over time. Renewable energy is often cheaper, so it’s good for miner profits. And governments are likely to boost subsidies for greener energy, making it cheaper still. On top of that, more mining companies are listing on global stock exchanges – and they’ll want to keep up their green score to boost their share price.
Why invest in bitcoin?
Here are three possible reasons:
1. It’s good for diversification.
The holy grail of investing is to build a portfolio with high returns and low risk. Of course, if you only invest in bitcoin, you might get high returns with high risk. So the basic idea is that you want to hold a few different assets in your portfolio. That way, one or two might be going up when others are going down, so you get a smoother equity curve over time.
Now, diversification only works when assets move differently some of the time – otherwise, there’d be zero benefits. Popular belief is that bitcoin is a “risk asset” and moves pretty much in tandem with the stock market. But looking at the table below, you can see that’s not quite true. Since 2015, the correlation of bitcoin’s monthly returns with the S&P 500 has only been 0.35. If they moved in tandem, the correlation would be 1. And as the table shows, bitcoin has even lower correlations with gold (0.09) and bonds (0.16).
So in my mind, there’s no question investors should own some bitcoin in their portfolios for diversification. The question is “how much?”. I wrote a blog post about this a few years ago here. The numbers are a bit outdated, but the general concept still stands.
2. It’s a hedge against fiat currency debasement.
The US Federal Reverse (Fed) has grown its balance sheet by about $8 trillion since Lehman Brothers collapsed in 2008. The mechanics of a central bank balance sheet are complex, but here’s what’s important: when it grows, it creates more currency. Of course, there are other factors involved (for example, bank lending) but the US money supply (grey line) has gone up massively over the past decade. So has bitcoin’s price (blue line)…
The supply of bitcoin, meanwhile, is mathematically programmed to be scarce. Recall from earlier that miners generate new coins when they mine transaction blocks. Well, every four years, there’s a halving event – and those mining rewards get cut in half. In other words, bitcoin’s supply is growing at a slower speed every four years. The way the maths works out, about 92% of all the coins have already been mined. By the year 2140, the supply will stop growing altogether, and miners will only earn transaction fees for their work.
If you believe in the economic principle of “too many dollars chasing too few goods”, bitcoin seems like a pretty good bet to me. True, it doesn’t have gold’s long-term track record of storing value. But it’s only been around since its first block in January 2009. Give it time.
3. It’s an investment in a new technology.
Blockchain is a new technology that’s likely to play a big part in our lives in the future. And by holding bitcoin as an investment, you’ll own a small piece of it.
But as with most earlier-stage tech investments, there are risks. The market needs to discover bitcoin’s true value, and that’s going to come with massive volatility – both to the upside and the downside. But if and when bitcoin gets bigger, its volatility will most likely die down. And it’ll probably trade like older and more established asset classes.
- Bitcoin (the blockchain with a big “B”) is a payment system to send bitcoin (the digital currency with a small “b”). It doesn’t need a financial institution to make it work – it has a global network of miners instead.
- Bitcoin is scarce, secure, and efficient for sending and storing big sums of money.
- It’s a volatile investment, but therein lies the opportunity for growth. It’s good for diversification too.
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