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The Costly Mistake Bitcoin Investors Are Probably Making

Another week, another new high for bitcoin, the largest cryptocurrency by market cap, and easily the most popular virtual currency on the planet. While traditional investors are used to seeing the stock market return 7% a year, inclusive of dividend reinvestment, bitcoin's price has surged by well over 500% since the year began, recently touching a new all-time high of $6,306 per coin. It also firmly places bitcoin's market cap above $100 billion. 

How on Earth has bitcoin become the top-performing and most talked about investment of 2017? It really has to do with four catalysts.

Image source: Getty Images.

Bitcoin's amazing 2017, in a nutshell

The first is the excitement surrounding blockchain, which is the digital and decentralized ledger that underlies most virtual currencies and records transactions without the need for a financial intermediary like a bank. What makes blockchain so exciting is that it's usually an open-source network, meaning altering logged data without someone else findings out would be practically impossible. Blockchain could really shore up security in the financial services industry, as well as a variety of other sectors.

Secondly, the U.S. dollar has been sinking pretty steadily over the past year. Recently hitting multi-year lows against the euro, the weaker dollar has left investors holding cash looking for ways to protect their wealth. Usually when the dollar is sinking, investors will buy gold. This is because of the scarcity of gold and the proven fact that it's a store of value (it's been used as a form of currency for centuries). But bitcoin is being considered a scarce asset as well. Protocols limit the number of mined bitcoin to 21 million, which some investors believe makes bitcoin a proper store of value.

Third, there's growing excitement surrounding bitcoin as a mode of payment. Five brand-name businesses have accepted bitcoin since 2014, and a host of smaller merchants have latched on since then. As a libertarians' dream currency, some investors are simply excited about the potential for merchant expansion.

And lastly, emotions have played a key role in pushing bitcoin higher. Even though we're beginning to see a few institutional investors getting involved – Goldman Sachs is tinkering with the idea of opening trading operations in bitcoin  – retail investors primarily control bitcoin's price movements. Since retail investors are far more susceptible to emotional trading than Wall Street institutions, it's led to a rush into bitcoin, with some folks not wanting to miss the boat.

Image source: Getty Images.

The costly mistake bitcoin investors are making

While it's been an undeniably great year for bitcoin investors, I'd argue that many of these investors could be making a crucial mistake. Namely, placing too much emphasis on bitcoin as a form of payment.

Though long-term buy-and-hold investment mogul Warren Buffett has thus far been wrong about bitcoin, he did raise an important point back in 2014. In an interview with CNBC, Buffett said:

Stay away from it. It's a mirage basically. It's a method of transmitting money. It's a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money, too. Are checks worth a whole lot of money? Just because they can transmit money? I hope bitcoin becomes a better way to do it. But you can replicate it a bunch of different ways. The idea that it has some huge intrinsic value is just a joke in my view. 

If you were to try to live off bitcoin, there's a really good chance you'd struggle to do so. Bitcoin's volatility, lengthy settlement times, and transaction fees work against the idea of recruiting more merchants to the virtual currency. Plus, there's really no floor beneath bitcoin without government backing or any concrete fundamental drivers.

It's also worth pointing out that the barrier to entry in the virtual currency space is pretty low. There are now nearly 1,200 global cryptocurrencies, and big businesses have in some cases banded together to create their own virtual currencies.

Image source: Getty Images.

Oh yeah, one more thing...

It's also possible that investors are misplacing their faith in bitcoin's blockchain. Back in August, bitcoin forked into two separate virtual currencies -- bitcoin and Bitcoin Cash -- because the bitcoin community was at odds over how best to upgrade its blockchain. Those in Bitcoin Cash chose to expand capacity within the existing blockchain. As for bitcoin, the SegWit2x upgrade took some information off the blockchain to boost capacity, reduce transaction fees, and speed up settlement times. The move was clearly made to attract big business.

However, bitcoin's blockchain may not be the preference of enterprises. There are currently more than 150 organizations testing a version of Ethereum's blockchain in pilot and small-scale trials via the Enterprise Ethereum Alliance. Bitcoin's biggest rival, Ethereum, also has a valuable feature known as "smart contracts" built into its blockchain. Smart contracts are protocols that assist with facilitating, verifying, and enforcing the negotiation of a contract. Right now, Ethereum looks to be the preferred blockchain, which is where the tangible value of cryptocurrencies really lies. 

It's quite possible that bitcoin investors are buying into the wrong catalysts, which could turn out to be bad news over the long run.

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