10 Things You’ll Want to Know About Bitcoin Before You Buy It

In recent weeks, there's been a lot more chatter and interest in Bitcoin again. To say I've been asked about it more in the last two weeks, then in two years of running Family Finance Mom, would be an understatement. "Should I invest in Bitcoin?" "What is Bitcoin?" "How can I invest in Bitcoin?" Suddenly, it's gone from the fringe of finance to mainstream, and everyone is worried about missing out. Our FFM Book Club discussion of The Mandibles may have also contributed to this... But before you race to buy Bitcoin for your investment portfolio, you need to understand what it is, how it works, and why it may or may not be the best investment for you.

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Should I Invest in Bitcoin?

A general rule of thumb you should always follow before investing in anything, especially when you are just learning how to start to invest, is never invest in something you don't understand. Bitcoin is not an investment with an actual underlying, physical asset. It's not like buying real estate that can generate rental income, or buying stock that can pay dividends and give you ownership of a company's earnings.

So what is Bitcoin? It's cryptocurrency. What does that mean, how it works, and why is it suddenly all anyone is talking about? I'll cover all that below, and more.

What is Bitcoin?

Bitcoin is cryptocurrency. To understand what that means - let's break that word itself into parts: crypto + currency.

Crypto is short for cryptography, a method of securing or protecting information through the use of codes. And currency is money.

For money to be considered valid or viable, it has to serve three primary functions:

1. It has to hold value.
2. It has to be a unit of account.
3. It has to be a widely accepted medium of exchange.

In the context of the US dollar, all of these very clearly hold true. We get paid in dollars. We can reasonably expect our dollars to be worth next week what they are worth when we receive them (minimal inflation). Our bank account, as well as businesses, all track or account for our transactions in dollars. And I can go just about anywhere in the country - and even in many foreign countries - and people will accept my dollars for payment.

Can the same be said for Bitcoin? We will come back to that... but Bitcoin was originally created to operate as currency - a decentralized currency, not controlled by any one country or government. It was to be a universally accepted form of payment, especially for online transactions, where someone in Australia could make payment to someone in Canada, in the US or China, seamlessly, without the added friction of exchange rates and unnecessary transaction costs.

And the record of the transaction, as well as exactly how much Bitcoin you hold in your account, rather than being accounted for by a bank, is recorded in code - here's where the cryptography comes in - in a decentralized system of computers all around the world, and accessible via your password-protected Bitcoin wallet.

Who started Bitcoin?

Here's where things get weird... no one officially knows.

In October 2008, in the aftermath of the housing crash, a mystery person (or persons), published a 9-page whitepaper outlining how to create a "peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution." If your tech-savvy and into coding, you might be interested in reading it. It was published under the pseudonym, Satoshi Nakamoto.

While people have stepped forward claiming to be him over the last decade, no one knows with certainty who he really is. And many experts believe, based on the coding complexity involved, and a host of other facts around the earliest bitcoin transactions, that the name actually represents a group of people, not just one person, and he's most likely not Japanese. If I or others refer to Nakamoto, recognize this is not a real person or even necessarily a single person.

Coding for Bitcoin began as early as 2007, bitcoin.org was registered as a domain name in August 2008, the whitepaper was published in October, and the first software release and "mining" of the first block of Bitcoin, reward with 50 Bitcoins, occurred in January 2009.

Nakamoto's official involvement in development ended in 2010. All 1.1 million bitcoins linked to him, except for some initial test transactions, have never been spent, and at current value, would be worth more than $40 billion, putting whoever holds those Bitcoins among the wealthiest people in the world.

What is Bitcoin Mining?

All Bitcoin currently in circulation has been mined. Mining is akin to transaction processing. When you go to the grocery store and swipe your debit card to pay, a transaction processor validates the transaction. They check to make sure you have funds in the bank to cover the payment, they authorize the payment, and then over a few days, the actual settlement and transfer of funds from your bank account to the grocery store's occurs.

When someone engages in a Bitcoin transaction, mining confirms the transaction by coding it into blocks and adding it to the blockchain - or master Bitcoin ledger.

Bitcoin miners effectively act as auditors - making sure you have Bitcoin to spend in your wallet, and that you don't have pending transactions that have already spent it. You know how you can overdraw your checking account if you write too many checks? Miners make sure that doesn't happen with your Bitcoin wallet.

So why are people willing to mine Bitcoin? Because for the expense of setting up the processors, keeping them cool and the electricity to run it, you can earn, or "mine," Bitcoin. For every 1 MB of Bitcoin transactions you verify, known as a block, AND demonstrating your processing power by being the first to come up with a 64-digit hexadecimal number (a "hash") (essentially proving your work), you will be rewarded with Bitcoin. Lots of miners are verifying the same transactions - so you could do the work, and receive nothing if you don't crack the "hash" first.

The amount of the award for every block halves for every 210,000 blocks, which has happened about every 4 years. The first block ever mined by Nakamoto received 50 Bitcoin. Today, you get 6.25 Bitcoin.

How Many Bitcoin Miners are There?

There isn't a ton of transparency here. I've seen estimates as low as 5,000 to as high as a million. The estimate of a million seems more likely based on some mathematical fact - there are pools of miners who work together. One of the larger pools discloses it has 200,000 miners, and collectively they capture about 12% of the network hashrate (i.e. they crack the hash first and are awarded the Bitcoin for their block 12% of the time).

This compares to a more knowable fact - there are only 2.4 million Bitcoin remaining to be mined.

Bitcoin is Limited

When Bitcoin began, it was declared there would only ever be 21 million Bitcoin ever. And it is only released into circulation as it is mined (see above). For 210,000 blocks mined, which to date has happened roughly every 4 years, the reward for mining a block of Bitcoin gets halved. You can see the impact of this on issuance in the time series below.

