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The Noob’s Guide to Bitcoin & Cryptocurrencies
Posted on: 8/1/17
Since early 2017, Bitcoin and Cryptocurrencies have been all over the news. Bitcoin started 2017 at around AU$800. From there it was almost a one-way bet as the price went skyward to peak around $24,500. It currently sits around AU$21,700 – not bad returns for a year.
This meteoric rise has put Bitcoin and other cryptocurrencies (collectively called ‘altcoins’ – alternative coins) in the mainstream media’s spotlight and has fuelled the cryptocurrency buying frenzy.
I’m sure we all know at least one person who caught the wave early on and is sitting on some nice profits. For those who haven’t a clue where to start, or have been thinking of dipping their toes into the world of Bitcoin and cryptocurrencies, I’ve written this article for you.
What is Bitcoin?
Bitcoin was created as a form of digital money that doesn’t have to go through a financial institution (i.e. banks). In other words, Bitcoin is a currency that is anti-banks, anti-government, and is ultimately the focal point of an alternative financial system.
Its creator was the elusive Satoshi Nakamoto, and the idea came about during the GFC back in 2008 when the US Federal Reserve was creating money out of nothing to try and save the economy.
Unlike US Dollars which can be created as needed, there is only a limited supply of Bitcoin that can ever exist. In fact, a maximum of only 21 million Bitcoins can ever exist, and it’s predicted that this cap will be reached in 2140. Currently, there are around 16 million Bitcoins in circulation.
What are the differences between paying in Bitcoin and paying with cash?
To understand how Bitcoin works, we need to look at how transactions are made in our current system (if you want to skip the reading, check this simple-to-follow video or, watch this very simplified explanation of how traditional transactions vary from Bitcoin transactions).
Say you buy something for $10 on your debit or credit card. This is what happens:
1. A request is sent through to your bank via a third party.
2. Your bank verifies that you have enough money available.
3. The transaction is then authorised or declined.
4. If the transaction is approved, money is deducted from your account and it is sent to the account of the person or business whom you’re buying from.
All this has to occur through the banking system - a type of centralised system that relies on trusting third parties like Mastercard, Visa, EFTPOS, and PayPal to mediate the transaction.
One of Bitcoin’s aims is to manage transactions without going through a centralised system. How does this occur? Say, for example, that I transfer you 1 Bitcoin. When this happens, a digital signature is created. This signature is secured with cryptography – hence the term cryptocurrencies.
If you then transfer this Bitcoin to someone else, another digital signature is created, but all previous signatures are kept. This record of all transactions is called a distributed ledger or, as it is more commonly known as, the blockchain. It is essentially the verification system which confirms and records every single Bitcoin transaction that has ever occurred.
Now, imagine if I had $100 in my bank account, wrote two cheques for $100 and gave them to two different people. One of them would get the money; the other would feel cheated because the cheque would bounce once they went to cash it in. This creates a ‘double spend’ of my $100.
The verification process of the blockchain is key to the Bitcoin system as it must prevent double spending. Remember: When you buy something at the shop, the bank does all the authorising to make sure you have enough money in your account. But who verifies transactions in a decentralised system like Bitcoin’s?
This is where the Bitcoin miners come in. Miners use computers to verify transactions across the network. Remember how every time there is a Bitcoin transaction, a digital signature is created? That digital signature is secured by a complex algorithm. The miners solve these complex algorithms with high-tech computers.
By confirming transactions across the network (known as ‘proof of work’), miners maintain the Bitcoin system. For their work, they are rewarded with Bitcoin.
If I can earn money ‘mining’ Bitcoin, why don’t I just do that?
It was possible to be a Bitcoin miner from your home back in 2010. Eight years on, you are competing with dedicated Bitcoin mining farms in countries where electricity is so much cheaper than it is in Australia. Mining Bitcoin is now considered no longer viable for the average person.
As a cautionary note, be wary of various crypto mining scams and Ponzi schemes that offer to do the mining for you – some are legit but many are not - more on this later.
What about all the other alternative crypto currencies (Ethereum, Ripple, Monero etc.), what are they?
Since Bitcoin’s inception, many other alternative cryptocurrencies (known as ‘altcoins’) have popped up. At the time of writing, there are just under 1400 of these. While Bitcoin is designed to be a form of digital money, many of these other coins have been created to serve various other purposes.
The common theme is that all of these cryptocurrencies utilise the blockchain technology. Many have cropped up in an attempt to decentralise other areas of business, including:
• Ethereum (ETH) uses the blockchain to create smart contracts. Centralised applications or systems where security or fraud may be a problem can use the decentralised Ethereum network. Ethereum forms the building blocks for other blockchain applications. You can see an oversimplified infographic explaining Ethereum here.
• Ripple (XRP) in its simplest form is blockchain technology for banks. Unlike most other cryptos, it is more centralised and ironically, a little bit anti-crypto. You know how transferring money overseas usually costs a hefty fee and can take days? Ripple hopes to make this process quicker and cheaper.
• IOTA (MIOTA) is a cryptocurrency associated with the upcoming revolution in the ‘internet of things’.
• Golem (GNT) works as a currency for buying and selling processing power from other people’s computers.
• TenX (PAY) aims to become the Visa or Mastercard of the cryptocurrency world, enabling real-world transactions of crypto.
• Power Ledger (POWR) is an Australian based coin with the idea of using the tokens to pay for renewable energy produced by others.
