Q: I have been frustrated watching the red hot performance of bitcoin. Every time I get ready to buy, the so-called experts wave me off. They say it can’t go any higher, but then it hits a new record high. If I would have invested $1,000 in bitcoin when I first thought about it, my investment would now be worth over $50,000. Should I invest now?
A: If you are looking for me to tell you something different than the “so-called experts,” you have sadly come to the wrong place. To me, bitcoin’s meteoric rise looks like a speculative bubble waiting to burst.
Of course, some people get rich during speculative bubbles. When that happens it can be hard to distinguish outcomes from intelligent action. In other words, was the person smart or just lucky?
Learning to see the difference is vital to investment success. You can learn a lot from watching a smart person, but luck is difficult to replicate. Several years ago, best-selling author Nassim Taleb proposed a thought experiment that illustrates my point.
Suppose an eccentric millionaire were to approach you with the offer to pay you $10 million to play one round of Russian roulette. Would you play? You know with absolute precision that you have an 83 percent chance of walking away a multi-millionaire. However, you also know that you have 17 percent chance of not walking away at all.
Without knowing the details, outside observers might laud the successful player as a genius. After all, he created a fortune in minutes. However, I doubt any rational person in possession of all the facts would think of Russian roulette as a sound wealth building strategy.
Taleb’s illustration highlights a principle that investors need to understand: we cannot always judge the quality of our decisions by their outcomes. It is very possible that bad decisions and poor strategies can produce excellent results, especially in the short run. Instead we must evaluate a particular strategy by considering the entire range of possible outcomes it could produce and the probability associated with each outcome. Good strategies rarely pair finite upside with catastrophic loss. Bitcoin looks like that kind of trade to me.
Q: Bitcoin is based on something called the blockchain. Is there a way to invest in blockchain technology without playing in the world of cryptocurrencies?
A: You are asking one of the most interesting questions I’ve heard in a long time. There is a very good chance that blockchain technology will have significant applications well beyond cryptocurrencies like bitcoin.
The blockchain is a database that simultaneously resides on several private computers scattered all over the world. Whenever a change happens in the database on one of the computers, it is simultaneously updated on all the computers. The blockchain is an efficient way to keep track of detailed agreements between people and to insure everyone is honoring their agreements.
Financial transactions are a natural application of the blockchain and big banks like JP Morgan Chase are exploring ways to use this technology in their operations. Stock exchanges are also actively looking at it.
There are a number of small startups that are trying to develop more mainstream applications of the blockchain, but most are penny stocks. Bitcoin’s performance has brought a lot of attention—and hype—to the blockchain. Investors are wise to be wary.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.