Is bitcoin rat poison or a castle in the air?

Eric Brouwer
Oct 28, 2019 · 7 min read

Warren Buffett and John Maynard Keynes have polar opposite investment theories. The former uses the firm foundation theory to make investment decisions while the latter employed the castle in the air theory. Both theories help us understand how different investment perspectives can construct opposing narratives for bitcoin’s price and valuation.

Buffett and Keynes have opposing perspectives on investing that help us understand how investors value bitcoin.

This article does not constitute legal or any other professional advice and is not intended to be relied upon as such.

Buffett vs Keynes: a battle of investment theories

Have you ever wondered why Warren Buffett, perhaps the most successful investor of all time, likened bitcoin to “rat poison squared”? The answer has to do with the investment theory that he subscribes to called: firm foundation theory. Once you understand his investment methodology you too will see why bitcoin may in fact constitute rat poison.

If you do not buy into the firm foundation theory, no worries, neither did John Maynard Keynes, one of the most famous economists of all time who also made millions in the market. Keynes, unlike Buffett, believed that intrinsic value does not drive stock market prices but rather the psychic of the market does.

Applied to bitcoin, these theories help us understand bitcoin’s price valuation and the striking differences between Buffett’s and Keynes’ approaches to investing.

Asset Valuation:

All investment opportunities whether in equities, debt, gold, bitcoin, and crypto involve making predictions on future performance. We make investments in certain securities and assets because we forecast that they will appreciate in value or return a sustainable flow of income. The problem, however, is that no one can predict the future. No one can say for certain whether any asset will go up or down. Indeed, it’s this unpredictability that makes investing so difficult, yet extremely rewarding.

As the valuation of assets depends on future events, investors have devised theories to help translate future profitability into present day asset valuations. The two most common and long-standing theories are the firm foundation and castle in the air theories. The former derives its roots from Benjamin Graham’s investment work and is heralded by Warren Buffett. The latter was most commonly preached and practised by John Maynard Keynes. Both methods rely on different valuation metrics, and as we will see, help explain investor sentiment towards bitcoin.

The Firm Foundation Theory

The firm foundation theory states that every asset has an intrinsic value that serves as that asset’s price anchor. The theory goes that an asset that has a price above an asset’s intrinsic value ie its anchor represents a selling opportunity, while an asset that has a price below its intrinsic value marks a buying signal. Investors then have the task of first determining an asset’s intrinsic value and then deciding whether to buy or sell that asset depending on whether the price rests below or above its intrinsic value.

Of course, determining any asset’s intrinsic value rests on making future predictions on the growth of that asset. The way that investors perform this task is by using the concept of discounting. Discounting requires an investor to analyse future income or dividends of an asset and discount that value to the present. For instance, $100 invested today at a 2% annual rate has a present value or intrinsic value of $98 because if you invested $98 at a 2% annual rate today you would approximately obtain $100 a year from now. On that basis, the firm foundation theory argues that the intrinsic value of an asset today is equal to its present or discounted value of all its future income.*

Bitcoin is “rat poison squared” because it has no intrinsic value

As Buffett famously said, “bitcoin is rat poison squared”. But why exactly does he think this? Well his reasoning derives from the firm foundation theory, a methodology that he supposedly adhered to in order to make his billions. Using the firm foundation theory we can readily see why he made this statement.

The problem rests with bitcoin’s anchor or intrinsic value. Under the firm foundation theory bitcoin has no intrinsic value because it has no future dividend or income stream like a security or rent from real estate. If you buy bitcoin you receive no right to receive a dividend nor any future income. Therein lies the rat poison. With no future income or dividend stream to discount future growth potential it becomes impossible to determine bitcoin’s intrinsic value according to the firm foundation theory. And with no intrinsic value, an investor like Buffett that adheres to this theory, cannot decide whether bitcoin is overpriced or under-priced. Accordingly, since bitcoin has no intrinsic value and cannot be analysed under this model, it has no asset valuation. In other words, its valueless or “rat poison squared”.

