So I put out a podcast the other day where I talk about the ideology behind Bitcoin.
In that podcast I mentioned how there is a case to be made for Bitcoin as an alternative asset class. That we could treat Bitcoin and other cryptocurrencies as forming a part of a balanced and diversified portfolio alongside other asset classes such as real estate, stocks, bonds and commodities like gold.
First, let's talk about where Bitcoin's value comes from.
Note: This is not financial advice. This is an objective analysis of bitcoin as an asset class.
I'm going to go about this by talking about the various inputs that go into all of these different asset classes.
Real estate. Here, the input is land and improvements (structures). Land is the physical location, the parcel of bare land that can be owned by a person. It really is a fascinating innovation if you think about it: the idea that every square meter of the Earth can be divided up and sold to someone who then owns that part of the Earth.
The land portion creates scarcity, because there's a limited number of 'ideal' locations for a real estate asset. Prices on bare land are determined largely based on location. The other aspect of real estate is the structures built up on the land: these structures are what ultimately bring in value for real estate assets in the form of cash flow (ie. rent).
In sum, the value of real estate is a function of its location and capacity for revenue. Scarcity is what causes prices to appreciate over time.
Stocks. Here, the input is a business that earns revenue selling products or services. If you have a successful enough business, it may become an attractive enough investment that other people will want to throw in their own money to own a part of that business. This is why the stock market was invented: to give everyday people with some money (known as "retail investors") the option of buying a teeny tiny piece of a business.
The benefits of owning a piece of a business is that you become entitled to some of the profits of that business. This can come in the form of dividends, where each stock-holder receives a little bit of money back at regular intervals, or in the form of capital appreciation: as the company's revenue grows, it becomes more valuable, and hence each stock in that company becomes more valuable.
In sum, the value of a stock is a function of the revenue (or potential revenue) of the business attached to that stock. If business revenue goes up, then the price of the stock tends to go up. If revenue goes down, then the price of the stock is likely to go down, too.
Bonds. The primary input for a bond is safety: bonds are generally seen as very safe assets, particularly when they're issued by large financial institutions (such as central banks) or governments.
A bond is a way for big institutions and governments to take on low-interest debt. They issue bonds, and those bonds are bought by both retail investors and "institutional" investors (this could be a corporation, organization, or even another government).
In return for purchasing a bond, the institution issuing that bond guarantees a small return on investment in the form of interest. For the past decade or so, the typical interest rate on government issued bonds has been in the neighborhood of 1-3%; this is barely above average background inflation (more about that later).
In sum, the value of a bond is a function of the perceived safety of the return on investment. The safer the bond, the lower the interest rate; the more risky the bond, the higher the interest rate.
Commodities. The primary input here is the physical good itself, and all of the time and energy it took to create that physical good. The value of a commodity as an investment comes from the difference between the cost of acquiring that physical good and the price you get for selling that physical good.
For example, you might buy a truckload of coffee beans from Costa Rica for $10,000, knowing that you have a buyer lined up in Colorado to buy those coffee beans for $20,000 dollars. After spending, say, an additional $3,000 dollars on the cost of transporting the beans to Colorado, you would expect to pocket $7,000 dollars in net profit from selling the beans to your buyer.
Of course there are risks here. For example, by the time you reach Colorado, the buyer might have found a better deal elsewhere and no longer be interested. Then you have to find a new buyer, who may not be willing to pay your expected price. Or maybe half the beans go moldy or are of a lower quality than expected, resulting in a renegotiation of the original agreement. If you end up only being able to sell the coffee beans for $12,000 dollars rather than the expected $20,000, then you'd be at a net loss after the transaction was completed.
Commodities are volatile, and the price can fluctuate wildly. For example, look at how the price of oil has fluctuated over the past few years. Oil is still a valuable commodity because we use so much of it; but when it comes to its value as an investment, some years are better than others.
Gold has traditionally been seen as the top of the food chain when it comes to commodity investing, and this example shows how scarcity can play into make a commodity more or less valuable.
The benefits of holding gold is that a) it can never go bad, and b) the amount of available gold is fairly constant. For these reasons, the price of gold has remained fairly stable over many decades, unlike most other commodities.
