Bitcoin – A Textbook Example of Investing Psychology

Bitcoin seems unstoppable. Since I last wrote about it in June, the price has doubled again. And with every new high, the bitcoin community gets more emboldened in their view that bitcoin is changing the world.

I however, remain unconvinced. The blockchain certainly will change the world, but cryptocurrencies not so much. Nothing has changed, bitcoin is still a speculative bubble. The price, in my view, will eventually go to zero. But of course, on its way there, it might first go to more ridiculous highs. A higher price does not mean that it is not a bubble. It just means that the bubble is getting bigger.

It is very amusing to watch this, as it is a textbook example in investing psychology. Having been critical about bitcoin for a while now, I get often asked whether I regret not buying any. The answer is, no I don’t. I don’t regret it in the same way I don’t regret buying that winning lottery ticket last week. Sure, now I know which numbers won the jackpot, but last week I did not. In hindsight, everything looks easy.

It was, and it still is, unpredictable where the price of bitcoin is going to top out. Is it $5000, $10 000, or $100 000, who knows. For all I know, there is an equal chance that tomorrow I might loose half, or even more, of my money. That is not a good bet to take. The first rule of investing is, to protect your downside risk. You always want to invest in things, which have high upside, and predictable low downside. An asset, in which you might double, triple, x-tuple your money, but in which you have an equal risk of loosing everything, is an asset to stay away from, if you are not a gambler. It is not worth the risk.

Most crypto investors, however, don’t seem to realize that there is a risk in bitcoin at all. They are making the classic mistake of confusing a bull market with brains. I know, I know, it feels good being invested in a bull market. This is particularly true for bubbles. You wake up in the morning, only to discover how much money you made in your sleep. What a great way to start your day. The longer the bull market progresses, the more you become convinced that you are indeed an investment genius, and you are already starting to plan for your early retirement.

All of this is classic investment psychology. People are chasing assets that have gone up in the past. Humans cannot help it. Inductive reasoning is deeply rooted in our thinking. We see a trend in the immediate past and project it into the future. That way, investors consistently invest in things that have already gone up by a lot. The fact that something has gone up in the recent past, makes us feel secure that there is little risk in investing in it. After all, the trend looks solid.

But, thinking about it rationally, the dumbest reason to invest into anything is, because it has gone up in the past. I think everyone will agree that the goal of investing is to buy low and sell high. So why buy high? The reason, of course, is that people expect to buy high, and sell even higher. What they overlook is that this is every suckers strategy in a bull market. But eventually, all potential buyers are invested in the asset. Once there are no buyers left, prices have to inevitable come done. This is the start of a bear market.

By its very nature, this turning point comes right at the top of the euphoria, when hardly anyone expects the bullish trend to reverse. This has to be the case, since the trend reverses when there are no buyers left, in other words when everyone is invested. But everyone is only invested, if they are positive about the market. At that point, prices have to come down to attract further buyers. These buyers will most likely be people who are already invested in the asset, and think they have a nice opportunity, to buy a bargain, before the bull market continues. After all, every time prices retreated in the past, the bull market eventually continued to new highs.

Unfortunately for them, that time, the bull market will have topped out and won’t continue. The longer there is a lack of new highs, the more people start to think that now is probably a good time to cash in their profits. But they are trying to sell into a market that has already run out of buyers. This makes prices fall even further. The more prices fall, the more people start to get nervous and will try to cash in. The downtrend in motion is going to feed on itself. Eventually, people are going to panic, and prices crash. At that point there will be virtually no buyers left.

Well, that is not quite true. Usually, investments have some intrinsic value. A company, for example, has real assets with real values. Once prices go below the intrinsic value of the underlying assets, smart investors, who are not driven by primitive investment psychology, come in as new buyers. They know they are buying a bargain. This is the reason, why every assets class goes through cycles of bull and bear markets. The trick is, to buy at the bottom of the bear market, and not at the top of the bull. That, however, is very difficult, for it is at the bottom of a bear market that everyone will warn you to invest, and it is at the top of the bull market that everyone thinks nothing can go wrong.

There is, however, a big problem with bitcoin. It does not have an intrinsic value. There are no real assets behind it. The reason why most people invest in it is, because they think the price only knows one direction, which is up. But because it lacks an intrinsic value, there will be no one stopping it from going to zero in a real bear market. And bear markets always follow bull markets, with almost absolute certainty, because there is never an unlimited amount of buyers. That means that there will be no smart money buying into bitcoin once it crashes. That is the nature of Ponzi schemes.

