4 Ways to Tell If Bitcoin Is in a Bubble

John F. Wasik is the author of Lightning Strikes, The Debt-Free Degree, Keynes's Way to Wealth , and 13 other books on innovation, money, and life.

No one wants to be on the wrong side of a bubble. If you invested in Internet stocks in 1999 (during the dot-com bubble) or bought a house with an adjustable rate in 2008 (during the housing crisis), you know what I mean.

There are good reasons to be wary when it comes to the cryptocurrency Bitcoin. Bitcoin is not regulated. There is no Federal Reserve backing it. There is no actual guarantee of Bitcoin's value, which is determined by software. Not to mention deposit insurance like the FDIC.

Despite the many red flags surrounding Bitcoin, there are still many people who consider it as an alternative currency.

Although Bitcoin has a high degree of machine-oriented decision-making, it is not immune to the laws of human nature. When people start speculating that the value of something "can only go up", people still go crazy.

Despite the recent decision by the SEC not to approve a Bitcoin exchange-traded fund (BTC ETF), let’s pause for a moment and review some basic laws of behavioral economics. Oh, and the same laws that apply to Bitcoin also apply to other markets, especially the stock market.

——The language of bubbles should not be forgotten . Whenever supporters of speculative investing want to defend bubbles, they always use phrases like "this time is different" or "this is not like real estate or tech stocks."

But these phrases only serve to isolate us emotionally. The reality is that anything speculative has a cliff edge downside. These people never liked Treasury bonds.

Robert Shiller, a global bubble expert and Yale University economist, said that in 2014, Bitcoin was "an amazing bubble." Shiller wrote the classic book "Irrational Exuberance." He is also a Nobel Prize winner in Economics. He recently said that the U.S. stock market is overvalued.

——' Animal emotions' transcend logic . When something becomes a speculative target, more people will treat it as a bet rather than an investment. For example, if you invest in stocks like Buffett, you will hold them for many years and reap the benefits through appreciation and dividends.

Speculative behavior is largely based on emotion, or what John Maynard Keynes, the founder of macroeconomic theory, called “animal emotions.” Herd mentality pays little attention to relative value, or more precisely, whether the investment vehicle is overvalued.

——Traditional valuation models don’t apply . Here’s an interesting test. Two ways to judge stock prices are to look at their price-to-earnings (P/E) or price-to-book (P/B) ratios. They tell you whether a company’s stock price is high or low. So what is Bitcoin’s P/E? How do we know if Bitcoin’s price is overvalued or undervalued?

In recent years, Bitcoin has seen four major pumps/collapses in valuation. One of those was a 93% drop. Can you imagine losing that much in a mutual fund, bond, or single stock?

Any true investment strategy includes understanding the potential downsides to an investment. If all factors are viewed as upside, then it is pure speculation.

— The gambling mentality obscures transparency . Everyone likes to roll the dice or buy a lottery ticket from time to time. It’s part of our nature.

But unless you have natural insight and an uncanny ability to do statistics and probability calculations in your head, you can't "bet." You don't know what the next point will be or what cards the other person holds. You can only guess.

So when I found out that there were “officially sanctioned Bitcoin casinos” and reports predicting that “Bitcoin could reach $3,000,” I thought it was a bit troubling. “Could reach”? On what basis? It certainly wasn’t based on earnings or dividends.

OK, I agree that Bitcoin shouldn’t be directly compared to traditional stocks. That’s like talking about apples and oranges.

But you can’t escape the fact that Bitcoin is steeped in the language of speculation and remains an opaque instrument to most of us. These are two undeniable red flags for me.