There is a very wide spectrum of opinion about how investors should interpret bitcoin’s extraordinary price rise. In this post, I discuss key findings about bitcoin investing that derive from recent research which I conducted together with two colleagues, Hoje Jo and Haehean Park.
Bitcoin’s price trajectory during 2021 has been nothing short of amazing, rising 78% between January 1 and the third week in February, and crossing the psychologically important value of $50,000. Many commentators have compared bitcoin to gold, and in some respects the recent trading in bitcoin is not unlike a gold rush, mixing fundamentals with strong streaks of irrationality.
It is easy for investors to lose perspective during asset pricing bubbles, as emotional forces come to dominate calm, dispassionate thinking. Market sentiment refers to excessive optimism, or froth, in the overall market. An important finding of our research is that the historical return to bitcoin has featured what behavioral economists call a high “sentiment beta.”
What exactly does a high sentiment beta mean? Most investors understand the concept of traditional beta, namely the degree to which an asset’s return moves relative to the overall market return. Likewise, sentiment beta refers to the degree to which an asset’s return moves relative to the amount of excessive optimism in the general market.
The prototypical high sentiment beta stock is the stock of a small, young company that has an exciting story, and while not yet profitable holds the potential to become exceedingly profitable in the future.
In bitcoin’s decade long history, its return has behaved much like a high sentiment beta stock. Our research documents three key features that connect bitcoin to general financial market dynamics.
First, bitcoin does not exist in isolation, but is instead tethered to the global financial system. Bitcoin has a traditional beta, just like any other asset. However, in periods when stock returns are high, bitcoin returns are more apt to be less tethered to the overall market than when stock returns are low.
Second, successfully investing in high sentiment beta stocks involves buying them during periods of low sentiment, because that is when they tend to be undervalued. The same is true for bitcoin: when market sentiment falls, bitcoin behaves more like a small firm that invests aggressively than when sentiment is high.
Third, the return to holding bitcoin is generally positive during periods when the stocks of higher profitability firms outperform the stocks of lower profitability firms. Keep in mind that growth stocks have significantly outperformed value stocks this past decade, with much of that outperformance coming from large technology firms, including Tesla
High sentiment beta stocks have two important characteristics. First, they are difficult to value on fundamental grounds, and second, they are difficult to arbitrage. The same is true for bitcoin.
The difficulty in valuing bitcoin stems in part because bitcoin, while it is an asset, does not generate cash. Bitcoin is not even a physical asset like gold that can serve as a physical input in the production of jewelry or electrical components. Instead, bitcoin is simply the unit of account in a particular blockchain-based transaction technology, where it serves as the medium of exchange. What confers fundamental value to bitcoin is the ability of its associated transaction technology to compete effectively against other transaction technologies such as those offered by traditional financial service firms.
John Maynard Keynes, one of the greatest economists of the twentieth century, wrote that most investors do not base their trading on considerations of fundamental value. Instead they base their trading on guesswork, trying to guess which assets other investors will find more attractive in the future. In the case of bitcoin, examples of institutions who have been active in the market for bitcoin have been BlackRock