Quite often and in particular with cryptocurrencies, the price is not based on the behaviour of an asset, but instead, the behaviour of the people who are buying it.
Lets take an example from gambling that predated all financial markets and can be traced back as far as the 1500’s. If you bet on say a NFL team to win the superbowl in Las Vegas, the odds that you receive or not based on how likely a particular outcome, but how much money others gamblers are betting on which team.
Lets talk about the maths (don’t worry nothing to complicated):
Lets say in a hypothetical superbowl final, the New England Patriots play the Kansas City Chiefs. Both teams have had an excellent season but the gamblers prefer the New England Patriots. A bookmaker in Las Vegas will set the odds one two things, (i) how much money they would like to make (they are generally not in it for the fun of it, but instead to make a profit) and (ii) how much money gamblers place on the game.
Lets say that money for the New England Patriots comes in at $600,000, that is the total some of money placed on the New England Patriots and less, but still a substantial amount has come in for the Kanas City Chiefs of $500,000.
The book maker decides that they would like to make $100,000 on the game, so these three numbers will dictate the odds.
First, lets look at what the odds are likely to be based on the New England Patriots (NEP),
So this means, that you will have to put $6 on in order to win $4, if the New England Patriots win.
Lets look at the reverse,
So, you would have to put $1 on the KCC to win $1.
It now should be clear, that either way, the bookmaker will make $100,000. The odds match up in such a way that the profit for them is guaranteed.
Now it should be clear from our example, that it wasn’t the bookmaker that determined the odds, nor the performance of the teams in the build up to the game, nor the behaviour of the teams. It was infact the behaviour of the gamblers. The people who were willing to bet.
This is not different to our comparison with non-revenue generating assets. Think of Bitcoin, what money does it make? You can only make money in Bitcoin if someone else is a little bit more excited about buying it than you were and go ahead and purchase it for a higher price.
So how is this different to investing in a stock?
Stocks are businesses that try to make profits, they add value, and this is why your investment can go up. But with bitcoin, its really not generating any money.
So why has Bitcoin done so well?
There are a few ways to justify Bitcoins climb. First, there are a limited number of Bitcoins (21 million), in economics, generally things that are scarce have value, or at least, this perception gets investors excited and willing to buy. But is Bitcoin really scarce? This is a complicated question for another post, but some people disagree with this, and believe that Bitcoin just gives the impression that it is scarce.
Second, it may have done well because it had a first-mover advantage. It went first, but this doesn’t always mean it will stay top. Google wasn’t the first search engine (Archie, Archive without the v was the first well documented).
But generally, there has been a buzz around Bitcoin pushing the prices up?
So is Bitcoin a bad investment?
This is hard to say, but I think the biggest thing now is electricity. Bitcoin in theory could be useful if the world used it, and it did become a global cryptocurrency. A lot about this has been said when Elon Musk invested a considerable amount of Tesla cash into Bitcoin. Many suggested that due to the amount of electricity the Bitcoin uses, this was a flawed investment from Mr Musk, who is in the eco-friendly electric car business.
Why does Bitcoin use electricity?
It is possible, with computers and an algorithm to ‘mine’ a bitcoin. This helps with the security of the asset and in its design is a good thing on the face of it. But when the price increases, this encourages more miners to the table in the hope of making a profit. Leading to Bitcoin to use more and more electricity becoming more and more inefficient.
A useful comparison with Bitcoin is with precious metals like Gold. They are only worth what somebody else is willing to pay and like Bitcoin, gold uses more materials via mining when the prices rise. The big difference with Gold is that is a physical product and has had a value for hundreds of years.
Remember, investing in Bitcoin is highly risky and you should seek proper financial advice before investing.
For another thought provoking investment opportunity, consider ETFs, read more about what is an ETF here.