Bitcoin: Is It an Investment, a Currency or a Speculative Trap?

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Bitcoin made headlines last year when the value of all outstanding pieces of the electronic currency reached nearly $10 billion.

It's not just speculators drawn to the new currency. Many businesses are also attempting to cash in on this growth:
  • Several public companies, including Zynga (ZNGA) and (OSTK), accept Bitcoins as a form of payment.
  • Venture capitalist Marc Andreessen's firm has invested nearly $50 million in Bitcoin-related ventures, and it is looking to invest even more.
  • And the Winklevoss twins -- who notoriously accused Facebook's (FB) Mark Zuckerberg of stealing their idea -- have been "in dialogue" with the SEC about opening the first Bitcoin exchange-traded fund, according to Bloomberg.
Yet a new survey from (TST) reveals that 76 percent of consumers are not familiar with Bitcoin -- and 79 percent would never consider owning a currency like it.

Does this signal opportunity for savvy investors? Or is this a fad you'd be wise to avoid?

The Basics of Bitcoin

Bitcoin is a completely unregulated form of currency developed by an anonymous Japanese programmer (according to some apocryphal claims) as a completely digital, peer-to-peer payment system that is independent of national currencies (which, Bitcoin users argue, are all subject to the riskiness of the underlying country).

Bitcoins are rewarded throughout the day to a "Bitcoin miner" whose computer solves a series of algorithms quicker than other miners.

The puzzles become more difficult over time, so the calculations take longer and the computations require more computing power. %VIRTUAL-article-sponsoredlinks%There will eventually be a total of 21 million Bitcoins (12.4 million are in circulation today) and we won't reach the point that they are effectively "mined out" until 2040.

The value of a Bitcoin is supposed to be market-driven, meaning they're worth whatever the two parties in a transaction value them as.

For example, in one of the original Bitcoin transactions, a "miner" bought two pizzas worth $25 for 10,000 Bitcoins. (The deal of a lifetime for the pizza seller -- as of this writing, those Bitcoins are worth $6.6 million.)

But as Andreessen admits in a New York Times article, "at this moment ... the value of Bitcoin currency is based more on speculation than actual payment volume." (In full disclosure, he later admits, "it is equally true that that speculation is establishing a sufficiently high price for the currency.")

Of course, euphoric speculation like this never lasts. As with the housing bubble's collapse and the dot-com bubble before it, Bitcoin prices are sure to drop -- a fact that should give one pause when considering whether or not to dabble in Bitcoins.

But There Are Even More Reasons to Think Twice

Economist Bryan Caplan recently speculated on that if Bitcoin continues to grow in popularity, reaching the point that it begins to threaten national currencies, regulators will likely begin to crack down on Bitcoin.

There's already government suspicion. In October, the FBI shut down Silk Road (a popular Bitcoin marketplace), arguing that the website was facilitating transactions of illegal drugs and illicit goods and services. Then last month, the CEO of BitInstant (another Bitcoin exchange) was arrested on money laundering charges. If Bitcoin continues to be associated with crime, its popularity will fade.

It's for this reason that Bitcoin is effectively banned in Russia and China -- and more countries are likely to follow.

Of course, there's also the question of how to acquire (and eventually sell) Bitcoins. eBay's (EBAY) Paypal is "cracking down on Bitcoin sellers," according to Entrepreneur. Fidelity's (FNF) customers were briefly permitted to invest in Bitcoin trusts -- but the company has since withdrawn that ability. There are dozens of fixed-rate exchanges, but many are based abroad, so the security of your transaction isn't necessarily a guarantee.

And it's unlikely you'd be successful mining your own Bitcoins. The computers needed to run the calculations cost as much as $11,000 each, and it's difficult to locate data to mine. (Of course, that price is for a good rig. A cheap, hobbyist mining rig ... that's entirely doable too.) According to TechCrunch, it would take you "over three years to generate any coins," and by then, "the energy cost and equipment deprecation will eventually cost more than the actual Bitcoins are worth."

But If You Insist on Speculating ...

If you still want Bitcoins as part of your portfolio, you should look at them as part of an "alternative investment" allocation. This category includes objects like art, wine, antiques, currencies and even commodities. The premise is that these investments are uncorrelated to the stock market and thus rise when the stock market falls.

Unfortunately, this isn't always the case. For example, in 2008 every commodity dropped alongside the stock market -- except gold, which had a modest 5.8 percent gain. The U.S. dollar also dropped that year, as did most major currencies.

Although alternative investments like these may -- in normal circumstances -- make a decent short-term hedge, they make poor long-term investments. In fact, the iShares S&P GSCI Commodity-Indexed ETF (GSG) (which tracks the performance of all major commodities) lost 35.5 percent, versus a 43.7 percent gain for the S&P 500, over the past 10 years. Similarly, the PowerShares DB G10 Currency Harvest Fund (which tracks the value of the major world currencies) also lost to the S&P 500, and was up just 1.8 percent over the same period.

Wealthy individuals on average have 10 percent of their net worth in alternative investments, according to the Capgemini/RBC Wealth Management World Wealth Report 2013. But a high-net-worth individual can afford to expose themselves to more risk -- a reality that an average investor should keep in mind.

So, if you're not a high-net-worth investor and if, despite the evidence indicating that Bitcoin speculation is a risky move, you still want to invest in them, you should look to keep your exposure minimal -- no more than 2 percent of your portfolio total in alternatives like Bitcoins. But even then, realize that you're just another speculator.

Motley Fool contributor Adam Wiederman has no position in any stocks mentioned. The Motley Fool recommends and owns shares of eBay, Facebook and Tesla Motors.

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