Bitcoin mania is in full swing and investors around the world are getting caught up in the hype. Unfortunately, investor frenzy is never a great predictor of future returns, especially for those who are late to the party. The lure of investment gold at the end of the proverbial rainbow is so powerful that many speculators do not apply rational investment principles when making investment decisions about bubbles.
What is a bubble?
A bubble occurs when there is so much hype around an investment, that speculators drive the price beyond any rational value. All bubbles are different, however they all follow a certain pattern. According to economist Hyman P. Minsky, there are five steps to a bubble:
- Displacement – a displacement happens when investors become obsessed with the latest “in thing” that promises to make them rich.
- Boom – prices rises slowly, but then gain increasing momentum as more investors enter the market. During the boom phase, the asset attracts widespread media attention which increases the fear of missing what could be a once-in-a-lifetime opportunity.
(If you do a search on Google on “Bitcoin Bubble,” you will find almost 700 000 results)
- Euphoria – valuations reach extreme levels during this phase
Bitcoin is now selling for $2 514/Bitcoin (at time of writing), whereas five years ago it was as little as $5.
- Profit taking – during this phase, the smart investors realise it is just a matter of time until the bubble bursts, they sell out and bank profits.
- Panic – in the final stage, asset prices descend even quicker than they rose as speculators start panicking.
Some early bubbles
The tulip bubble began in 1633 and burst in 1637. At the peak of the bubble a single tulip could be traded for an entire farming estate, in one month, the price of tulip bulbs rose 2 000%! Once the bubble burst, a tulip was the same price as a common onion.
The ostrich feather boom took place between 1890-1914. This was driven by fashion as the feathers were primarily used to decorate hats. At one point, you could get more money for 1kg of feathers than 1kg of gold. The boom ended in 1914 and was blamed on Henry Ford and the arrival of the first motor car. Ladies were not able to wear their elaborate feather hats in cars that had roofs, and so the demand for feather hats collapsed.
What does bitcoin have to do with tulips and ostrich feathers?
There is no doubt that blockchain technology and cryptocurrencies could have a massive impact on all forms of business, especially financial services. However, this does not guarantee that bitcoin will be the first choice as a store of value. It is very difficult for proper investors to consider an asset than can appreciate by 180% in 6 months. Similarly, bitcoin has lost more than 80% on a few occasions causing serious investors to allocate very small amounts of money to bitcoin and only as a form of speculation. In June 2016, bitcoin’s market share of all cryptocurrencies was 81%. In one year, it has dropped to 41%. This drop is not due to Bitcoin’s price decreasing, as shown below, the price has skyrocketed since 2013, instead it is due to other cryptocurrency competitors growing more quickly. In comparison to the younger cryptocurrencies, bitcoin is slower and more limited.
Change in bitcoin value
‘We learn from history that we do not learn from history’ (George Hegel)
One of Warren Buffet’s pearls of wisdom is to only invest in what you know. How many investors in bitcoin understand what bitcoin is and how it really works? Apparently, there are only a few hundred people in the world with such skills and for many, bitcoin continues to remain a mystery. If you don’t understand your investment and you are buying when there is a state of euphoria, tread very carefully, you might be the last buyer at the highest price.