Introduction

Investments is a wonderful field to work in, not only because you can contribute meaningfully to changing people’s lives by helping them secure their financial future, but because it is an interesting field filled with many different views and opinions on a variety of topics.

One such topic that appears to divide people into one of two camps, is cryptocurrencies. Blockchain technology is a lot less controversial, at least in my opinion, as most people recognise that useful technologies have at least a chance of becoming mainstream, although this is far from assured.

Cryptocurrencies, on the other hand, have people sitting at the far extremes of the debate – some calling them scams, while others think they represent the best asset class to protect your wealth from inflation through the depreciation of fiat currencies.

The difference between gambling and investing

Although these terms are often thrown around loosely, without careful definition you will find many people differ on what it means to them. This is usually a good reason to define terms so that you do not end up talking past each other when debating the merits or pitfalls of each.

To me, the definitions are as simple as possible. It is not the risk that differentiates them, as you will see if you search the Internet for a definition, but rather the expected return.

Let us unpack this.

The definition of gambling as a high-risk activity misses the fact that you could gamble with very little risk and that certain investments can be very risky. Instead, think about gambling as an activity with a negative expected result. Expected result is very well defined in statistics, as the probability weighted outcome of all possible results.

Now, it may be clear why all activities at a casino are considered gambling i.e. you should expect a negative result on average over many bets as the house should ultimately win. Investing, on the other hand, has a positive expected outcome. Do not confuse an expected outcome with a realised outcome, as the first is an ex-ante expectation and the latter, is an ex-post realisation. Just like you can win at the casino, you can lose (e.g., a negative return) in investing, without changing the expectation that investing should yield a positive result.

Many people do not understand why the expected result from investing is positive and think this is just wishful thinking by investors, so let me straighten this out. When you determine the price you would pay for a security, you “build in” a positive return i.e. you will only buy the security if the price at which you can buy it will yield a positive return because you have assessed its intrinsic value to be worth more than you would pay.

How do you value a security and why would someone sell you the security if the expected return was positive? Let us address each of these points in turn.

The intrinsic value of a security is unfortunately not only unknown but it is in fact unknowable. Two people will therefore arrive at a different value for the same security using their own methods and assumptions, of which there are many, and not important for this discussion at this point – we will address it later.

The implication, however, is that those two people may be prepared to trade based on their different assessments of the intrinsic value of the security, which addresses the second point. There are many other reasons for a trade to be completed in a security.

A seller may want to exit a position because they would like to use the investment for some other purpose – consumption, or a better investment opportunity. Similarly, many investors often have large inflows of capital that they may want to invest. In summary, trades could take place because people have a different view on the intrinsic value of a security, or because they have different needs.

Where does that leave cryptocurrencies?

This is where things get tricky because although different people can come to different assessments, you will probably not get agreement on how cryptos should be valued. For an asset to have an intrinsic value today, it should have an intrinsic value tomorrow. If you think a company is going to fail tomorrow and it has no assets, you would not be prepared to pay anything for that company.

The value of an asset tomorrow is iteratively the present value of its value in the future. The value in the future will depend on two things. The first is any cash that it generates and either pays out to investors or reinvests to produce even more cash in future. The second is any other assets it creates that are worth something e.g. intellectual property or patents.

Now try applying this logic to cryptocurrencies. Does Bitcoin produce an income? Actually, it consumes many things to just exist for the purpose of enabling transactions. It consumes energy, compute, property, labour, capital etc. What does it produce? A network that facilitates transactions. Can you put a price on that service? Well, the service providers that represent the cryptocurrency exchanges do put a price on the service and make money doing so, but the currency itself does not produce anything and therefore does not generate an income.

So miners – those validating the transactions on the blockchain – can make money from mining, and exchanges can make money from facilitating transactions. In fact, all along the value chain, you will find companies or people making money from Bitcoin, but this does not make Bitcoin itself have any value i.e. the value of Bitcoin could be anything and it would not change its use (to facilitate transactions) and the way people derive money from it.

Now because Bitcoin requires mining, it is at least partially linked to the cost of mining it. If Bitcoin mining is profitable, more people will start mining, thus reducing the profit from mining. If the price drops, fewer people will continue mining, perhaps putting a lower limit on the price. But here we hit a potential problem because the system requires someone to pay for the mining which is currently not the case, at least not explicitly.

So, who pays the miners? Well, the network just “magically” creates Bitcoins to pay the miners, but this will eventually end as Bitcoin has a maximum number of tokens that will ever be created. What happens then? Well, the people transacting will need to pay the miners, or no miners will exist. How much are they prepared to pay? It depends on how valuable the service is to them and not on the cost to mine. This is where the relationship will break down if you do not have a meeting of supply and demand.

What is a Bitcoin worth to an investor?

So, we have spoken about the worth of Bitcoin to users of the transaction system, but we have not spoken about its use to investors. As Bitcoin produces no income, it has no value as an investment unless you believe in a “greater fool” who will pay you more for your Bitcoin than you paid. The expected return is therefore negative (including costs), versus the alternative of investing in the risk-free asset which has a positive return expectation.

You could, of course, believe that Bitcoin will become increasingly valuable because of the service that it provides to people wanting to transact with the benefits it provides, but you would be left defending exactly what that intrinsic value should be. Merely pointing to extrapolations of past price trajectories is not a valid way of determining intrinsic value.

You could argue that many other “assets” share these properties and are nevertheless considered investments e.g. art, wine, stamps, etc. I am going to divide the room even further by throwing gold into the mix. In essence, the comparison is partially valid but not completely so. Although art and stamps do not provide an income, they could do so if put in museums or online and people were charged a fee to view them. Wine could be drunk if its value went to zero and gold could be turned into jewellery or be used for other industrial uses. Bitcoin unfortunately does not have any of these properties as it is completely digital with no inherent value, other than what it was created for – transacting.

In conclusion

This makes Bitcoin an exercise in gambling and not investing. Again, to be clear this does not mean that you cannot make money on it, just like you can make money by gambling at a casino, but your expected return is negative. Does that mean that you should not invest in Bitcoin? Not necessarily. Just like you may want to gamble at a casino or on the Lotto, you could decide that you want to gamble some of your hard-earned money on a low-probability event with a chance of “hitting it big”. Do so with the full knowledge that you are gambling, not investing.