A Guide to Understanding Bitcoin

Economist Carlos Hernandez explains Bitcoin saved his family's life in Venezuela, where the country suffers from hyperinflation.

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That’s the voice of Carlos, a Venezuelan economist who entered the media spotlight last year after writing a New York Times op-ed about how Bitcoin saved his family’s life. 

Venezuela is going through economic and political turmoil right now, and it’s messing with the way Carlos uses his money. Venezuela suffers from hyperinflation, which is what happens when the price of everything rises really quickly—too quickly. 

These days, if you get paid $10 in Venezuelan Bolivars to mow the lawn for someone in Caracas, they could be worth half that within just a few hours.

But that’s not the only thing Venezuelans have to worry about money-wise. 

Imagine trying to leave the country, getting stuck at the border, and getting all of your money taken away from you.

That’s what was happening to Carlos, so he turned to Bitcoin to see if it could help him regain some control over his finances.

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For all our coverage on Bitcoin, check out the following: 

What's the Deal with Bitcoin: The Foundation

What's the Deal with Bitcoin: Should I Invest? 

The Price of a Pandemic: Does Bitcoin Know Something We Don't

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What is Bitcoin? 

Bitcoin is digital money that allows for secure peer-to-peer financial transactions over the internet. 

That’s a fancy way of saying that it lets you send money to someone else without using an intermediary—i.e. a bank or other financial institution.

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How did it all start?

The origins of Bitcoin are mysterious. It all started in 2008, when two anonymous computer programmers registered bitcoin.org and posted a whitepaper there outlining their vision for a peer-to-peer cryptocurrency, free from the control of any central government or bank.

Trust in financial institutions was at a low at the time. As the big banks became more reckless and the financial system came crashing down, people began looking for ways to bypass the traditional institutions that had failed them.

The Bitcoin founders’ solution was to create a decentralized digital currency that wasn’t controlled by any institution in particular.

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Crypto investor, Avichal Garg explains why there’s a distrust with the current banking system, and how Bitcoin is a potential solution to that.

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How does Bitcoin work?

The double spend problem

The way financial transactions work in a traditional, centralized system is that a bank or government uses a ledger to keep track of all the money that’s going around. (Just like the ledger you use to do your small business bookkeeping and accounting.)

• Issues with a centralized system mean there’s one point of failure.
• There’s potential for corruption and manipulation, that would be hard to confirm. 
• Errors can be made that are not accounted for by other parties. 
  

Keeping track of money in a decentralized system is trickier, because each participant has to keep their copy of the ledger updated themselves.

• Issues with a decentralized system is that multiple parties have to record the same information, without error. 
• Any one mistake on one ledger can cause mass confusion across the system. 
  

Benefits of a Decentralized System? 

• Cut out middleman which can reduce fees
• Reduce friction in transaction time, moving things quicker
• Seizure resistance & financial freedom can provide peace of mind. 

That’s the double spend problem. It’s what you get when instead of having one person keep score, you leave it up to each individual person to keep score themselves. And before Bitcoin, it was the main thing that prevented us from creating a truly decentralized currency.

So how do you prevent people from lying about the transactions in their ledger, allowing them to, for example, spend the same bitcoin twice?

The “blockchain”

The creators of Bitcoin leveraged blockchain—or, distributed ledger—technology to get around this problem.

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This is what people mean when they refer to “mining” Bitcoin. Bitcoin miners are really just people who work to maintain the Bitcoin system, a bit like how an army of editors work to maintain and keep Wikipedia running.

Can I mine my own bitcoin?

Yes, but only if you have access to cheap electricity and lots of computers.

These days, unless you’ve got a warehouse full of computers and access to a small town’s worth of electricity, the amount of Bitcoin you get probably won’t justify the costs involved in mining it. You might as well buy Bitcoin directly, which we’ll get into later in this guide.

Crypto investor, Avichal Garg explains the “double spend” problem and what a distributed ledger is.

Why Bitcoin is a bit like gold, and why that’s important

Bitcoin isn’t the first popular money alternative to come along.

Gold has been around since the beginning of human civilization, and it fulfils many of the same functions:

• No single government controls it, so there’s no single, centralized point of failure 
• There’s a global, liquid market for it (i.e. you can sell it relatively quickly and easily)
• It has a limited quantity
• It’s easy to assess the value of it (Go to coinmarketcap.com or Coinbase to see the current price of Bitcoin)
• The government can’t seize it from you
  

Unlike gold, however, Bitcoin hasn’t yet proven itself as a good store of value, i.e. something that keeps its value over time and doesn’t depreciate. Although it has the potential. 

Economist Carlos Hernandez tells us how he uses Bitcoin to buy goods in Venezuela.

Store Of Value

When the world is going nuts and things are unstable, you want your wealth to have some levels of stability. Examples of uncertain times: 

• The Great Depression 
• 2008 Financial Collapse 
• 2020 COVID-19 Pandemic 
  

The US Dollar, real estate, and fine art have all been considered good stores of value at some point in history. Bitcoin has the potential to be a good store of value, but because the price of it varies so much, it’s unproven.