With mathematical certainty, in crypto currencies, for every investor making a profit, there will have to be others who loose that exact same amount of money. It is a zero sum game. So if you hear about someone having made a lot of money in bitcoin, you know there is some poor sucker who has lost that same amount. That poor sucker might not yet know it though, because he things he can cash in his coins at any time for the price advertised on the internet. Eventually, however, there will be a lot of suckers, who will not only have to cancel their plans of an early retirement, but will instead have to start saving again at a lower level then they started. In numbers, those will be more people than the numbers of winners, as most people come to the party at the late stage of a bull market.

None of what I write here, will likely affect a lot of the readers, who are currently invested in crypto currencies.. They will say, Nico, your investment psychology theory is all good and well, but you don’t understand bitcoin. Bitcoin is different. Bitcoin is not just a Ponzi scheme. It is going to replace the global monetary system. That is the reason why prices are going up. You just don’t understand what is going on.

Again, this is classic investment psychology. People always convince themselves that the bull market they are invested in is different from previous ones. Confirmation bias is one of the strongest psychological biases we have. We always like to confirm our theories about the world. This is particularly true if we have a lot of money invested in these theories. So, I am fully aware that most people reading this, will shrug it off as another idiot not understanding the revolution.

I know how strong this psychology is from my own experience. I have been invested in bull markets in the past, in which I too dismissed anyone criticizing the idea that the upwards trend is unsustainable. So, I have been there, done that, and no, bitcoin is not different. It is not going to replace the global monetary system. Right now, I don’t know of any honest business that does its accounting in bitcoin, or any other crypto currency. In addition to that, all the articles I read about bitcoin, and there are many, even in major newspapers, are all about, how much higher will the price go, how much money can you make in crypto. And that is why people are invested in it, not because of some idealistic reason to fight the government.

So, for what it is worth, be warned. If you have investments in crypto currencies, you are invested in a Ponzi scheme. At the end of this, for every winner, there will have to be the same amount of losers. The only way to not end up on the loosing side is, to sell before everyone else does. I am not saying you should not gamble in this game. That is up to you. Just be aware that it is a risky game, at the end of which there will be a lot of suckers. And you might be one of them, if you play for too long.

  16 comments for “Bitcoin – A Textbook Example of Investing Psychology

  1. Ken Ferguson
    Sep 5, 2017 at 10:10 am

    In response to your previous article I wrote

    “This article is completely wrong.

    Currencies have been notionally tied to commodities with “intrinsic value” but this has not what has given them their real value. Even before 1931, users of the pound sterling did not turn up at the Bank of England and demand their bit of gold- had they all done so there would not have been enough to go round. The real value of a currency is determined by the faith of its users in it and the amount of goods and services it can buy.

    In our inter connected world currency value is also set in relation to the value of other currencies. Most are are sponsored by nation states, or groups of states, and although value can be affected by the perceived strength and asset value of the sponsoring state, there is no direct correlation. Regarding Bitcoin, whether Paul thinks the “magic numbers” have value is irrelevant- as long as others perceive that value he can trade his Bitcoins for dollars, Krugerrands or whatever he fancies.

    Had I bought Bitcoin five years ago I would now be a very wealthy man but I still think it has a great future. It gives people the opportunity to trade in goods and services with funds that have not necessarily been subject to taxation by any nation state and that has got to add great value to the currency. The only potential threat to the value of Bitcoin is that the nation states will get together to try to prohibit its use but they will have to get control of the internet before they can do this.

    And hopefully that will remain impossible to achieve.”

    You are still entirely wrong!!

    Of course in June I put my money where my mouth is and I am now twice as wealthy as I was then. So stop talking Bitcoin down Nico and buy some- perhaps by trading in some of your Krugerrands (with all their intrinsic value).

    Of course there is risk in everything but Bitcoin is a bet on freedom from Government and freedom from taxation.

    • Paul Marks
      Sep 5, 2017 at 12:51 pm

      You are wrong Mr Ferguson – people did value the Pound for the gold they were promised, my father was around in 1931 (you were not – at least I do think that you were) and he certainly cared that he could no longer get gold for his “Pounds”.

      Why would someone give “goods and services” for “Pounds” anyway? Coins (at least high denomination coins) were gold or silver till modern times (certainly my father’s generation were used to gold sovereigns and silver in lower denomination coins. Indeed American coins had silver in them till the Kennedy Administration and gold was paid (to foreign governments) by the American government till the Nixon Administration in 1971.

