Why Invest in Bitcoin

Dyutiman Das
15 min readFeb 22, 2021

This article is to educate people unfamiliar with crypto currencies about the necessity of having a part of their savings in bitcoin.

Money is Not Wealth

Money is not wealth, wealth is purchasing power and over time money loses purchasing power.

Consider two people Alice and Bob. Both of them have one thousand United States Dollars (or just dollars for short) each. Are they equally wealthy? Not necessarily. Suppose Alice lives in the year 1820 while Bob lives in 2020. Immediately we realize that Alice is considerably wealthier than Bob. Alternatively, suppose that Alice lives in the United States while Bob lives in Zimbabwe, both in the year 2020. Now Bob sounds much wealthier than Alice. This is because the additional information makes us realize that while they both have the same amount of money their purchasing powers are vastly different. Wealth is determined by purchasing power.

Why Do We Save Money?

We save money to preserve our purchasing power in the future.

When we save a fraction of our salary every year it is for the purpose of future expenses, whether to buy a home, a car, unexpected or inevitable healthcare costs or as capital to generate income during retirement or to pass on to children. So the two components of savings are (i) time, that is the future date when we consume our savings and (ii) the goods and services that we will consume. So when we save money, we are trying to preserve our wealth by preserving its purchasing power, specifically the power to purchase the goods and services we expect to consume. It’s important to keep in mind that this basket of target goods and services vary from people to people, and they experience different degrees of loss in purchasing power (commonly known as inflation).

Now suppose Alice from 1820 is an ancestor of Bob. Alice saved her considerable wealth of one thousand dollars which is passed down the generations to Bob. However, when Bob receives his inheritance the considerable wealth has almost vanished. Why? Because although the numerical value of the money is still the same, the purchasing power of the one thousand dollars has depreciated significantly. On the other hand if Alice had say bought gold or a piece of land the value would be preserved better, although in case of land property taxes would have erased the entire value of the land, and the same might be true for gold due to storage cost.

A Financial Battery

We need a financial battery to save our wealth so that we can retain the purchasing power of the money we save.

Imagine a cell phone battery which we charge overnight. Even if we do not use the phone throughout the day, by the evening the battery is almost drained. Better the battery, less the leakage. Analogous to storing electrical energy in the cell phone battery, Alice put her wealth into money or dollars; and like the battery the money leaked its purchasing power so that by the time Bob inherited it, most of that power was gone.

Hence the need of a financial battery (also called a “store of value”). Just like electricity can’t exist by itself, wealth is an abstraction which can’t exist by itself but needs to be stored in some financial instrument or commodity which acts as a store of value. To be a good store of value certain properties have to be satisfied: it has to be durable, portable, fungible, divisible etc.

In addition there are two extremely important requirements, it should be scarce and it should be accepted by other people. If it is abundantly available then there would not be any demand for your assets since people can get it from anywhere. If it is not accepted by other people then it can’t be exchanged for goods and services.

Money or cash has many of these properties. However, as more money is printed it becomes less scarce and hence loses its value, just as in the case of Bob’s inheritance in the example above. Gold is a great store of value and although scarce it is not scarce enough. Modern mining technology increases gold supply by about 2% each year (so gold would lose 87% of its value in a hundred years). And if price of gold goes up then the miners will be incentivized to mine even more thus decreasing its scarcity.

Bitcoin as a Store of Value

Bitcoin satisfies all the requirements for being a store of value except one of the most important ones … adoption. At least it does not satisfy it yet, but that may be changing.

Bitcoin is a digital code, a ledger that keeps records of transactions for example who paid whom how many bitcoins. That’s it. Due to some computer wizardry hacking this ledger is extremely difficult. It’s also very difficult for governments to confiscate or ban it.

Perhaps the most important property of bitcoin is that the code is designed such that there will ever be a maximum of 21 million bitcoins. Why this particular number is neither known nor important, but the fact that there is a ceiling is the most important aspect. Bitcoins come into existence by a process called mining which we will not go into here. So far about 18.6 million bitcoins have been mined which means the ceiling of 21 million is not too far away. And the ceiling is immutable.

So unlike gold or any other commodity the production of bitcoin does not depend on market demand. The production cycle is immutable and hardcoded in the structure of bitcoin. Hence the scarcity of bitcoin depends entirely on demand. If more people want it, it becomes more valuable because the production can’t be sped up and this production rate will also slow down as the years go by according to preprogramed logic. This digital scarcity is the key to bitcoin’s possibility as a store of value.

A Bet on Adoption

Making you rich is not bitcoin’s purpose, but it just might.