• All of these examples are subject to change, but it’s really what they’re being COMPARED to. Would you rather have cash in US$ or in Venezeulan Bolivar? 
  

Another way Bitcoin is different is that it has a fixed supply: the code underlying it says that there can only ever be 21 million bitcoins total. That protects it from any drops in value due to excessive Bitcoin production, which is what happens to commodities like aluminum or silver whenever we discover large new deposits of them. 

• Fixed supply is what creates an increase in value, provided there’s an increase in demand. Value of a rare pair of Jordan sneakers go up, because there are only so many in supply. 
• The US$ has the ability to lose value if the supply of those dollars goes up. For example, when the Federal Government prints more money in times of uncertainty (like a pandemic), it DEVALUES the dollar because there are more in circulation.

Bitcoin Investor Anthony Pompliano discusses having a holistic and world view when thinking about Bitcoin.

So why should I buy Bitcoin?

We’ve established that Bitcoin has many of the advantages of other currency alternatives like gold, but that it’s also not a particularly good store of value. So why buy Bitcoin?

1. It lets you get around institutions you don’t trust

If you don’t trust traditional institutions—like central banks, governments, and police—bitcoin offers you an easy way around them.

That’s why Bitcoin has found so much appeal in places around the world where trust in traditional institutions is low and where political volatility is high. Instead of depending on a broken system, Bitcoin users effectively create their own separate financial system.

It’s easy for the government to expropriate physical cash or assets. It’s a lot harder for them to access your Coinbase account (for now, at least).

2. It’s easily convertible into other currencies.

It can get pretty stressful to have all of your life savings tied up in an experimental digital currency, the price of which can skyrocket or crater overnight.

One way Carlos gets around the volatility of Bitcoin is by converting it to and storing it in the form of less volatile cryptocurrencies like USD Coin (USDC), which is pegged to the value of the US dollar.

3. You can always sell it for cash

Bitcoin is liquid, i.e. there’s always someone out there who wants to buy some from you. That means that whenever Carlos needs some Bolivars, he can always simply sell some Bitcoin for them.

4. It doesn’t have the physical risk of gold

With gold, you have to physically store it, either in safe at home or with a bank. Imagine desperately needing gold and lugging it around, or having to go to the bank and then converting into whatever cash is needed. Not only would it be physically strenuous, you are at risk of getting robbed. 

Bitcoin is digital, and therefore all you need to remember is your digital “key” which will give you access to it anywhere in the world. It’s a lot harder for someone to rob you if they can’t see what you have. Don’t tell anyone! 

The risks of buying Bitcoin

For the most part, Bitcoin is still an ultra-risky investment. It’s got a lot of potential, but the potential for failure is high too. High risk, high reward. Why is that?

Crypto Investor, Ari Paul explains the potential value of Bitcoin, and how one should think of investing in it.

It’s not like other investments

When you buy stock in a company—say, Apple—you know what you’re buying into. These companies create amazing products that we want, and their success in doing so is reflected in their stock price.

It’s not nearly as clear what you’re buying into—or what price you should be aiming for— when you invest in Bitcoin. Even if you believe in the future of cryptocurrency in general, the standards for that success are less clear than, say, the performance of a stock. That makes it a lot harder to set up expectations and benchmarks around a Bitcoin investment.

It’s still early days

When an investor buys Bitcoin, they’re not just buying an asset with underlying value. They’re also buying into the idea of Bitcoin. 

That idea won’t quite work (i.e. Bitcoin won’t be a stable, universal currency that is low-risk and a good store of value) until lots of other people buy into it as well. 

It has crashed, a few times now

All assets are hyper volatile in their early days. While the stock market might see large corrections every ten years, crypto markets see them every two to three years.

Take, for example, the huge run Bitcoin made in 2017. It gained almost 20X from the beginning of the year as increasing news coverage, public familiarity, and apps like Coinbase made it easier than ever to buy in. 

Then, suddenly, the price of Bitcoin dropped 80%. 

For those familiar with speculative markets, this was normal. For those who were new and jumping along for the ride, it was terrifying.

Crypto Investor, Ari Paul explains the volatility of Bitcoin and the history of its crashes.

And then in March of 2020, the price of Bitcoin crashed again after the global shut down due to the COVID Pandemic, only to recover in price again. 

So how much should I buy?

Know your limit and stay within it

A simple rule of thumb here is: don’t invest more than you can afford to lose. When you’re thinking about how much your portfolio should be “allocated” to a risky asset like Bitcoin, think of the RISK! 

Will Bitcoin losing 90% of its value have a significant impact on your life? Then you probably own too much Bitcoin.

Besides, can you afford to be speculating on a risky asset at this stage in your life? Do you have a family? Do you have a mortgage and other debt? Are you saving? These are all questions you need to ask yourself before embarking on a Bitcoin adventure.

Do some simple math

Maybe your Bitcoin to total investable assets ratio should be 1%. Or maybe if you have a bit more risk appetite like some serious Bitcoin investors and  it can  be closer to 5-10%. Again, understand that this has a risk of losing 80-90% of its value. It can be volatile. BUT it has the potential to 5X, 10X, 50X overtime. 

