Bitcoin and bandwagons

22 April 2021
4 min read

If there’s anything we’ve learned from the first couple of months of 2021, it’s to avoid confusing gambling with investing, says Richard Wood.

If the past few months is any guide, it might appear that making money in markets is easy – just buy Tesla or Bitcoin (or, for a short but mad time at the start of this year, GameStop – more of which below) and you are sure to double your money!

Anyone who tells you this is the way to invest is using the wrong terminology. What they are describing can more accurately be called gambling, and it’s certainly not something we’d recommend. Here are a couple of examples explaining why.

Bitcoin – boom, bubble or bust?
In October 2008, a mysterious anonymous white paper called ‘Bitcoin: A peer-to-peer electronic cash system’, introduced the world to its first cryptocurrency.

Bitcoin was driven by blockchain technology – a decentralised way for two parties to exchange value. This was the main attraction compared to traditional currencies like USD or GBP. Bitcoin has no need for a governing body, no central bank and is merely a digital ledger that facilitates and records transactions. Without getting into too much detail about how this works, the complicated mathematical procedures in place make falsifying Bitcoin transactions unlikely.

Twelve years down the line, the cryptocurrency space has seen thousands of alternatives, or ‘altcoins’ (like Ethereum, Polkadot and Tether) come to market, all of which attempt to improve on the blueprint pioneered by Bitcoin.

Cryptocurrencies have a way to go before they can challenge traditional currencies, though. Bitcoin can handle a paltry 350,000 daily transactions compared with VISA, which executed around 500m per day in 2019.

Furthermore, in a society that is ever more focused on sustainability, a currency that requires enormous warehouses full of energy hungry computers to keep it going is somewhat out of sync with the current zeitgeist. The Cambridge Bitcoin Energy Consumption Index estimates that the Bitcoin network currently consumes around 110 TWh of energy per year, roughly the same as the whole of the Netherlands!

Despite the implementation issues, the value of Bitcoin, along with many of the other ‘altcoins’, has skyrocketed of late, causing a lot of excitement amongst investors/gamblers. The only thing we know for certain about investing in cryptocurrency is that it is highly speculative. The extraordinary volatility of most ‘coins’ makes them an unreliable store of value. Going to sleep and waking up 10 per cent richer (or poorer) is commonplace.

Added to this, Bitcoin is not a capital asset. It doesn’t pay dividends, nor does it have a positive expected return. Positive outcomes are simply the result of demand outstripping supply, although speculators are quick to forget that the future expectation of demand is already factored into the current price. There are 18.6m Bitcoins in existence, yet recently the sale of 150 of them resulted in a price drop of 10 per cent, demonstrating no depth or liquidity to the Bitcoin market.

It is possible that we may one day turn into a world where cryptocurrency is adopted by the masses. Who knows if that is even remotely likely, and better yet who knows which cryptocurrency will be the one that ticks all the boxes? As an investment today, cryptocurrency plays no role in portfolios and any investor (gambler) should be willing to accept a maximum loss of 100 per cent.

GameStop – Reddit vs Wall Street
January this year saw a group of amateur investors, using the ‘Wall Street Bets’ forum on discussion website Reddit as a platform, band together to take on the professional hedge fund space in the US.

The group focused their conversation on a few stocks, most notably US consumer electronics firm GameStop. On the other side were hedge fund managers engaged in ‘shorting’ GameStop stock — essentially betting that its share price was on a downward trend. A successful short involves borrowing stock from a third party, selling it on the marketplace and then buying it back later when the price has fallen. This allows the short seller to return the stock to the third party and cash in the difference in price.

The danger with shorting is that if prices unexpectedly rise, it becomes more expensive for the short seller to buy the stock back, so they can’t afford to return it to the party they borrowed it from in the first place. Professional investors are aware of these risks more than anyone.

The Reddit group of small investors focused on heavily shorted stocks, including GameStop. By purchasing shares in these firms, they pushed up the price, creating huge losses for some of the hedge fund managers. These weren’t small market movements, either. By January 27, the share price of GameStop closed nearly 2,000 per cent up on the start of the year. Yet the next day, the price dropped by almost half.

The motivation of many of the Reddit speculators was to ‘stick it to the man’, although many were undoubtedly looking to make a quick buck. It certainly caught the eye of the regulator on suspicion of market manipulation.

A few days later, it was all over. By mid-late February, the price was back down to around $40 USD (from a high of $347 on January 27).

Many of the Reddit speculators, who’d invested sizeable (for them) sums of their own, were completely wiped out.

Ironically, one of the very hedge funds the Reddit bandits were opposing has done very well out of the whole saga. Forbes reported that Senvest, which had a five per cent stake in GameStop in October when the price was around $10-$15, made a profit of $700m by selling when the price reached $300.

The lesson? If you want excitement, just follow the stories, and enjoy the schadenfreude that follows.