Bitcoin is a store of value. If you inject your wealth into it, bitcoin’s purpose is to retain its purchasing power not increase it. This happens in the final stage when bitcoin is adopted as the monetary standard and everything else is measured in it (just as we currently measure everything in dollars). If prices of goods (apples for example) measured in bitcoin fluctuate that will simply be considered as the volatility of apples and not that of bitcoin.

However, we currently do not live in the bitcoin standard but in the dollar standard. Investing in bitcoin comes with some risks and the early adopters will get compensated for taking that risk. Thus all those who invest in bitcoin before full adoption will considerably increase their purchasing power if the adoption happens. If bitcoin fails to gain mass adoption then the investors will lose their investments. That’s the risk they are taking and being compensated for.

So currently investing in bitcoin is a bet on bitcoin’s adoption.

Valuation of Bitcoin

What should be the fair value of bitcoin in dollars? Valuation is determined by supply and demand. The supply is predetermined according to the design of bitcoin. There will ever be 21 million bitcoins. So the valuation primarily depends on the demand.

Bitcoin is a store of value and thus in direct competition with gold, the traditional store of value. Suppose bitcoin reaches the same market capitalization (number of coins times price) of gold which is of 10 trillion dollars then each coin would be valued at 10 trillion dollars/ 21 million or about 500 thousand dollars.

But there are much bigger targets than gold. Consider the passive investing into S&P 500 funds like the ETFs SPY or VOO. People do not invest in them because they have an opinion on the underlying 500 companies. They do so because they have no opinion and use the equity asset class as a store of value for protection against inflation. Thus much of the investments from these index funds could also flow into bitcoin.

The total supply of bitcoin is composed of (i) coins in circulation, (ii) coins being hoarded in cold storage (iii) coins being currently mined or yet to be mined and (iv) lost coins. The most relevant being of course the coins in circulation which is only about four to five million.

The demand is what we have to think of as we go through the adoption phase. The global wealth is in the hands of asset managers who have to allocate certain percentage to different asset classes. Until now bitcoin’s market capitalization was too small to be considered by asset managers. But in early 2021 bitcoin reached a market capitalization of one trillion dollars and now it is in their radar. Suppose the asset allocators choose to assign 5% of their portfolio or 5 trillion dollars to bitcoin. This money will chase not the 21 million, but only the coins in circulation that is about 5 million coins. So in this scenario bitcoin could reach 1 million dollars in value. Of course, as the price increases this will coax some of the hoarders to sell which might increase supply a little and thus regulate the price. Is this realistic? Consider that Bank of New York Melon is now allocating to bitcoin. Just this one bank has 42 trillion dollars under management!!! So you do the math.

There are many models for valuation. One very popular one is the stock to flow model. This model determines value according to the scarcity of precious assets like silver or gold. While this model has tracked the price of bitcoin well so far we have to consider that as bitcoin becomes scarcer than the scarcest asset (that is gold) the model becomes an extrapolation, i.e. it’ll be in uncharted territories and we don’t know if this extrapolation will be appropriate or not. Nevertheless it’s important for the bitcoin investor to understand the implications of this model.

But What About …?

You may come across many concerns or dismissals of bitcoin. Here are some thoughts on the common ones that I have come across.

Bitcoin is a Ponzi scheme: a Ponzi scheme is where you bring in new investors to pay the previous investors. Many early investors in bitcoin are true believers and are hoarders, they will not sell at any price. Instead a lending business is starting whereby they can earn interest income without having to sell.

Bitcoin has no intrinsic value: neither does the dollar or gold or paintings by Picasso. Yet they can all be stores of value. Gold has very limited use, but Bitcoin technology is finding more use-cases, especially in decentralized finance.

Bitcoin is volatile: bitcoin is yet to become a store of value and its purchasing power is indeed volatile. However, this volatility has been decreasing rapidly. More importantly, bitcoin is no more a speculative asset than S&P500. The risk adjusted gains (gains divided by volatility) is comparable or greater than S&P500.

Bitcoin can get hacked: the encryption technology of bitcoin is the same as what guards our bank account passwords. There are other attacks possible, but the strength of bitcoin is in the network which is already too big for such attacks. However, this is an engineering question and outside the scope of this article.

But this raises an interesting question. Ultimately, bitcoin is a technology. Technology evolves, so could bitcoin become antiquated? This depends on the community of engineers maintaining the network and the speed of other technological developments, on whether the Bitcoin engineers will be able to adapt to competing technologies. What we can assume is that with institutional adoption there’s money involved, so the Bitcoin network will not lack resources to remain at cutting edge.

