Investment Assumptions

When it comes to your investment assumptions you should question everything

Bullion.Directory precious metals analysis 19 September, 2014
By Terry Kinder
Investor, Technical Analyst

By going on auto-pilot, the brain saves energy. While this can be very handy in our daily lives, it can be very costly when our brains to operate on auto-pilot by using investment assumptions.

So, what are assumptions? One definition of assumptions is “facts or statements taken for granted”. These assumptions are often unquestioned and that is what gets us into trouble.

Let’s take a look at a few examples of investment assumptions and also some questions that we might have asked about each of the investment assumptions below.

1. One of the commonly heard investment assumptions is that Bitcoin adoption will lead to higher Bitcoin prices for speculators or holders of the digital currency.

This is one of several investment assumptions that has been trotted out numerous times by some Bitcoin investors. It even sounds plausible at first. Increased use for Bitcoin leads to increased demand for Bitcoin. Supply is limited, therefore the Bitcoin price should go up. But, is this investment assumption correct? Asking a few questions can help us decide.

What is Bitcoin? At its core, Bitcoin is a protocol. Bitcoin is a technology. What has our experience been with the price of technology in the past? What happened to the price of computer hard drives? Over time, the cost per gigabyte has dropped dramatically. You can assert whatever law or reason you want, but that isn’t our purpose here. As computers were more widely adopted, the price of hard drives dropped.

In a sense, by purchasing Bitcoin, you aren’t buying a competing currency to the dollar, euro, etc. Instead, you are buying a protocol. The Bitcoin protocol allows Bitcoin to be used as a medium of exchange, to make online purchases, etc. The protocol helps reduce costs for online merchants to receive and send money digitally.

The protocol allows developers to build things ranging from letters of credit to the equivalent of online stock exchanges. An added benefit of the Bitcoin protocol is that eliminates the need that the two parties in an exchange trust each other.

When you purchase Bitcoin, you are investing in the Bitcoin protocol. The protocol is a technology. Like other technologies, the Bitcoin protocol is likely fall in price over time.

2. Another one of the investment assumptions held by some people who purchased Bitcoin was that the network effect would lead to higher Bitcoin prices.

The network effect is the idea that as the Bitcoin network was built out, it became more valuable. Some investors assumed that since Bitcoin was an essential part of the network it would increase in price. This is likely an incorrect assumption.

An example of the network effect is the automobile. In and of itself, the automobile isn’t that valuable. In a world with no roads, no fuel, and nobody wanting to travel from place to place the automobile isn’t worth much. However, within the context of the interstate highway system, gasoline stations, the need to transport goods far and wide, the desire of people to travel, etc.. the automobile is more valuable.

But, is it correct to assume that the growth of the transportation network leads to higher automobile prices? No, basic reliable transportation has not soared in price. Despite the fact that the automobile is viewed as central to the transportation network, its price is very reasonable. The transportation network itself is almost certainly more valuable today than it was in 1900, but that hasn’t led to a base model automobile costing $1,000,000.

Some investors have cited the network effect assuming it would result in a greater value for Bitcoin within the wider network. But the Bitcoin network consists of a wide universe of businesses which utilize the Bitcoin protocol.

There are all kinds of Bitcoin businesses – from online merchants, to exchanges, to companies building whole new businesses on top of the Bitcoin protocol. The value is distributed across the network.

Overall, the entire network is gaining in value. Like the automobile, Bitcoin is part of a larger network. The network effect led to a higher value for the overall network, but we shouldn’t assume it will lead to a $100,000 Bitcoin price anytime soon.

3. One of the all time great, and still highly disputed investment assumptions, is the idea that Quantitative Easing (QE) – aka money printing – would lead to hyperinflation and high prices for gold and silver.

This assumption was built on the idea that increasing the amount of money in the system would would lead to “too much money chasing too few goods” and, ultimately, hyperinflation.

To date, that idea hasn’t played out the way many had assumed. One problem with the hyperinflation investment assumption was that the velocity of money dropped to record low levels. Instead of a hyper-inflationary spiral, we have experienced either low or higher inflation, depending on which statistics, if any, you believe. Some even argue that deflation is the real danger. Regardless, hyperinflation has not yet occurred. That doesn’t mean it can’t, or won’t, but the investment assumption of QE leading to hyperinflation hasn’t played out thus far.

Our investment assumptions are one way our brains operate on auto-pilot. These investment assumptions are “facts or statements taken for granted”. They allow us to make shortcuts and get from point A to point B more quickly. However, in the case of investing, our investment assumptions can cause us to make incorrect decisions.

Investment assumptions can be dangerous things. One way to make better decisions is to question our investment assumptions on a regular basis.

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