Castle in the air theory

While the firm foundation theory relies on discounting future earning potential to come up with a present day valuation of an asset, the castle in the air theory uses psychic principles of the market to value an asset. Any assets’ valuation relies not upon future earnings, dividends, or income but rather what someone is willing to pay for that asset today or into the future.

It was Mr Keynes that posited the theory so succinctly and who made millions in the market by putting such a theory into practise. He stated that investors in valuing an asset do not rely on intrinsic value as stated under the firm foundation theory, but rather do so by analysing the market’s consensus on a particular asset. As Keynes put it: “It is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence”.

Under this theory, an investor therefore tries to decide how the market will behave in the future and then attempts to act before the market. If an investor thinks the market will favour a certain sector then the investor will buy securities in that sector before the crowd and sell them at a profit. The successful investor looks to the psychology of the market rather than attempting to rely on future earnings prospects. According to such a theory, an investor will buy a particular security on the basis that they will be able to sell it to someone else in the future for a higher price.

Investors built the most grandiose bitcoin castle of all

If we apply the castle in the air theory to bitcoin it helps us understand not only the value of bitcoin but also why we had a tremendous bubble or castle in the air. Simply put, since bitcoin has no intrinsic value under the firm foundation theory, bitcoin’s value is worth whatever someone else will pay for it. This isn’t necessarily a bad thing, rather it’s simply an observation and implication of the castle in the air theory. Neither is such as conclusion unique to bitcoin. Indeed, Keynes posited the theory with traditional securities such as stocks and bonds in mind as obviously bitcoin had not yet been created. Thus, all assets derive their valuation from the psychology of the markets and what someone in the market will pay for it.

The castle in the air theory also explains the massive run up in the price of bitcoin to near $20,000 in 2017. As sentiment grew in bitcoin and cryptocurrencies generally, the psychology of the market pushed bitcoin to all-time highs. Investors, spurred by media predictions and bullish forecasts, started buying bitcoin in anticipation that they would be able to sell bitcoin at a higher price to someone else. The logic that someone else would be willing to pay more for bitcoin spurred the bubble in bitcoin. It was the future expectations of investors that bitcoin’s price would keep rising higher that built the most grandiose castle in the sky. Of course like any bubble and investment built upon psychology rather than reason, bullish sentiment can quickly turn negative, incentivising a rush for the exit. Hence, market psychology both built bitcoin’s castle and also burnt it to the ground.

Another castle or more rat poison?

That is the key question and debate in bitcoin today. Will we see another run up like we had in 2017 with the tremendous building of castles in the sky or will we finally witness bitcoin plunge towards its rat poison valuation of zero?

If you abide by the firm foundation theory and want to invest like Buffett the answer is certainly the latter. You may posit that it’s only a matter of time before bitcoin goes to zero, as in the end the market will correct and the price of every asset will head towards its intrinsic value. Indeed, bitcoin’s recent plunge below $8,000 is evidence that bitcoin may be heading down that path.

Or you may say that none of that matters because its market psychology and investor behaviour that drives price discovery. Whether bitcoin has no intrinsic value is neither here nor there, you may argue. Instead, what does matter is that someone is willing to buy bitcoin at today’s market price. And if you believe that others will buy bitcoin at a higher price in the future then it is prudent to buy bitcoin now as in the future others will be building an even greater bitcoin castle in the sky.

Despite those opposing views, always remember that the future is unpredictable and so too is the future of bitcoin and its price. It may go up it may go down. So do your own research and inform your own view.

*Malkiel, Burton G.. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Twelfth Edition) (p. 31). W. W. Norton & Company.

You can read more of my articles on my website:

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Eric Brouwer

Written by

Trainee solicitor specialising in FinTech, blockchain, crypto, investment funds, and financial services regulation. @EricBrouwerC

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +793K followers.

Eric Brouwer

Written by

Trainee solicitor specialising in FinTech, blockchain, crypto, investment funds, and financial services regulation. @EricBrouwerC

The Startup

Get smarter at building your thing. Follow to join The Startup’s +8 million monthly readers & +793K followers.

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