Many companies appeared in the dot-com boom back when the internet was becoming mainstream. With the introduction of Bitcoin and the blockchain, the same phenomenon has occurred with altcoins.
Is Bitcoin in a bubble?
Some have been labelling the rise of Bitcoin as the biggest financial bubble in history. There have been comparisons to the Dutch tulip mania, the South Sea Bubble, and more recently, the dot-com bubble. Jordan Belford, the notorious Wolf of Wall street labelled Bitcoin a bubble last month.
There is little doubt that cryptocurrencies are a high risk, highly speculative market to invest in. Just like many early internet companies that failed, it is likely that many of these new coins will fail – in fact, there is a large graveyard of those that already have.
At the end of the day, all the current investments in altcoins are bets on their future potential. Nearly all of these cryptos are still developing, and there is a lot of speculation built into their price tags. If investors see that the crypto they’ve invested in isn’t going to grow into something of use, they will likely pull their money out of that coin.
As for whether Bitcoin is in a bubble or not, I like to look at both sides of the argument:
Arguments for the “Bitcoin bubble”
Looking at the history of the Bitcoin price, if the cryptocurrency is indeed in a bubble, all of the smart money made its way into it a long time ago. Typically, bubbles take off once the ‘mainstream’ is made aware of an opportunity and this is followed by a sharp but brutal drop. If we apply these typical signs of a bubble, then it looks like Bitcoin is currently in the final stages.
Take a look at the difference between typical bubble price behaviour and Bitcoin’s price movements (up to 8/1/18):
The similarities are uncanny.
The four most expensive words in the English language are “this time it’s different”. Maybe Bitcoin isn’t in a bubble, but betting against history is usually a bad bet, especially when it comes to human behaviour.
Arguments against the “Bitcoin bubble”
On the flipside, (and contrary to the previous figure) a lot of institutional investors have not added Bitcoin or any altcoins to their investment portfolios. There has been a lot of hesitation and scepticism around cryptocurrencies and as such many have yet to put money into cryptos. This leaves a lot of money on the sidelines that can still flow into the market.
Bitcoin and cryptocurrencies are also considered a new asset class (other examples of asset classes are shares, bonds, real estate) which has lead to people not being sure how they fit into a portfolio.
Financial bubbles can also last a lot longer than people expect them to. John Maynard Keynes was known for saying that ‘the market can remain irrational longer than you can remain solvent’. The other thing to keep in mind is that bubbles tend not to burst when there are so many people proclaiming they are in one. When talk of a bubble is so common, money stays out of the market. It’s only when absolutely everyone is ‘in’ the market, and there are no bubble doomsayers left that a bubble collapses.
Whether Bitcoin is or isn’t a bubble is up to you to decide. At the end of the day, however, the underlying value of the blockchain is here to stay. The dot-com boom and bust of the 2000s may have killed off a host of start-up tech companies, but the internet only kept improving, giving us services we take for granted today like Skype, YouTube, Google, Netflix, and Facebook.
If Bitcoin and the alternate cryptocurrencies experience a similar crash, it may be for the better as only the best cryptos would survive.
Invest now or wait for a crash? Is it too late to invest?
Once again, this is ultimately up to you to decide. Take a look at the facts, do your research and come to your own conclusions.
We’ve said it before, but cryptocurrencies are a volatile, high-risk, highly speculative market and are not for the faint-hearted. Having already gone mainstream, cryptos are attracting a new wave of people who think this is their ticket to get rich quick.
If you’re looking for a quick buck, play this game at your own risk. It was easier to double your money when Bitcoin was $1000 than when it is at $20,000. The risk to reward trade-off is not as favourable as it used to be. It is entirely possible for Bitcoin’s value to skyrocket again but remember: Most of the smart money has moved.
2018 could be a strong year for cryptocurrencies, however, there is always the risk that everything has run ‘too hard too fast’, and some major corrections are likely due to occur throughout the year. Cryptocurrencies are very volatile, with prices fluctuating ±30% of their value within a 24-hour period. It’d be like having $1000 one day then waking up the next day to find out you’ve only got $700.
The underlying blockchain technology is revolutionary. Even if Bitcoin went to zero, the technology behind the blockchain would continue to be used in business across the world in the coming decades.
A small bit of money invested in cryptocurrencies could potentially give you some long-term rewards especially for the ones that survive long term. Amazon shares were $107 towards the height of the dot com boom. It crashed but then slowly crept up to where it is now at $1150 so even if you’d bought in at the peak of the dot com bubble, you’d still be ahead today.
If you were to go into the crypto game, an ‘all in’ approach could end in tears. Managing risk is a skill that all the best investors in the world have in common. One way to do this is to only risk amounts you can stomach to lose – from my own experience this is usually less than you’d think. I once had an investment (in shares) which went from $2000 to $400 in a single day; the reality hits you harder than the hypothetical scenario.
Do not be one of those people who bet the farm on cryptos. If you’re right, good for you, but if you’re wrong – you can permanently cripple your finances.
Above: The exact way NOT to invest in crypto
Here are some ideas to keep in mind if you’re going to delve into cryptocurrencies:
Already invested in cryptocurrencies? Here are some things to consider:
How to actually buy crypto
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Welcome New Readers
Have a look around. If you're new the best place to start would be by downloading and reading the FREE Early Retirement Introductory eBook.
Welcome New Readers
Have a look around. If you're new the best place to start would be by downloading and reading the FREE Early Retirement Introductory eBook.
