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 ExxonMobil 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. ExxonMobil 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's (NASDAQ:AMZN) Coins and Facebook's (NASDAQ:FB) 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.
And even when a currency has a juggernaut like Facebook behind it, it can fail to meet expectations. Facebook launched its Credits in 2011, but in 2012 announced that it would alter its system. In a post describing the changes, the company stated that "most games on Facebook have implemented their own virtual currencies, reducing the need for a platformwide virtual currency." Its ambitions for a lucrative application currency exchange failed, and many pointed to the difficulty of capturing users' credit cards and complicated exchange system between cash and credits, and credits and in-game currencies like those in FarmVille.
Amazon, however, has plenty of credit cards stored. And as it's much easier for users to spend branded coins, both psychologically and technologically, Amazon Coins will help fuel purchases in Amazon's Kindle ecosystem. Additionally, in stride with Amazon's usual low-margin, high-volume strategy, it plans to give away "tens of millions dollars' worth" of coins to customers in May.
A poor investment idea
Bitcoin might be fun to gamble on, but as a long-term investment, its current reliance on the largest bitcoin exchange makes it iffy at best. One of the important aspects of bitcoin is its distributed nature, but in its infancy, it has yet to fully realize that value due to a lack of trusted exchanges.
Fool contributor Dan Newman has no position in any stocks mentioned, but does own 5 bitcoins purchased back in 2011. The Motley Fool recommends Amazon.com and Facebook. The Motley Fool owns shares of Amazon.com and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.