Based on this halving process, the last Bitcoin is anticipated to be mined in 2140. After that point in time, miners would be paid a fee for processing transactions that you as a network user would pay. The expectation is these fees would remain minimal given the number of miners competing for them.

Bitcoin is Volatile

The limited quantity of Bitcoin, combined with variablity in demand over time, has driven the price of Bitcoin to near $40,000 in early 2021.

But the price is highly volatile. What do I mean by that?

In finance, we use volatility as a measurable level of risk associated with a particular investment. It measures how much the price moves up and down, on average, over a given time period. We compare volatility to returns to assess if something has a good risk-adjusted return. We expect higher returns in order to be willing to take on greater volatility. And some people have a greater appetite for higher volatility than others.

For comparison's sake, the chart below shows the annualized volatility - how much we saw these investments move up or down in a given year on average vs. the annualized return they actually produced over the last 10 years. You can see cash has the lowest risk and lowest return, bonds have slightly higher volatility for slightly higher returns, and stocks, in general, have higher volatility still, for even higher returns.

Here's where Bitcoin falls on this same chart...

Its price has increased over 200% on an annualized basis over the last 10 years, from essentially $0 to nearly $40,000. But it has also had massive price swings in both directions along the way.

You need to know, understand, and be comfortable with riding out that kind of volatility before you buy it.

20% of Bitcoin Has Been Lost

Imagine as an early tech adopter, you bought some Bitcoin back in 2010 or 2011 when it was essentially worth nothing. You had a digital wallet (more on this in How to Buy Bitcoin below), but now 10-years later, when it's worth $40,000 per Bitcoin, you've forgotten your 'key,' or password, and can't access it.

Unlike your bank that has a process for password resets and retrieval, no such operation exists for Bitcoin. Due to that, an estimated $140 million worth of Bitcoin is estimated to have been lost or stuck in wallets people can't access.

From Bitcoin.org directly:

"Lost bitcoins remain dormant forever because there is no way for anybody to find the private key(s) that would allow them to be spent again. Because of the law of supply and demand, when fewer bitcoins are available, the ones that are left will be in higher demand and increase in value to compensate."

Bitcoin.org

Is Bitcoin Actually Currency?

Recall our definition of the functions of money from earlier...

1. It has to hold value.
2. It has to be a unit of account.
3. It has to be a widely accepted medium of exchange.

Does Bitcoin do these things?

It holds value - but the value is highly volatile, and even just in the first weeks of 2021, has ranged in price from just under $30,000 to nearly $40,000, and more than 30% increase.

Because of this volatility, that makes it exceedingly difficult to use it as a unit of account. A store isn't going to post prices for its items in Bitcoin or account for its inventory in Bitcoin with the price moving so significantly over such a short period of time.

And lastly, while it was originally created to facilitate payment, and is accepted on some online platforms, it is not widely accepted as a medium of payment. Some country's ban it entirely.

By those examples, it's hard to say it is truly currency. I would more describe it as a speculative digital asset, whose value is dependent on its limited issuance, and placing trust in technology, mathematics, and increased adoption.

Bitcoin Isn't the Only Cryptocurrency Out There

Bitcoin has become synonymous with cryptocurrency, like Kleenex has with tissues... but it is far from the only cryptocurrency game in town.

Other cryptocurrencies include:

• Ethereum
• XRP
• Litecoin
• Chainlink
• Bitcoin Cash - founded by an early Bitcoin developer

... and more! These various cryptocurrencies are not free from controversy either. Ripple Labs, the issuer of XRP, is currently facing charges from the SEC. My personal favorite finance turned soap opera read in this space is the history of One Coin, a cryptocurrency that gained popularity in Europe in 2016, before it's founder, referred to as the CryptoQueen, disappeared along with all the "real" money people had invested in it.

Even Bitcoin has experienced hacks, with several of these hacks amounting to 10,000s to 100,000s of Bitcoin.

How Can I Buy Bitcoin?

If you are interested in purchasing Bitcoin, you will need an account on a cryptocurrency exchange, as well as a separate, secure personal digital "wallet" to hold your Bitcoin.

You would fund your cryptocurrency exchange account with cash from your bank account. Buy Bitcoin from a seller, just as you would buy stocks in a brokerage account. Once the Bitcoin is in your exchange account, you send it to your secure wallet.

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So, Should I Invest In Bitcoin?

The investment thesis for those who are pro-cryptocurrency (not just Bitcoin), goes something like this...

The US government has exponentially increased its issuance of dollars since the 2008 housing crisis, and increased issuance even more over the last year during the pandemic. This is true for many developed nations and world reserve currencies, not just the US dollar.

That makes the appeal of cryptocurrency, with a known limited quantity, more likely to hold value overtime, as the value and purchasing power of the US dollar is eroded by excess issuance and inflation.

On the anti-cryptocurrency side of the equation? You have to trust that this peer to peer system is infallible, secure, that the limitations said to exist actually do, all when there is little regulation, oversight and no clarity on who stands behind it all (which pro-cryptos say doesn't matter because of the blockchain ledger).

So, should I invest in Bitcoin? Only you can answer this question for yourself: based on your financial circumtances, your risk appetite, and your trust in the blockchain system, the security of cryptocurrency exchanges and digital wallets.

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Do you feel like you have a better understanding now of cryptocurrency and Bitcoin? What other questions do you still have? If you'd like a better understanding of how cryptocurrency could ultimately displace government-backed currencies, like the US dollar, check out our Q4 2020 FFM Book Club read, The Mandibles.

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