Why has the Price of Bitcoin Has Escalated so Quickly?

The meteoric rise of Bitcoin has taken headline news hostage. Over the holidays I visited more relatives than I can count and each one asked me the same thing: So what do you think of Bitcoin? Truth is, nobody knows what to make of Bitcoin yet. Cryptocurrencies only emerged within the past decade and unlike traditional money, no paper notes or metal coins are issued and no central bank or regulator is involved. Bitcoin is simply a form of code made by computers stored in digital wallets which can be purchased using fiat money (i.e. money declared by the government to be legal tender) or “mined” by powerful computers solving complex mathematical problems. Sound simple yet?

Unlike stocks it is not clear that Bitcoin offers investors positive expected returns. Unlike government bonds, Bitcoin doesn’t provide a highly certain repayment of promised cash flow and reduce uncertainty of future wealth. And unlike holding cash in fiat currencies, it doesn’t provide a way to plan for immediate, unknown expenditures. Investment decisions should be factual, based upon data and research. Media and social hype should not be a reason to buy (or sell) an investment. However, understanding social behavior surrounding Bitcoin can make us better long-term investors.

Don’t be a sheep

Herding describes investors lacking individual decision-making who simply act in the same manner as the majority, primarily due to greed or fear of missing out. Herding is well explained and demonstrated in this short video, which confirms irrational decision-making based upon popular choice. Most investors have no clue what Bitcoin really is or how Blockchain works, yet continue to tout the cryptocurrency. Ask yourself a simple question: Am I wanting to invest in Bitcoin because I understand exactly what it is, or am I investing because media or investing “experts” make me feel like I’m missing out?

Hindsight is 20/20

Tell me how many times you’ve seen the headline: If you would have invested [blank] in Bitcoin last year you would have now made [blank]. Hindsight bias makes an individual think an event was more predictable than it truly was in the past. This type of thinking leads investors to believe they should have seen the Bitcoin rise coming. It also causes investors to think they can (and should) find the next Bitcoin, time the market, and come out rich. Research shows individual investors who attempt to time the market end up with lower performance than those who invested with a disciplined approach. Believing one can predict investment returns and find the next big thing leads into the next behavioral trap, overconfidence.

You’re not that great of an investor

The tricky thing about overconfidence bias is the less investors think it applies to them the more overconfident they are. Essentially, investors overestimate their knowledge and underestimate risks while exaggerating their ability to control financial events. Investors who have made money in Bitcoin believe they will continue to make money while downplaying the extreme volatility. They were successful and smart enough to invest early so there is no reason to believe they will continue to be successful in the future, right?

At the end of the day, the excitement of Bitcoin is undeniable but its reliability as a long-term investment is questionable. Looking to the future, it will be interesting to see how the underlying Blockchain technology will revolutionize banking and other industries within the coming years.

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