Why Invest in Bitcoin?

I have written many past posts about Bitcoin in particular and cryptocurrency in general, covering how Bitcoin fits into an overall asset allocation strategy, different ways of getting exposure to Bitcoin and have also recommended weightings in my monthly portfolio updates.  For this post, I thought it would be good to go back to basics and focus on Bitcoin and why it's something that everyone should have a "non-zero" allocation to.

First of all, what is Bitcoin?  Bitcoin is the first peer to peer digital payment system ever created.  It is entirely decentralized.  There are thousands of exact copies of the Bitcoin ledger stored on computers all over the world.  These are called "nodes" and are used to validate authenticity of bitcoin transactions - if any node were to go down there are many many more that have the same information, thereby making the blockchain extremely resilient.  Transactions are validated by miners, who use high powered processors and compete to solve complex math equations.  If successful, a miner will write the next block of the Bitcoin ledger (a copy to be retained on all nodes for future reference) and will earn a block reward (newly issued Bitcoins).  Once written, the block is immutable and unchangeable and so are all the blocks that were written previously.  Also, anyone can see it since the blockchain is public, so while the identity of the parties to a Bitcoin transaction are not visible, the address of their wallets is and other aspects of the transaction such as the amount of Bitcoin being transferred are public.  Perhaps one of the most notable aspects of Bitcoin is the ability to balance privacy with transparency in this way.

The amount of Bitcoin processing power is called hash rate.  The higher the hash rate, the more difficult it is to attack the system in order to compromise the ledger and create fake transactions - the so-called "50% Attack."  This was recently done with a smaller coin (Bitcoin SV).  At current hash rate levels (which have been growing on an annual basis roughly in line with the price of Bitcoin at about 200%), it would be virtually impossible to harness the computing power necessary to overwhelm the network.  As the network grows, so does the hash rate.  Hash rate did dip when China recently shut down all mining operations in their country, but it quickly recovered as miners relocated to more friendly countries including the US.  Helping this along (and part of the game theory embedded in the Bitcoin code), when hash rate drops, the difficulty of mining new blocks also drops, making it more lucrative for existing miners to solve the equations faster and thereby earn more Bitcoin.  When hash rate recovers, the difficulty increases.    

Because of Bitcoin's decentralization, it is "trustless" and does not require an intermediary such as a bank or other entity to complete a transaction.  Similar to physical gold and silver, it can be "self-custodied" by holding the coins in a hardware wallet (basically a USB flash drive) as opposed to on an exchange like Coinbase.  Storing Bitcoin on a hardware wallet requires you to know the keys, or a series of random words that will allow you to recover your account.  If those keys are lost, then your Bitcoin is lost forever, so it's important to save them in a safe place.

Bitcoin is a scarce digital asset:  there will only ever be 21 million Bitcoins in existence.  Currently, there are 18.8 million bitcoins in existence and the remaining 2.2 million will be mined over the next 30 years or so, until all coins have been issued.  Every four years, there is a "halving" event, which reduces the miner's reward by half (currently 6.25 coins per block).  At today's price of about $50K per coin, a miner makes $312,500 each time they successfully write a block, so Bitcoin mining while extremely difficult and capital intensive (requiring hundreds if not thousands of processors in most large operations and plenty of cheap electricity), can be lucrative.  Indeed, investing in Bitcoin miners and related companies has become popular.  

Bitcoin is and has been for some time the largest cryptocurrency by market capitalization, currently at $946 Billion.  Etherium is currently number two at about $392 Billion.  Because of Etherium's popularity in the decentralized finance (DeFi) and nonfungible token (NFT) worlds, it has seen strong demand, even though the protocol is very different from Bitcoin.  For example, it is more centralized (a core group of developers can make changes to the protocol), has no maximum supply and is moving to a less rigorous but less energy intensive method of validating transactions called proof of stake versus the proof of work method that Bitcoin uses.  It is generally believed by the Bitcoin community that proof of work is superior to proof of stake for securing the network.  

The investment thesis for Bitcoin is fairly straightforward.  As a scarce digital asset, it is similar in many ways to gold or silver.  Unlike gold, it is "compact" and a significant amount of value can be stored in a very small space (on a hardware wallet the size of a USB flash drive).  Also unlike gold, it can be transferred easily to whoever you want, without the need of a third party intermediary.  To me, these are significant improvements over gold.  But as a digital asset, there's more that Bitcoin can do.

Bitcoin also has the capability of being the "base layer" of a new monetary system, with second and third layers built on top of it that can handle more transactions and faster processing speeds at a fraction of the cost - rivaling Visa or Mastercard payment networks.  One of the complaints with the Bitcoin base layer currently is that it takes 10 minutes to write a new block and each block is limited to 1 Megabyte of data.  These limitations are eliminated with second layer protocols such as the Lightning Network (which sets out to do much of what Etherium has sought to do).  Etherium sought out to solve those speed and volume issues on the base layer, but as time has gone on it's clear that this is very difficult to do without sacrificing security, which is the main reason why Bitcoin was architected the way it was.  I think Etherium and the 10,000 or so other "Alt Coins" have their function and place, but they are very different from Bitcoin. 

I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2021.  To see all my books on investing and leadership, click here.  

Stay safe, healthy and positive.