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An Introduction to Bitcoin

While contemplating the existence of a higher power, French mathematician Blaise Pascal came up with what is now known as Pascal’s Wager. For him, it made logical sense to pay the small price of living a pious life in exchange for the potential infinite reward brought about by believing in God. Conversely, not paying the price would potentially result in infinite punishment. For me, this line of thinking can be applied to the digital currency that gets people talking every few years, bitcoin.

 

Let me start by saying that I was initially a skeptic – a big one. The latter stages of 2017 had all the markings of a bubble: a new technology, rampant speculation, hucksters looking to defraud unwitting investors. Not surprisingly, the bubble popped early in 2018 and Bitcoin lost 85% of its value over the following year. There’s a rallying cry amongst bitcoin evangelists from which they certainly drew strength during this time period: HODL (Hold On for Dear Life). Other bubbles in history have resulted in the development of infrastructure that actually becomes quite useful for society (think: railroads and the internet). Like Mike McDermott in the movie Rounders, bitcoin kept hanging around.

 

What the heck is bitcoin? The easiest way to think about it is internet money with a fixed supply. Whereas the paper money in your wallet and the numbers in your bank account are backed by the full faith and credit of the US Government, bitcoin is backed by a network of computers that collectively verify transactions and holdings. Here’s where the leap of faith occurs. Why should anybody trust that money created by a pseudonymous computer programmer have any value at all? Great question! The value of something is whatever somebody is willing to pay for it. In the case of currencies issued by governments, that value is supported by the collective faith that the currency in question can be used as a store of value and medium of exchange. For whatever reason, if faith erodes to the point where you no longer trust that you will be able to exchange that money for a good or service, hyperinflation ensues. It becomes a game of hot potato as people look to spend money as soon as they get it because the currency is devaluing so quickly. For example, a loaf of bread in Germany cost 160 Reichsmarks at the end of 1922, but jumped to 200,000,000,000 Reichsmarks by late-1923. Back to bitcoin, by limiting the supply at 21 million bitcoins, that sort of hyperinflation problem theoretically should be solved. As for faith, the more people that use bitcoin and believe in it, the more accepted it becomes.

 

There are still many issues with bitcoin. Hackers? Check. Volatility? Get your Dramamine. Regulation? Here it comes. Despite that, it still might make sense for you as it did for me. It all depends on your personality and risk tolerance. I started buying a small amount every week in a dollar cost averaging program in early 2020 in the spirit of Pascal’s Wager. I fully understand that it could go to zero, but the potential upside was worth the small cost. We’ll get into more detail in future blogs, but hopefully this answered some questions and raised some more for people. Don’t hesitate to reach out with any questions.

Author: David Rath, CFA

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