Bitcoin is too slow: bitcoin is not meant for everyday exchange but a store of value, a savings account not a checking account. Nevertheless it’s far faster than traditional finance.

Bitcoins can be lost: so can gold coins, or cash. Custody services already exist and are increasing in number.

Bitcoin uses too much energy: compared to what? Bitcoin as a store of value is competing to replace gold, so we need to compare with the energy usage in mining, forging, transporting and protecting gold. I don’t know what the numbers are, but that’s the way we need to think about it.

Another trend has been to use waste energy (like flares in oil and gas wells) to mine bitcoins. It’s in the miners’ interest to find the cheapest to produce energy, so making use of waste energy is a very innovative development. Note that transmission of electricity from remote areas is difficult and includes significant energy loss. Hence consuming the electricity on the spot for bitcoin mining avoids this issue and hence not competing with commercial usage of the electricity.

What about Other Coins?

There’s a plethora of coins like Ethereum, Polka dot, Dogecoin, Cardano, Chainlink etc. Why not invest in those? They could give you much higher returns than bitcoin, right?

All of them come with their own risks. Bitcoin and Ethereum are the safest. The others are speculative, some of them are also scams. This article is only about bitcoin although it might be prudent to invest in Ethereum as well (say a 80/20 allocation between Bitcoin and Ethereum).

What Are the Risks?

Several common concerns have been addresses here. The main risk I see is that of adoption. If bitcoin fails to be adopted then it is worthless. However, when institutions like Blackrock, Fidelity, Bank of NY Melon, Tesla and others are getting into this space it seems like adoption is happening and speeding up.

Given the technology, bitcoin can’t be banned outright. However, the government could make conversion to fiat currency like dollars extremely difficult or illegal in which case most investors would stay away from this asset class. Nevertheless, if bitcoin gains massive adoption by main stream Wall Street it is very unlikely to be banned by the government.

Is This Time Different?

In the past bitcoin has gone through severe crashes in price. Long term the price appreciates significantly, but the investor should be prepared for massive corrections.

But there are reasons to think that this time is different and there might not be the massive corrections as in the past. The previous two cycles of bitcoin were fueled by retail investors who withdrew their money to lock in their gains causing a bear market. However, this cycle is dominated by institutions who behave very differently and are in it for the long haul. But nevertheless, you should be prepared for massive drawdowns.

So why not wait for the drawdown to invest? Because (i) the drawdown may never come and (ii) even it the price falls in the future the future bottom might be much higher than current price.

Acquisition of Bitcoin

The first question is what percentage of your portfolio should you allocate to bitcoin. Start with a percentage that you are comfortable losing. Say 5%. If bitcoin appreciates ten times, then your portfolio gains by 45%. If bitcoin goes to zero then you lose 5%. Ultimately, it’s your money so you have to decide what kind of risk you are comfortable with. Allocations of up to 25% is not uncommon among investors because they also happen to be believers in bitcoin. Some investors like Raoul Pal call themselves “irresponsibly long” and are almost hundred percent invested in bitcoin. However, that is definitely not recommender for average investors.

The next step is to open a crypto currency account. Common providers are Coinbase and Gemini. You’ll need to connect the crypto account to your bank checking account. Do not choose the debit card option as they will charge you a lot for that.

Now it is time to buy bitcoin. The right strategy depends on the phase of the market. At the time of this writing bitcoin is in a strong bull market. This might tempt you to buy the entire amount all at once. How this will turn out is unknown. One conservative strategy is to decide how much you will invest each year, divide by 52 and invest that amount of dollars each week. This is called dollar cost averaging. If the price is high you will be buying small fraction of coins. If the price is low you will be buying a larger fraction of coins.

Note that the fees charged by the exchange are a larger percentage for smaller purchases. So make sure in Coinbase to buy at least 200 dollars per purchase, otherwise you will be paying too much in fees.

The goal here is to only keep accumulating bitcoins. If you sell then you will incur a huge tax liability. So if you are not going to sell then you could also consider BlockFi. [Unfortunately, as of early 2021 BlockFi is not able to operate in New York State which has allowed only a few cryptocurrency services to operate]. BlockFi is just like a regular bank but for crypto currencies. You can earn up to 6% in interest for bitcoin. In fact you can also move your dollars to BlockFi and convert to crypto dollars or stable coins and earn 10% interest while traditional banks are giving almost zero interest.

