There is a very wide range of opinions on how investors should interpret Bitcoin’s extraordinary price spike. In this post, I discuss key Bitcoin investing insights that come from recent research that I conducted with two colleagues, Hoje Jo and Haehean Park.
The price of the Bitcoin virtual cryptocurrency is displayed on a phone screen in this photo. Bitcoin … [+]
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Bitcoin’s price history in 2021 was nothing short of astonishing: it rose by 78% between January 1 and the third week of February and exceeded the psychologically important value of USD 50,000. Many commentators have compared Bitcoin to gold, and in some ways the recent Bitcoin trade is no different than a gold rush, mixing fundamentals with strong streaks of irrationality.
It is easy for investors to lose perspective during asset price bubbles as emotional forces dominate calm, dispassionate thinking. Market sentiment refers to excessive optimism or foam in the overall market. A key finding of our research is that the historic return to Bitcoin revealed what behavioral economists refer to as high sentiment beta.
What exactly does a high mood beta mean? Most investors understand the concept of traditional beta, which is the extent to which the return on an asset moves relative to the overall market return. Likewise, sentiment beta refers to the extent to which an asset’s return moves in relation to over-optimism in the general market.
The High Vibes Prototype Beta Stock is the stock of a small, fledgling company that has an exciting history and is not yet profitable, but has the potential to become extraordinarily profitable in the future.
In Bitcoin’s ten-year history, its return has behaved similarly to a high-sentiment beta stock. Our research documents three main characteristics that link Bitcoin to general financial market dynamics.
First, Bitcoin does not exist in isolation, but is tied to the global financial system. Bitcoin, like any other asset, has a traditional beta. However, in times of high stock returns, Bitcoin returns are less tied to the overall market than in low stock returns.
Second, successfully investing in high sentiment beta stocks means they will be bought during times of low sentiment when they tend to be undervalued. The same goes for Bitcoin: when market sentiment drops, Bitcoin acts more like a small company investing aggressively than when sentiment is high.
Third, the return to holding Bitcoin is generally positive during times when the stocks of companies with higher profitability outperform the stocks of companies with lower profitability. Remember, growth stocks have significantly outperformed value stocks over the past decade, with much of that outperformance coming from big tech companies like Tesla TSLA TSLA TSLA TSLA. Bitcoin is similar in this regard, but with increased price movements.
High sentiment beta stocks have two important characteristics. First, they are fundamentally difficult to evaluate, and second, they are difficult to convey. The same goes for Bitcoin.
The difficulty in valuing Bitcoin is partly due to the fact that while Bitcoin is an asset, it does not generate cash. Bitcoin isn’t even a physical asset like gold that can serve as physical input in making jewelry or electrical components. Instead, Bitcoin is simply the unit of account in a specific blockchain-based transaction technology in which it serves as a medium of exchange. What gives Bitcoin fundamental value is the ability of its transaction technology to compete effectively with other transaction technologies such as those offered by traditional financial services companies.
John Maynard Keynes, one of the greatest economists of the 20th century, wrote that most investors do not base their trades on considerations of fundamental value. Instead, they base their trades on guesswork, trying to guess which assets other investors will find more attractive in the future. In the case of Bitcoin, examples of institutions active in the Bitcoin market were BlackRock BLK BLK BLK BLK, BNY Mellon, and Mastercard MA MA MA MA.
Recent academic research has found how dopamine flows in the investor’s brain track asset prices during bubbles. The movement in asset prices during the bubbles reflects dopamine flows much more than the core values, which investors by and large ignore.
There is good reason to believe that most investors who trade Bitcoin pay little or no attention to the relative transaction costs associated with using Bitcoin instead of traditional credit cards to conduct transactions. For example, how many investors know that a single Bitcoin transaction consumed the same energy as 80,000 Visa VVVV transactions in 2018, compared to 453,000 Visa transactions today? What do these comparisons suggest for the future potential of Bitcoin as a competitive medium of exchange? For example, how many investors who trade Bitcoin know that Bitcoin is a country instead of a digital currency and is one of the 30 countries due to power consumption? How many know that processing Bitcoin transactions today consumes around half of the electricity in all data centers in the world?
Elon Musk was a major investor in Bitcoin, and Tesla has announced that it will accept Bitcoin if it sells new cars. Think about what this means for car buyers using Bitcoin to buy new Teslas.
Business textbooks tell us that an asset that can only function as a medium of exchange must be stable over time. But consider this: A buyer who paid $ 100,000 worth of Bitcoin for a new Tesla on Jan. 1, 2021 would have paid 78% less if they had waited seven weeks. Bitcoin’s market value is hardly stable. In fact, the pattern of returns resembles lottery-like stocks more than bond-like assets that usually play the role of the medium of exchange.
Of course, just like some people who win the lottery, some investors will benefit significantly from investing in stocks with lottery-like payouts. Behavioral economists caution investors to understand the added risks they face in trying to profit in high sentiment markets. Luck usually plays a big role in these markets. Just ask the investors who have traded GameStop stock.
Though Tesla announced it bought $ 1.5 billion in Bitcoin in January 2021, analysts at JPMorgan JPM JPM JPM JPM have seen Bitcoin prices rise over the past five months amid low institutional flows. If so, it suggests that most of the price spike was due to trading by individual investors, which is in line with the results of my own research.
Since GameStop GME GME GME GME is still in our collective consciousness, it is worthwhile to send a “reservation notice” to investors trading highly speculative assets. In a perfect world, investors would do well to properly consider underlying fundamentals when trading, especially for an asset like Bitcoin. Needless to say, the world is far from perfect.