Billionaire investor Warren Buffett recently gave an ominous warning to those who hope to make a fortune from buying cryptocurrencies like bitcoin. "In terms of cryptocurrencies generally," Buffett told CNBC, "I can say with almost certainty that it will come to a bad ending." In fact, he said that if it were possible to buy a five-year put option -- which makes money as an investment loses value -- he'd do so "on every one of the cryptocurrencies."
In many ways, Buffett's sharp words against cryptocurrencies match those he's spoken against gold. That's not all that surprising, since the two share eerily similar characteristics.
Betting on hope
While Buffett has a well-documented hatred for gold, some of his most critical comments on the shiny metal came in his 2011 letter to shareholders of Berkshire Hathaway (BRK.A -0.22%) (BRK.B -0.03%). In that letter, he detailed three basic choices investors have to grow their wealth. One of the categories he described in detail are "assets that will never produce anything, but that are purchased in the buyer's hope that someone else -- who also knows that the assets will be forever unproductive -- will pay more for them in the future." He pointed out that "tulips, of all things, briefly became a favorite of such buyers in the 17th century" and that gold was "the major asset in this category" because "if you own one ounce of gold for an eternity, you will still own one ounce at its end."
The point is that these assets don't produce anything of value. They don't throw off a spendable income stream like commercial real estate or even a bond, they don't grow food like a farm, and they don't make goods or provide services like a business.
In short, these investments don't create wealth for investors by producing it. Instead, Buffett noted: "This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce -- it will remain lifeless forever -- but rather by the belief that others will desire it even more avidly in the future."
That sounds an awful lot like the current craze over cryptocurrencies.
Buying begets more buying -- until it doesn't
The similarities of cryptocurrencies with gold and other unproductive assets should be of grave concern to those tempted by them, given the history of unproductive assets. The reason Buffett picked on gold at the time was that it was a hot commodity, with its price rising roughly 200% in the five years leading up to that letter. That prompted Buffett to surmise that the "rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis."
However, he warned that "as "bandwagon" investors join any party, they create their own truth -- for a while." In gold's case, it would notch another double-digit gain in 2012 before beginning a long descent in 2013, losing more than 40% of its value at one point. It's still down by about a quarter since the end of 2011.
Gold isn't the only unproductive asset that enjoyed a rapid price rise in the past for a while. Buffett noted that "both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices." However, again he warned that "bubbles blown large enough inevitably pop," which is exactly what he believes will happen with cryptocurrencies in the coming years.
Behold a better way
While it's possible to make a fortune buying and selling unproductive assets, it often takes more luck than skill, since timing needs to be perfect. That's why Buffett prefers to buy productive assets like businesses, farms, or real estate. He likened them to commercial "cows" that will "live for centuries and give ever greater quantities of 'milk' to boot." More importantly, "their value will be determined not by the medium of exchange but rather by their capacity to deliver milk." In other words, they won't rise in price just because someone else is willing to pay more but instead because production from these assets has increased, since owners can milk them for cash and reinvest it into additional productive assets and compound their wealth.
That's just what Buffett has done over the years, turning the cash flow from a failing textile company known as Berkshire Hathaway into a multibillion-dollar business empire by reinvesting the money into more profitable businesses. Buffett believes that "over any extended period of time, this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest." So while there's a temptation to buy cryptocurrencies given their epic run -- which could continue for a while -- the safer and surer way of building lasting wealth is to invest in productive assets like businesses because they can compound it over time.