You can always grow more coffee beans or wheat, or harvest more lumber. This means the available amount of these commodities can fluctuate. When demand soars and availability is low, prices can skyrocket. When demand tanks and availability is high, prices can drop substantially.
Gold doesn't have these features: gold has some utility as a precious metal (it's used in small amounts in many of our electronic devices), so demand is fairly constant. Mining gold is difficult and costly, so the supply doesn't fluctuate that much from year to year.
In sum, the value of commodities is a function of supply and demand. Commodities that are in demand but scarce will always be expensive; while commodities that are abundant and in low demand will always be cheap.
The main input for Bitcoin is trust. Or, to be more specific, trust in the form of the amount of energy that is consumed to operate the Bitcoin network and to create each subsequent block of transactions (or, on a more micro-scale, the amount of energy it takes to create every new bitcoin).
So, I guess you could say that the value of bitcoin is ultimately derived from the amount of energy it takes to run the network. And it takes a lot of energy.
But here's where the trust part comes in: the more time goes by, the harder it becomes to try and go back and change or alter the transactions that happened in the past. This means that as time goes on, all of the transactions that have ever taken place on the bitcoin network become more and more secure from any future attempt to alter them.
In this way, bitcoin represents an unalterable ledger. In its entire 13-year history, the bitcoin network has never been hacked. Whenever you do hear of a hack that stole a bunch of bitcoin, it's always been because some individual somewhere made a mistake or was compromised.
This is the cost we pay for self-custody of a currency like bitcoin. If best practices are followed, it's impossible for anyone else to access your bitcoin. No government or group can take your bitcoin from you.
This forms a strong system of trust. And there's also a high level of transparency. If you want to find out what bitcoins belong to which wallet, you can simply go back and look at the bitcoin ledger yourself to verify. Anyone can easily run the bitcoin software on their own computer to verify transactions.
And this is the big idea: operating the bitcoin blockchain and facilitating transactions requires a large amount of computation power. But it only takes a tiny amount of computation to verify that those transactions are legitimate.
As a result of this, it becomes very difficult to fake a set of transactions. Thanks to the beauty of mathematics and cryptography, it's practically impossible to forge the bitcoin ledger in a way that isn't immediately obvious to any outside observer running the basic software.
Further, bitcoin operates on a system of consensus. All of the computers that run the bitcoin network (operated by people we call "miners") have a stake in the network's integrity, because any miner who participates is a) investing money to run their computers, and b) receiving bitcoin as a reward for securing the network.
It's simple economics: miners are doing all of this computational work in order to gain a profit. If the bitcoin network fails or loses its integrity or ceases to be trusted, then all of the miners will lose both their investment in mining hardware and any chance of future profit.
So in this system, everyone operating the bitcoin network has as a stake in keeping the system operational and trusted. Since miners are paid bitcoin in return for their computation power, the price of bitcoin is pegged to the real world:
The minimum viable price for a single bitcoin to be sold by a miner is equivalent to the cost of producing that bitcoin.
Since the only way to create new bitcoins is to mine them, and mining them costs a set amount of energy, there's no incentive for a bitcoin miner to sell bitcoin at a loss.
Also, since it's generally expected that the amount of computation being deployed to secure the bitcoin network will continue to rise, the minimum price of a bitcoin is expected to rise too.
So, that's the economics of bitcoin as an asset in a nutshell. Its value comes from the fact that it's trusted. It's trusted because it costs a lot of energy to secure the network. And miners are willing to spend a lot of energy to secure the network because bitcoin is a trusted asset that can act as both a store of value and a viable currency.
Comparing bitcoin to other asset classes
When it comes to real estate, bitcoin shares one of its best features: scarcity. Bitcoin is a scarce asset, because the number of bitcoins that can ever exist is capped at 21 million. The difference is that while real estate exists at a specified location, bitcoin can be taken anywhere. If you can memorize your private key, you can even take bitcoin with you wherever you go in your head.
So here, bitcoin does have some advantages over real estate as an asset in terms of its portability. While a natural disaster might destroy your real estate assets, no natural disaster can take down the bitcoin network (because it's decentralized and distributed globally).
