Fast rising markets are quick to catch the attention of financial news. Here I present my views on Bitcoin and how to possibly invest in or speculate in it.
In summary, I think bitcoin has no fundamental value and therefore no true pricing because bitcoin is an exchange of value (currency) and in itself is almost useless (not an asset or commodity). As a currency, the value is dependent on the demand for the assets it can buy, but there is a negligible amount of assets that only bitcoin can buy. The price of bitcoin can take any number - in fact, as a means of exchange, a smaller number is more convenient. My opinion is that people in general are pricing it as though it has value and that the value is increasing.
To profit from bitcoin, you have to estimate how people will 'price' bitcoin, which is incredibly complex because it's an endeavour in human psychology within the context of finance.
However, by looking at past prices, you can position yourself favourably (if the past is representative of the future). Buy in drawdown periods, not when the market is making new highs or is frothy. Expect to lose up to 80% of your investment, so allocate your funds accordingly. Hold the investment for a long enough time, say one year, and then maybe hopefully you will see some returns. How much the returns are is beyond the scope of modelling.
Full article below.
VALUATION AND PRICING OF ASSETS
Valuation is important because the value of an asset is the price it is expected to revert to. Prices will imperfectly reflect an assets’ value, but will usually (or be expected to) fluctuate around that level. Major deviations are expected to be corrected by market participants once information has been processed by most of them. This is contingent on rational behaviour of the participants, which is presumed, at least in the long run.
If fundamental valuation is to be disregarded in pricing assets, one would have to rely on a method that can reliably identify irrationality and its expressions in order to profit from price movements. This is assuming irrationality is systematic and predictable.
We start by comparing BTC to currently investable assets so that we can use its valuation premises to derive its fundamental value.
An asset that has value due to its use in the production process or as a finished product (e.g. iron ore, industrial chemicals, machinery, pencils). The value of a commodity is composed of its value in use in the production process, or its value as a finished product. This is in turn dependent on the strength of demand, which is reflective of consumer preferences. The strength of the demand of a commodity is also influenced by an asset return component, in which demand is higher when buyers anticipate higher prices in the future (which could be based on expected higher consumer demand for the asset).
Nonphysical contracts which have some form of expected future financial return, e.g. a legal claim to income (as in bonds) or to participation in ownership of a company (as in shares). The strength of demand for these assets derive mainly from the anticipated increase in financial returns (in the form of greater real contractual income, in the form of price appreciation etc). Basically, if people think the price will be higher in the future than what it is now, they will buy it.
A medium of exchange which has no intrinsic value (fiat money). The demand is based on its value in use, which is what can be bought by it, and its expected financial return component (expected appreciation which is in turn dependent on the expected increase in demand for the assets it can buy). For example, if there are no Australian assets that can be bought, there would be no demand for AUD. The AUD should increase when buyers demand more Australian assets, or when buyers anticipate the demand for Australian assets will increase in the future.
Commodities, financial assets, and currencies are also stores of value. Each class has a different basis for its value. For example, fiat money could be seen as the weakest store of value as it is dependent merely on the faith of the issuing government and its economy, whereas certain commodities are likely to have value in most states of the world (e.g. raw materials, food).
Transactions occur when the strength of demand meets the willingness of supply. When general demand is high (for whatever reason), buyers bid up prices to try to obtain the asset. Sellers currently hold the asset, and are less willing to let go for the same reasons. This is how prices rise.
The willingness of supply is also influenced by immediate need for cash (liquidation of assets), excess of need for usage, and other minor factors such as preferences (risk aversion, wealth preservation).
VALUATION OF BITCOIN
Though Bitcoin may currently be viewed by the general public as a commodity (like gold), but is actually fundamentally more like a currency. It doesn’t have any value in use. Rather, it is a medium of exchange.
The differentiating factor between BTC and other currencies is that there is only a tiny amount of goods/assets that are purely denominated in BTC. This means that there is negligible fundamental demand for it, i.e. there is hardly any reason why someone would need to use it to buy something (apart from the need to be anonymous).