Another strategy is to trade bitcoin in a tax advantaged retirement account like an IRA. Fidelity allows purchase of trusts like GBTC or ETHE. This is more risky than buying bitcoin. But here you can sell to lock in gains without incurring an immediate tax. Eventually there will be an ETF in the United States, you have to watch out for it and move to the ETF as soon as they are available. Another alternative is Bitcoin IRA where you can buy bitcoin directly in the IRA. But this is not as safe or reputable as Fidelity, so caveat emptor.

Liquidation of Bitcoin

So when is the right time to sell or liquidate the bitcoin position? The answer is never … or almost never. Why are you saving money in the first place? Presumably for certain big consumptions like buying a house or funding retirement or to pass on to children. That’s the time to sell or pass on the bitcoin holdings.

The internet is an abstract continent. In the early days of America people would go West to stake a claim on land. In the early days of the internet people would buy up domain names and sell them later to people who really needed those names. The crypto currencies are a new territory within the internet and acquisition of bitcoins is taking a stake in that realm, your real estate in the new economy. You give up that stake only when you absolutely need to.

It’s Never Too Late

It’s never too late to buy bitcoin. If you buy early it can increase your purchasing power. If you buy late, it will preserve your purchasing power.

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Update Dec 2023

As we go into the next bitcoin cycle, it’s time for an update. The underlying thesis has remained the same as above, but in this update I will apply the general considerations discussed above to the specific situation we are facing this cycle. Although adoption is increasing bitcoin has not reached full public participation, far from it. So the people trading (or in possession of) bitcoins are a very niche community, let’s call them bitcoiners. The behavior of this community is driven by certain narratives, and it’s important to understand those narratives.

The narratives for the coming cycle (expected to peak September or October of 2025) are the following:

  1. The bitcoin halving (expected April 17th, 2024): new bitcoins are generated by the bitcoin code every ten minutes or so. The rate of new coin generation will be reduced by 50% after the halving, thus significantly lowering additional supply. In the past cycles, bitcoin’s price rose exponentially after the halving, and the bitcoiners expect the same.
  2. Bitcoin spot ETF: The government (actually the SEC) is expected to approve several bitcoin spot ETFs early in 2024. This would mean anyone with a 401k or IRA retirement account would be able to purchase bitcoin. Financial advisors could start advising clients to hold say 1% of their portfolio in bitcoin, as an asset uncorrelated with the rest of their portfolio. There are already bitcoin futures ETFs, but the futures ETF “bleed” money (a topic I will not discuss here) which makes them less attractive. Spot ETF is the next best thing to owning actual bitcoins.
  3. The Federal Reserve is expected to start cutting interest rates: this would make borrowing money cheaper. Money is the fuel of the financial system, just like oil is the fuel of a car, and the government would make it cheaper.

Given these reasons most bitcoiners are expecting a significant rise in bitcoin’s price, definitely above the previous all time high of 69k USD. As a result 70% of bitcoins have not changed hands in the last year, there are very few coins left in the market to buy since no one is selling at current prices. One major source of bitcoins are the miners who have to sell the coins they mine in order to pay for their infrastructure cost. However, after the halving, the coiners will have a lot less coins to sell. Also they’d demand a higher price per coin to cover the fixed costs.

So if the ETF starts brining in new buyers, then the price of bitcoin will have to rise to incentivize the reluctant bitcoiners to part with their coins. As the price rises, the media narrative would bring even more people in thus pushing the price even higher. The spot ETF is actually opening the door of bitcoin to the regular investors, i.e. a huge pool of money.

In what ways can the expectation of the bitcoiners be wrong?

  1. Perhaps there will not be much demand for the spot ETF. Larry Fink of Blackrock (one of the ETF applicants who had dismissed bitcoin only a few years ago) says that they are being pushed by clients to provide bitcoin related services. Apparently, they have already started selling the ETF to select clients even before the ETF has been approved. Of course this could all be a sales pitch.
  2. Reduction in rates by the Federal Reserve generally preceeds a recession (they can see the economy getting worse and that’s why they are reducing rates in the first place). If there is a recession in the economy, many of the bitcoiners might be forced to sell because of issues with their other sources of income.

Whatever the event might be, it’ll have to be something that completely changes the narrative of the bitcoiners. But the four year halving is kind of a foundational myth of bitcoiners, so if shaken that could fundamentally change the nature of bitcoin as a store of value. On the other hand, all the news currently is bullish. The Kingdom of Qatar is investigating how to buy 500 billion dollars worth of bitcoin. Last cycle El Salvador did that, but Qatar is a much bigger player.

That’s the lay of the land for now. Let’s sit back and watch this fascinating drama unfold; or perhaps an anti-climax. Irrespective, the next couple of years will be a game changer for bitcoin, one way or the other.

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