    • Nico Metten
      Sep 5, 2017 at 5:00 pm

      “It gives people the opportunity to trade in goods and services with funds that have not necessarily been subject to taxation”

      And yet, no one is really doing that. No honest business is accepting payments in Bitcoin. That is why bitcoin right now is not a currency. People are buying it, because they are speculating on higher prices. That is what you are admitting to do as well. And as long as that is the case, Bitcoin cannot become a currency. It is a speculative asset, a Ponzi scheme. If it ever were to actually function as a currency on a big scale, then yes, it would not need the intrinsic value. But it cannot get there without the intrinsic value. I wish it was succeeding. I have no interest in it failing. But I cannot just make up a reality that just ain’t so. So thank, but I keep my gold.

  2. Paul Marks
    Sep 5, 2017 at 1:04 pm

    Some people value the “special numbers” of Bit “coin” – personally I do not, but (and here Mr Ferguson is correct) I wish I had bought some of these “special numbers” years ago – so I could sell them to people who do value them.

    Mr Ferguson claims that people did not value the gold or silver they were promised by paper money – that is not true, it is a false claim byMr Ferguson. Although NOT a dishonest claim – as he was not around at the time, and so does not know the truth.

    People most certainly did value the commodity they were promised – and were most upset by the link being broken. Indeed before the First World War most people did not bother with “White Fivers” – a sovereign (a gold coin) was a nice thing to have till modern times (and I mean very recent times).

    Still economic value is subjective – if people really value the “special numbers” of Bit “coin” that is fair enough, but it is naught to do with “goods and services” (as Mr Ferguson mistakenly claims) as no one is under any obligation to give you “goods and services” in return for Bit “coin” – so if you do not value the “special numbers” for their own stake (as people do, not do not as Mr Ferguson mistakenly claims, value gold and silver) then stay clear of Bit “coin”.

    “Betting on Bitcoin is betting on freedom” – well the person who pushes Bit “coin” more than anyone else in the world is Max Keiser (he has been pushing the special numbers for years – in almost every show he has made) – and he works for Mr Putin.

    Now that does NOT mean that Bit “coin” is a bad idea (the “special numbers” could be a wonderful idea) but freedom? I doubt Mr Putin is in favour of that.

    • Ken Ferguson
      Sep 10, 2017 at 3:25 am

      Paul

      It is pleasant to think of a world where all currencies were linked to a single commodity (like gold) but in our global financial system it is quite unrealistic. Personally I have a hankering for the Scottish free banking system of the 18th century bit I am not naive enough to believe it is going to make a comeback!!

      Triffins paradox explains why it was necessary for reserve currencies to abandon the gold standard as the UK did in 1931 and the US did in 1971.

      no one is under any obligation to give you “goods and services” in return for Bit “coin”

      No one is under any obligation to give you goods and services for any currency- it is the perception that they are prepared to do so that gives a currency it’s value. And that is the only worthwhile measure of value.

      Which brings me to Nico

      No honest business is accepting payments in Bitcoin.

      Really?

      http://www.wheretospendbitcoins.co.uk/search

      I agree that it is much easier to use bitcoin to purchase drugs and pornography (and the ability to do such things anonymously is part of its attraction) but which of the above businesses are you saying is dishonest? Or you could always trade Bitcoin for another currency. And use that to buy gold nuggets if that’s your thing!!

      The dollar and the pound have only been used as reserve currencies based on the strength of their respective economies and banking systems and since 2008 investors have realised just how precarious those actually are. Since 1971 the world has been crying out for a new reserve currency, a truly international currency that can be freely traded and maybe Bitcoin is that currency.

      In which case we should all buy some more now!!!

      • Nico Metten
        Sep 10, 2017 at 8:26 am

        “Really?”

        Yes really. None of the businesses in the list are accepting bitcoin. You can sell your bitcoin for fiat and than they take that fiat. Technologies like BitPay just make it easier for you to do that, by facilitating all of this in one easy transaction. Every time you use Bitcoin like that, you decrease the demand for it, because these bitcoins are not going to the business.

        “Since 1971 the world has been crying out for a new reserve currency, a truly international currency that can be freely traded and maybe Bitcoin is that currency.”

        Yes, and the world is going to get one. Blockchain will most likely play a role in it. The Chinese and the Russians are working on their on reserve currencies. These will most likely be SDRs. To make people trust them, they are going to use Blockchain technology as a clearing mechanism. But it is not going to be Bitcoin. This currency will be backed by real assets and the force of the state.

  3. Sep 10, 2017 at 8:30 pm

    I have read that Bitcoin has intrinsic value as a payment / clearing system. I wonder what you think of that argument Nico?