Regardless of what your ideal ratio is, it’s impossible to think about any of this before you first take stock of your financial situation—your current and long term assets, your liabilities, your expenses—and know exactly how much you can afford to risk.

Bitcoin in the future: a hedge against inflation

We’ve talked quite a bit about volatility and crashes here, and why Bitcoin might be less appealing to a macro investor.

But there’s also a strong positive argument to be made for Bitcoin from a macro perspective, and that has to do with its ability to act as a hedge against inflation.

During economic downturns, the government usually prints money to kick the economy back into gear. But as more dollars enter the economy, there’s a higher risk of inflation, where the buying power of each dollar decreases over time. 

This is what your grandparents are talking about when they complain about how a can of Coke used to cost ten cents. Inflation is a big problem in many economies, because it decimates people’s savings and makes it difficult to plan for the future.

Because there’s a fixed supply of Bitcoin, it can’t inflate the way a currency controlled by a central bank does, which means it has the potential to be a great long-term hedge against inflation (or, if you’re in Carlos from Venezuela’s position, hyperinflation). 

Crypto Investor, Avichal Garg explains what happened with Bitcoin during the global pandemic, and how it can be a potential inflation hedge.

‍Our recommendation: hold, don’t trade

For the purposes of this guide, we think that if you believe in the future potential of Bitcoin, the wisest thing to do at the moment is to buy and hold, or HODL as they say.

Trading Bitcoin in the short term is just not worth the risk. There are professionals out there that do that full time, and it’s difficult and complicated enough for them. The fees, tax overhead and volatility make short term trading simply untenable for most small investors.

Mining Bitcoin might have made sense in the early days, but today that’s also out of reach to most people. Unless you’ve got a server farm’s worth of computers and electricity, it's wise to leave the mining to the big boys.

Far better to buy some modest amount of Bitcoin and hold on to it for the long term. You don’t have to buy it all at once. Folks who bought back at the highs of 2019, are forever scared, because Bitcoin crash 80-90%. Set your allocation goal (1-5%) and buy over time vs in one go. 

How do I actually buy Bitcoin?

Via a Bitcoin exchange

If you’re a complete beginner, your best bet is to sign up for one of the major Bitcoin exchanges like Coinbase or Gemini. Both are simple to use, and they have the ability to store on their platform. 

• You’ll need identity verification, i.e. you’ll probably have to scan and submit some form of photo ID and hook your account up to a bank account or debit card.
  

• Make sure you turn on TWO-FACTOR AUTHENTICATION. 

Cold Storage - a step further

Otherwise known as  Bitcoin wallet—cold storage means to take Bitcoin into your own custody, and offline, hence the “cold”. This is for those who feel that for Bitcoin to be truly under their control, they need to take their purchased Bitcoin off the exchange, and onto a wallet.  

There are dozens of different Bitcoin wallet providers out there, but Bitcoin.org’s excellent guide to wallets should help you determine which one is right for you.

Don’t Buy Locally, peer-to-peer

One of the least safe (but also quickest) ways to buy Bitcoin is directly from another person using a service like LocalBitcoins.com. This is a bit like buying a car off Craigslist.

Glossary

Hyperinflation

A runaway form of inflation, where money loses its ability to function as a medium of exchange (i.e. facilitate the exchange of goods and services).

Peer-to-peer

Meaning ‘between individuals’ or ‘users,’ usually over the internet.

Transactions

Any time money changes hands: due to a sale, an exchange, an investment, a deposit in a bank account, etc.

Financial institution

A bank, federal reserve, hedge fund, private equity firm, or any of the other organizations we typically associate with financial activity.

Cryptocurrency

Any digital currency that is secured using some form of cryptography to secure and verify transactions.

Ledger

Anywhere you record financial transactions—i.e. the books your accountant or bookkeeper keeps.

Distributed ledger

A decentralized ledger system whereby each participant has a copy of the ledger. 

Blockchain

The technology that allows Bitcoin and other cryptocurrencies to maintain distributed ledgers.

Bitcoin mining

Earning Bitcoins by helping maintain the Bitcoin system, mainly by contributing computing power to the network of nodes that works to verify transactions in the Bitcoin system.

Liquid assets

Any asset for which there exists an active market of willing buyers, and which is relatively easy to sell.

Store of value

Any asset that can function as a long-term savings tool, i.e. doesn’t depreciate or suddenly lose value.

Physical assets

Anything physical good or object that holds value, i.e. banknotes, New York real estate, gold, etc.

Stablecoin

A form of cryptocurrency designed to be less volatile, usually pegged to the value of some other asset.

USD Coin (USDC)

A stablecoin cryptocurrency whose value is pegged to the US Dollar.

Bitcoin wallet

A digital repository for your Bitcoins.

Bitcoin exchange

A marketplace used by Bitcoin buyers and sellers to make exchanges.

Inflation

An economy-wide increase in prices, sometimes resulting from an increase in the money supply. 

Volatility

A quality that causes the price of an asset to vary wildly, making that asset a risky investment.