What You Need to Know About Bitcoin Psychology

NEW YORK (TheStreet) -- One sign of speculative excess and investment mania stoked by policies of the U.S. Federal Reserve is earnings of S&P 500 companies are up 6% while the actual index is up 27%.

Another sign of speculative excess is furor over bitcoin, the new digital currency -- or cryptocurrency, to be exact -- that is being talked about all over social media, has been looked at by Congress and, as we saw on CNBC last week, will be accepted as payment for anyone wishing to travel into space when Virgin Galactic is ready for its first launch.

Grasping the full context of the history, mechanics of the currency and social impact is beyond the scope of this article. For a complete breakdown readers should start with Wired's Bitcoin Survival Guide.

As an introduction, bitcoin is computer code that was created in 2008 by one or more pseudonymous programmers known as Satoshi Nakamoto. Bitcoin operates over a global network of computers referred to as bitcoin miners. It is open source, which means anyone can become a miner if they have adequate programming knowledge.

The system is designed such that there can only be a finite number of bitcoins created. Blockchain.info reports there are currently 12 million bitcoins in existence with the limit set at 21 million. The intention of limiting the number of bitcoins is one of the cornerstones of the concept that central banks are inflationary and bitcoin is not.

Bitcoins can be stored digitally and used via an app similar to the app for a Starbucks (SBUX) gift card. Bitcoins can also be kept in physical form but that greatly reduces the utility. Bitcoin currently converts to $810 so one physical coin is not practical for paying for dinner as opposed to paying via an app on your phone because in digital form it can be broken down into whatever fraction necessary to cover a $63.22 meal.

The bigger issue for this article is the price action of bitcoin and the psychology behind it. Anyone interested in a more thorough technological understanding should do more research.

To end users, bitcoin might seem similar to PayPal: currency stored online that can be used for online purchases. Bitcoin having its own exchange rate into other currencies is the difference as far as end users are concerned.

That a new currency has been created on the Internet -- simplistic explanation -- isn't necessarily troubling. The system claims to be built on trust and people should be free to trust the system or not and accept any negative consequences.

What is troubling is the price action. According to Wikipedia, the first transaction using bitcoin was in 2010 when "laszlo" paid 10,000 bitcoins for two pizzas. From there the U.S. dollar conversion rate has skyrocketed. In 2013, the conversion rate has gone from $190 to $810 as of this morning.

That kind of price movement is clearly a sign of a wildly speculative mania that repeats in market history. Part of the psychology behind the bitcoin is to be anti-inflation and anti-central bank because of the perceived harm that central banks do with inflationary policies. But it is likely that bitcoin's shocking rise is partly attributable to Fed policy as noted above.

Speculation does not invalidate bitcoin as a currency, although it doesn't help. But very often when prices rise so much so fast, there is invariably a whoosh down in price that is just as fast, if not faster. People who bought in at $700, $800 and $900 will get hurt badly. The product, the bitcoin, might be different, but human behavior is not.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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