Written by Preet Banerjee
Friday, February 2nd, 2018
"I'm thinking about investing in Bitcoin. What is it?"
These are actual sentences I heard coming out of the mouth of a family friend recently. She verbalized the thought process that many people have: people have been hearing about how the value of bitcoin has shot through the roof, and they don't really know what it is.
Let's start by addressing this thought process, then we'll dive into the basics of Bitcoin and cryptocurrencies.
"Investing" in bitcoin
Right now, it would be hard to build a case that buying bitcoin is an investment for average investors. You should think of it as being a speculation instead.
The difference between investing and speculating is usually about the amount of risk and time involved. Speculators are hoping to make a quick buck, and with that comes a possibility of losing a buck quick, too. Prudent investing for most people is about looking for a reasonable return and risk tradeoff over long periods of time, using a well-built portfolio that is diversified, matched to your tolerance and need for risk, and re-balanced periodically.
So, is it possible to "invest in bitcoin"? Certainly there are entrepreneurs who are building businesses designed to function in the Bitcoin and alternate cryptocurrency ecosystems. These companies might facilitate the growth of cryptocurrency use, such as providing services needed as this space evolves. There will be companies raising money from investors to do so. But this is not what the average person is referring to when asking themselves if they should "invest in bitcoin". Most people are asking about whether they should buy bitcoins themselves, hoping that the value of the currency will keep shooting higher. Because the value of a bitcoin can fluctuate so rapidly up or down (shortly after shooting up to the $10,000 USD threshold, it also lost $1,000 USD in minutes) you should view it as a speculation.
You can make a lot of money speculating, but you can lose a lot of it, too.
There is no doubt that there is a mania surrounding Bitcoin. And with mania come evangelists and cheerleaders. There are a lot of people knee-deep in the cryptocurrency ecosystem who know what they're talking about, but there are now a lot more people who are simply riding the hype train and echoing all the positives and potential while discounting the risks. It happens with every bubble. Your guard should be up whenever you're reading anything about Bitcoin and cryptocurrencies going forward.
The Quick and Dirty Explainer
"Bitcoin versus bitcoin"
Sometimes, when people refer to Bitcoin (using a capital "B"), they mean the Bitcoin network, which is the overall payment network. When they refer to bitcoin, a bitcoin, or bitcoins (with a lowercase "b"), they mean the digital tokens that represent the electronic currency being referred to when you see headlines talking about the value of a bitcoin. Having the same word refer to two different things, and not everyone using the uppercase versus lowercase distinction uniformly, contributes to the confusion in general surrounding Bitcoin.
One of the reasons for interest in Bitcoin is that it can cut out the intermediary to handle transactions. Users could transfer bitcoins to one another directly. It's an alternative to electronic payment systems like credit card payment networks.
A Decentralized Network
Unlike other payment networks, there is no one central agency facilitating and maintaining the record of transactions. Instead, there is a giant public ledger that is collectively maintained by thousands of users around the world. This is what is known as the Bitcoin Blockchain.
Bitcoin has its own Bitcoin Blockchain, as blockchain technology is itself not specific to Bitcoin. It can be used for other cryptocurrency networks (like Litecoin, Ethereum, etc.).
These blockchains are digital ledgers, publicly available to all users on the network. When you make a transaction to buy or sell bitcoin, that information is sent to the entire Bitcoin network. That information must be added to this digital ledger. Communication of information to the ledger, and the ledger itself is encrypted, and this is part of the reason why the term "cryptocurrency" is used.
Your first question is likely: "What's to stop people from adding fraudulent transactions to this ledger or just creating or destroying bitcoin out of thin air?" Read on.
You may have heard about the concept of "mining bitcoins". There is no physical mine where people dig to find bitcoin. Bitcoins are digital tokens. Instead, the concept of mining refers to users on the network who are competing to collect the transaction information that is being added to the public ledger, verifying those transactions against the ledger, and solving a complex formula (a mathematical puzzle) that would then allow them to add a "block" to the ever growing blockchain. The reward for solving the puzzle and adding a block to the blockchain is a bitcoin.
Because there are thousands of users who are competing to verify transactions and add blocks of new transactions to the ledger, the sheer number of miners competing helps ensure accuracy of this public (but encrypted) ledger.
In the late 2000's, Bitcoin was introduced to the world by someone (or some people) referring to themselves at Satoshi Nakamoto. No one knows who this is, and it's been speculated that it could be a small group of people instead of just one person. Nonetheless, the system is now controlled and maintained by thousands of users, and not just one person, or small group of people. The smallest unit of a bitcoin, 0.00000001 bitcoins, is referred to as a Satoshi.
The prices of bitcoin and other cryptocurrencies have been soaring and plunging and making headlines almost everyday. It's easy to get caught up in the hype. But when so many people get so emotional about an "investment" they don't really understand, red flags should be going up in your mind. The underlying technology is quite promising, but for now, the actual currencies themselves should be treated as speculative in nature.