“A bubble is an economic cycle characterized by rapid escalation of asset prices followed by — a massive selloff.” (Investopedia definition)
You come home from work one day and see your next door neighbour off-loading an expensive flat-screen T.V. He tells you he has become wealthy from his Bitcoin holdings. You gotta buy some he tells you the price is going crazy.
Rational thought is gone – you rush inside and Google Bitcoin. When you discover that Bitcoin is the most Googled word in the world, surpassing even the Kardashians, you are convinced you are on the road to riches.
Since November 2016 the value of a Bitcoin has risen from $800 to over $15,000 at time of writing. Bitcoin now trades on the Chicago Board Options Exchange and the Chicago Mercantile Exchange. These are futures markets and have contributed to the fast rising price of Bitcoin. As Bitcoin has come to get more market acceptance, so interest in this cryptocurrency has rapidly grown.
One of the reasons why the value has grown so quickly is there can only be twenty one million Bitcoins in existence. As the price goes up, the investors hold onto them, anticipating further price rises. This supply shortage further drives up the price.
At some stage a herd mentality takes over, fuelled by greed and the price goes through the roof. In this stampede no one stops to think – they have to jump in before the price rises even further.
With all bubbles, at some point the price defies belief. Once this happens the losses mount as fast as the price once rose until the asset becomes worthless.
But is it a bubble or not?
The hard fact is that no one knows for sure. If it is a bubble and you invest now you could lose a fortune. If it isn’t and you don’t invest, you could lose out on a potential fortune.
“Hindsight” of course “is 20/20” but by then it’s too late to do anything about it, so the best advice at this stage is this – be guided not by the herd mentality we talked about earlier but by your own research. If you do invest, the only prudent thing to do is to use money you can afford to lose.
All we can say for sure is Bitcoin is starting to exhibit all the characteristics of a bubble and that at some stage there is the risk the price will collapse. So perhaps if you feel the urge to buy Bitcoins, resist the urge to Google “how to buy Bitcoins” and instead take a deep breath and go and watch the Kardashians!
If you are still not convinced, consider what happened to Sir Isaac Newton, an intellectual giant and one of the fathers of modern science. He initially bought into the South Sea Company and as prices rapidly rose, he sensed a bubble and sold out, making a very good profit. But prices continued to rise at a dizzying pace and he reinvested just in time to witness the collapse of the company. Newton was ruined by the South Sea Bubble.
The current situation with Bitcoin does not invalidate the concept of a digital currency which has the potential to do what banks do – be a credible third party between a buyer and seller and guarantee payment when the conditions of the contract are met. The big difference is that cryptocurrency uses blockchain technology and is much cheaper. It’s here to stay.