Future value proposition: Real estate does have the advantage of generating income in the form of rent. Bitcoin could theoretically facilitate a similar system as well: in the future, with the Lightning Network, it might become possible to "rent out" bitcoin in order to open up a transaction node. This transaction node could facilitate thousands of individual transactions, that would then be settled on the main bitcoin network. The person renting out their bitcoin could feasibly receive a return on their investment in the form of collecting small fees from each transaction (fractions of a penny multiplied by thousands of transactions can add up).
Stocks are digitized assets that represent a share in a company. Similarly, bitcoin is a digitized asset that represents a share in the bitcoin network.
The difference is that to buy and sell a stock, you need to go through a brokerage. There are limits on how, where, and when you can buy stocks. Not so with bitcoin.
Also, a company can fail. Their stock can go to zero. The only way bitcoin goes to zero is if the entire network fails. So, with stocks you might hedge your bets: invest in many stocks, or an index like the S&P500, so that the fortunes of any one company don't destroy your portfolio.
But, even entire stock markets are subject to fiat currency failures. For example, if the United States' financial system collapses and the U.S. dollar becomes worthless, then so too will any of your U.S. dollars invested in the stock market, even in the S&P500. Your wealth could go to zero overnight.
But with bitcoin, you're just betting that someone, somewhere will continue to see value in bitcoin. And because it's a trusted asset that isn't tied to any one currency (or even to the global financial system itself, really), bitcoin will always hold value as long as bitcoin continues to exist.
Future value proposition: If bitcoin adoption continues to rise, then the price will continue to go up. This is because there's a limited number of bitcoins to go around, and the more people that want bitcoin, the higher the prices will go. Over the past 13 years, bitcoin has seen a substantially greater ROI than any other significant asset that's ever existed.
Think of bonds like a safe version of a stock. They're also vulnerable to the collapse of the institution that issues them. If you buy a bond issued by a government, and the government fails and can't pay back their debts, then you lose your investment.
That doesn't sound too safe, does it?
Gold is physically constrained. It's difficult to move, costs money to store securely, and can't realistically be used as a currency. Like real estate, it can be vulnerable to a natural disaster.
Other commodities don't fare much better. Prices fluctuate. Many commodities, like coffee, go bad. So they need to be exchanged for money in a short timeframe, whether or not market conditions are favorable.
And no matter what your commodity is, there's the difficulty of transportation and storage.
Bitcoin doesn't have this problem. It's at least as secure as gold (with gold, you have to trust someone to secure it; with bitcoin, you just have to trust that the miners keeping the network operational have a vested interest in doing so). It's completely portable, with zero storage fees. And it's completely liquid: it can be used as a currency within a matter of minutes.
In terms of volatility, bitcoin has that too. But unlike commodities, many of which tend to decrease over time and go through periods of bubbles & busts, bitcoin has (so far) had a tendency to trend up with time. And the built-in scarcity aspect of bitcoin means this is likely to continue well into the future.
Sure, bitcoin isn't a perfect asset. It doesn't need to be. It just needs to be differentiated enough from all existing asset classes to be a worthwhile investment. And it seems to tick a lot of boxes here.
Like real estate, bitcoin is scarce. But it's also portable.
Like stocks and bonds, it's a digitized asset that's expected to increase in value over time. But its value also isn't tied to national currencies; if the U.S. dollar goes to zero, bitcoin doesn't have to follow.
And like a commodity, such as gold, bitcoin is a tangible store of value that's tied to the real world (via energy consumption). But it's also not physically constrained and difficult to transport or store: moving bitcoin around is as easy as sending an email.
If we look at these features objectively, bitcoin appears to have a huge amount of upside. The only thing in question is whether the bitcoin network itself will continue to exist into the future. If the bitcoin network fails, bitcoin will go to zero. But if it remains a reliable, secure, and trusted ledger of value (knock on wood) for decades to come, then the value of assets being secured by the bitcoin network could increase exponentially.
Which way will it go? I have no idea.
But it may just be time to start treating cryptocurrencies, particularly bitcoin, as legitimate financial assets that are in a class all on their own.
If you're interested in more cryptocurrency-related content, check out this podcast episode that I put out:
Disclosure: I do own some bitcoin, as well as other cryptocurrencies. So take this opinion as-is and do your own research.