    • Nico Metten
      Sep 10, 2017 at 8:47 pm

      Yes, that is the blockchain technology. This technology is indeed very valuable, and will change the world. But it does not have a monetary value, because blockchain technology is not scarce. For something to have a monetary value it needs to be valuable and scarce. That is why air for example, which is probably the most valuable thing to us (it is definitely the last thing I can live without) is free. It is very valuable but not scarce. Blockchain technology is the same. It is in the public domain. Everyone can use it for their application. As such it is not scarce, but valuable. Its monetary value however is zero.

      What is scarce is the individual bitcoin unit. But the individual bitcoin unit is not useful, in other words valuable for anything. It derives its monetary value purely from the fact, that people are bitting the price up. And once prices reverse the upwards trend, it will lose that value.

  4. Ken Ferguson
    Sep 11, 2017 at 10:34 am

    But the individual bitcoin unit is not useful, in other words valuable for anything.

    Just not true!!!

    If I offered to buy your car for 100 gobshites, you would rightly refuse the deal.

    Why?

    Because you lack the confidence that the gobshite is a liquid unit of currency and that anyone else would want them.

    If however there were a market for trading in gobshites and you knew that you could trade them immediately for £1000 per gobshite, you might well accept my offer.

    We can argue over the likely future value of bitcoin but to say it has no value is plain wrong, I’m afraid.

    • Nico Metten
      Sep 11, 2017 at 10:50 am

      You misunderstood my point. You have to differentiate between something being valuable in the sense of being useful, and a monetary value. Bitcoin units don’t have a use value. They do indeed have a temporary monetary value, and I said that. But this monetary value comes from people expecting the price to go up. Once bitcoin reverses its upwards trend, which it will at some point, like everything else, it looses that monetary value. In every Ponzi Scheme, the units have some temporary monetary value, until the Scheme collapses. Then it falls back to its intrinsic use value, which in case of bitcoin is zero.

  5. Ayumi
    Sep 12, 2017 at 8:18 am

    “Since 1971 the world has been crying out for a new reserve currency, a truly international currency that can be freely traded and maybe Bitcoin is that currency.” … or it could be SDR or some other blockchain currency.

    Sigh. personally, I agree with Nico, not a fan of it.

    By the way, Japanese government now regulates digital currencies. https://calvinayre.com/2016/05/26/bitcoin/diet-approves-bill-regulating-bitcoin-exchanges-in-japan/ I’m not sure if it’s taxed, yet.

    You might think I’m crazy, but since becoming a Christian, I see ‘one world government’ and ‘one world currency’ as inevitable, because the bible says it will happen.

    Likely in the name of “common good for all”.

    Revelation 13:16 “It also forced all people, great and small, rich and poor, free and slave, to have a mark on their right hands or on their foreheads, so that they could not buy or sell unless they had the mark, which is the mark of the beast or the number of its name.”

    Personally, I think this is a chip or something you implant, like a contactless card, which thousands of people are already doing.

    We know how getting off the gold standard was a bad idea. When the whole thing becomes unsustainable (as it is now, with ridiculous amounts of debt), the governments round the world are gonna have to collaborate to come up with a solution.

    I think Universal Basic Income might have something to do with this ‘solution’.

    What if the solution was a world electronic currency where 1) debts are cancelled 2) everyone gets UBI ? Wouldn’t the egalitarian populace celebrate? What if, “to keep your identity safe”, you had to implant a chip in your hand instead of carrying an ID-credit/debit card?

  6. Ken Ferguson
    Sep 12, 2017 at 8:46 am

    Nico

    Bitcoin units don’t have a use value.

    But other currencies do? Really?

    I’ll try planting a pound coin and see if it grows.

    Ayumi

    By the way, Japanese government now regulates digital currencies.

    They can try. The whole point of Bitcoin is that the internet will continue to allow people to trade anonymously free from Government intervention and taxation. OK the Silk Road was closed down but another twenty sites immediately emerged to take its place.

    “You might think I’m crazy, but since becoming a Christian, I see ‘one world government’ and ‘one world currency’ as inevitable, because the bible says it will happen.”

    You are correct. I think you’re absolutely barking.

    • Nico Metten
      Sep 12, 2017 at 9:08 am

      Real money, like gold, does, yes. Pounds were once backed by it, which is how they became a currency. But you are of course right. At the moment, pounds are backed by nothing, it is fiat money. And I would not recommend betting your money on fiat currencies either. They are certain to loose their value over time.

  7. Jan
    Sep 14, 2017 at 10:46 am

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