What is Bitcoin and is it a good investment?

Bitcoin (BTC) is a new type of digital currency with cryptographic keys that is decentralized on a network of computers shared by users and miners around the world and is not controlled by a single organization or government. It is the first digital cryptocurrency to gain public attention and is being accepted by a growing number of merchants. Like other currencies, users can use the digital currency to purchase goods and services online, as well as in some brick-and-mortar stores that accept it as a form of payment. Currency traders can also trade bitcoins on bitcoin exchanges.

There are several main differences between Bitcoin and traditional currencies (such as the US dollar):

  1. Bitcoin has no centralized authority or clearinghouse (such as a government, central bank, MasterCard or Visa network). The peer-to-peer payment network is operated by users and miners around the world. Currency is anonymously transferred directly between users over the Internet without going through a clearing house. This means transaction fees are much lower.
  2. Bitcoin is created through a process called “Bitcoin mining”. Miners around the world use mining software and computers to solve complex Bitcoin algorithms and approve Bitcoin transactions. They are rewarded with transaction fees and new bitcoins generated by the solution of bitcoin algorithms.
  3. There is a limited amount of bitcoins in circulation. According to Blockchain, as of December 20, 2013, there were approximately 12.1 million Bitcoins in circulation. The difficulty of mining bitcoins (solving algorithms) gets harder as more bitcoins are generated, and the maximum amount in circulation is limited to 21 million. The limit will not be reached until approximately 2140. This makes bitcoins more valuable as more people use them.
  4. A public ledger called “Blockchain” records all Bitcoin transactions and shows the respective holdings of each Bitcoin owner. Anyone can access the public ledger to verify transactions. This makes the digital currency more transparent and predictable. More importantly, transparency prevents fraud and double spending of the same bitcoins.
  5. Digital currency can be purchased through bitcoin mining or bitcoin exchanges.
  6. Digital currency is accepted by a limited number of online merchants and some brick-and-mortar retailers.
  7. Bitcoin wallets (similar to PayPal accounts) are used to store bitcoins, private keys and public addresses, and to anonymously transfer bitcoins between users.
  8. Bitcoins are not insured or protected by government authorities. Therefore, they cannot be recovered if the private keys are stolen by a hacker or lost on a failed hard drive, or due to the shutdown of a Bitcoin exchange. If the private keys are lost, the associated bitcoins cannot be recovered and will go out of circulation. Follow this link to learn about bitcoins.

I believe Bitcoin will gain more public acceptance because users can remain anonymous when buying goods and services online, transaction fees are much lower than credit card payment networks; the public ledger is available to anyone, which can be used to prevent fraud; the currency supply is limited to 21 million and the payment network is managed by users and miners instead of a central authority.

However, I don’t think it’s a great investment tool because it’s extremely volatile and not very stable. For example, this year the price of Bitcoin rose from around $14 to a peak of $1,200 before falling to $632 per BTC at the time of writing.

Bitcoin rallied this year because investors assumed the currency would gain wider acceptance and rise in price. The currency fell 50% in December because BTC China (the largest Bitcoin operator in China) announced that it could no longer accept new deposits due to government regulations. And according to Bloomberg, China’s central bank has banned financial institutions and payment companies from processing bitcoin transactions.

Bitcoin is likely to gain more public acceptance over time, but its price is highly volatile and highly sensitive to news such as government regulations and restrictions that can negatively impact the currency.

Therefore, I do not advise investors to invest in Bitcoin unless it was purchased at a price of less than USD 10 per BTC, because this will allow a much larger margin of safety.

Otherwise, I think it’s much better to invest in stocks that have solid fundamentals and great business prospects and management teams because the underlying companies have intrinsic value and are more predictable.

Disclosure: Viktor Liang has no positions in Bitcoin and has no plans to change his position in the next 72 hours.