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The relatively new currency of bitcoin recently peaked to a value near $240 per bitcoin from less than $20 at the start of the year. This 1,200% return in less than five months would pique anyone’s interest.
Many call this a bubble, while others are still bullish on the possibilities of an even richer bitcoin. No matter what side you are on, beware of these bitcoin-specific risks that other traditional investments lack.
Extreme dependence on sentiment
Any value of an item comes down to what someone will pay for it. Some items have an intrinsic value because they can help produce goods or services that can be sold. As Warren Buffett described in his 2011 annual letter, contrasting the value of farmland and Exxon Mobil Corporation (NYSE:XOM) with all the gold in the world:
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil Corporation (NYSE:XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions. … The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Gold, with limited utility, acts mainly as a store of value that is backed by humans’ long-term fascination with the shiny metal. Bitcoin is much the same, but with a much less storied history, and much less physical presence. As such, any slight shock to the confidence of the market can greatly affect its value. A few days ago, when the largest bitcoin trading site, Mt. Gox, was attacked and couldn’t handle all of its traffic for a short time, the value of bitcoins dropped from $142 per bitcoin to $120.
One of the supposed benefits of bitcoin is that it is a peer-to-peer currency that does not rely on any central bank. As such a distributed currency, it shouldn’t rely on one organization to succeed. Whereas past digital currencies like Flooz, Beanz, and e-gold relied on a singular company and its success, bitcoin shouldn’t. As Amazon.com, Inc. (NASDAQ:AMZN)‘s Coins and Facebook Inc (NASDAQ:FB)‘s Credits are only valuable if those companies survive, bitcoin is meant to be free of any single organizational tie to prosper. But, with a lack of credible, efficient, and secure exchanges, losing full access to the largest exchange for a short while means a definite hit to bitcoin’s value.