My 10-minute presentation at our client advisory board meeting this week looked at bitcoin tulip mania.
I shared the story of Tulip Mania in Holland, which started in the 16th century, and drew some parallels to the bitcoin mania we are witnessing today.
Back in 1593, tulips were brought from Turkey and introduced to the Dutch. The novelty of this new flower placed it in great demand and pushed up prices; the basic economic model of supply and demand at work.
After some time, the tulips contracted a non-fatal virus called a ‘mosaic’. It didn’t kill the tulip but it did alter the flower, causing ‘flames’ of colours to appear on the petals.
These colour patterns appeared in a wide variety and increased the rarity of an already (at the time) unique flower.
Tulips, which were already selling in Holland for premium prices, began to rise in price based on the virus alternations and the desire for different petal patterns. Everyone began to deal in tulip bulbs, essentially speculating on the tulip market, which was believed to have no limits.
The true bulb buyers (the garden centres of the time) began to fill up inventories for the growing season, depleting the supply further and increasing scarcity and demand.
Soon, prices were rising so fast and high that people were trading their land, life savings, and anything else they could liquidate to get more tulip bulbs.
Many Dutch persisted in believing they would sell their hoard to hapless and unenlightened foreigners, thereby reaping enormous profits.
We call this the greater fool theory; the price of an object, in this case tulip bulbs, is determined not by its intrinsic value but by irrational beliefs and expectations of market participants.
Nobody knows for sure by how much tulip bulb prices went up. But at the peak of the market, a person could trade a single tulip for an entire estate. At the bottom, one tulip was the price of a common onion.
The Dutch aren’t speculating on tulip bulbs today. But people are speculating on the price of something else, a cryptocurrency called bitcoin.
The origins of bitcoin can be traced back to a paper written in 2008 by the pseudonymous Satoshi Nakamoto. Nobody knows who Nakamoto is, although he does own one million of the originally mined bitcoin.
Bitcoin is a cryptocurrency, which can be loosely defined as “a peer-to-peer, decentralized, digital currency whose implementation relies on the principles of cryptography to validate the transactions and generation of the currency itself.”
So it’s an electronic currency, a data entry in an electronic ledger.
Decentralised means nobody is in charge of it; the currency is created and transferred by networked computers.
These use cryptography to guarantee the security of the transaction and also to generate new units of the currency, a process known as ‘mining’. This is where computers use their processing power to solve complex (and entirely pointless) mathematical algorithms.
Every Bitcoin includes a blockchain, an anonymous digital record of the unit’s transaction history. The creator earns the value of the new coin when it enters the system. You can buy or sell Bitcoin on online exchanges, and there are even a few Bitcoin ATMs scattered about, where you can feed in real life cash in return for the digital currency.
Like tulip mania, bitcoin mania is causing otherwise rational people to lose their minds.
Back in July 2010, you could buy one bitcoin for 8 US cents. The price became 1 US dollar in February 2011. It rose further to $31 in July 2011, started 2017 at $800 and then reached a high of $17,900 on 15th December 2017. 1 bitcoin currently equals 10,229 US dollars.
Bitcoin is an unregulated cryptocurrency, favoured by criminals, that has high transaction fees and long transaction times. In fact, just last week the online payment provider Stripe stopped supporting bitcoin as a payment option because it’s become a speculative asset rather than a useable currency.
Our position at Informed Choice is that bitcoin speculation is a modern incarnation of tulip mania.
In fact, according to Goldman Sachs last week, it’s already surpassed tulip mania and the dot-com bubble in scale. They went further and said: “We think the concept of a digital currency that leverages the blockchain technology is viable given the benefits it could provide: ease of execution globally, lower transaction costs, reduction of correction since all transactions could be traced, safety of ownership, and so on. But bitcoin does not provide any of these qualities.”
So how do you avoid buying tulips, tech stocks or bitcoins?
1 – Know and understand every part of your investment portfolio.
A key part of our investment philosophy at Informed Choice is recommending simple, easy to understand investments. If you need a doctorate in computer science to fully understand the blockchain and cryptocurrency, you probably shouldn’t invest in it.
2 – Look out for signs of Extraordinary Popular Delusions and the Madness of Crowds.
This phrase is from an early study of crowd psychology by Scottish journalist Charles Mackay, first published in 1841. There are times when large groups have better answers than individuals (wisdom of the crowd) but madness of crowds is more likely. If everyone is ranting and raving about a new, untested investment, it’s best avoided.
3 – Don’t worry about missing the party.
Behavioural economics tells us that, as investors, we feel the pain of losses to a much greater extent than we enjoy the experience of equivalent investment gains.
There’s nothing wrong with sitting on the side-lines and missing out on the next big thing. The music always sounds good, until the police raid the party.