Increased acceptance, usage and regulatory approvals only facilitate the ease of exchange – it does not affect the value, as much as how the widespread use of the US Dollar does not cause its exchange rate to be at a higher number unless the demand for US assets increase as well.
Therefore, the reasons why BTC is bought is likely a combination of (a) false thinking that it is an asset that has value, and (b) expected increase of that value in the future.
BTC can actually take any value and it wouldn’t make a difference to its users (in fact, a smaller integer is more convenient). It only makes a difference to those people who bought it in anticipation of an increase in price, and there is no fundamental reason why it should increase in price if its intrinsic value is the same.
The value of a bitcoin is likely an irrelevant question since it is only a medium of exchange. Without a fundamental value, no one can really talk about investing in bitcoin as though it were an asset. One can only speculate what number it will take in the future, and take a position that will profit from it.
PRICING OF BITCOIN
The anticipation of the price of bitcoin is difficult mainly because it does not have a fundamental value, and therefore must be estimated by reading the crowd – how it prices bitcoin now, and how it will likely price bitcoin in the future.
There is significant hype about an asset whenever it starts to pick up in price like what bitcoin has done this year. The tricky and dangerous part about riding a bubble wave is that it is very difficult to determine when to get out because that involves determining the point when the crowd decides the party’s over. It becomes an exercise in reading crowd psychology.
Traditional metrics of risk and return are not very relevant here in forecasting as it cannot be reasonably assumed that the distributions of returns and its volatility will persist. Historically, when a bubble bursts, it hardly repeats itself the same way (pattern).
What you can do on a personal level is to limit your losses, and pick a time when the bubble phase is not too frothy, and hope that it later becomes frothier.
Limit losses by having an expectation that the trade can lose the entire sum invested, and allocate a portion of your total investment portfolio accordingly such that even if the entire sum is lost, your total wealth and investment objectives are not severely impacted.
If the short term trend of the market has little bearing on its long term trajectory, going in when the market is in short term drawdown increases your chance of realizing a long term profit, as opposed to buying when the market is making new highs.
Historically, drawdowns have been severe - up to 80%
This occurred thrice:
2011 Jul, lasting about 1.6 years
2013 Apr, lasting about 8 months
2013 Dec, lasting about 3.2 years
Most cannot tolerate such large drawdowns and will likely liquidate their investment during that phase. Especially in the latest 3 year drawdown – not many would have the patience to stick it through, nor do they have any fundamental valuation as a backing to justify them doing so.
You might stand a better chance if you enter at a point when bitcoin is in its drawdown phase, at a phase of around 50-60%, and be prepared to wait for up to 2+ years if required.
365-day holding period returns show the percentage return if one were to hold it for exactly a year (since bitcoin trades 24-7). This imposition of a holding period typically helps in that the investment is not liquidated earlier than initially planned because of a sharp and severe fall in prices.
Historically, if one were to have a 365d holding period, the chances are that one would have gained from the investment – most of the instances (orange line) are above the 0% line, unless you picked the dates in late 2013 (which was when the bubble was very frothy). Apart from that you would’ve enjoyed neat returns which put stocks to shame.
A longer HPR in a market that is assumed to be rising most of the time will exhibit a more positive skew in its returns distribution.
For bitcoin, it was beneficial to have a longer holding period – the positive skew in 365d HPR is much greater than in the 30d HPR.
This could be a guideline in estimating how long one should hold an investment in bitcoin, assuming the past is representative of the future.
Though bitcoin may not have a fundamental intrinsic value, the historical risk reward distribution seems to be favourable. However, this hangs critically on how representative the past is of the future. In assets such as shares, such an assumption has been shown to be fairly and usually true. It may not be so for bitcoin.
Regardless of that, expectations can be formed and a position can be taken to at least put the odds in your favour if historic patterns do occur again.
Buying in periods of drawdown and having a long enough holding period can help to that end.