If the surging popularity of Bitcoin has somehow passed you by, you may have been living under a rock. The cryptocurrency’s value has skyrocketed this year from $1,341 in January to a new high of around $25,000 (in Australian dollars) this month. It’s not a surprise Bitcoin is on everyone’s lips, and many are wondering if they should try their luck trading bitcoin.
Here are a few things you should be wary of before buying or trading bitcoin.
Don’t invest in anything you don’t understand
Billionaire Wall Street icon and Berkshire Hathaway CEO Warren Buffett once said, “Never invest in a business you cannot understand.”
Even though Bitcoin has started to enter the mainstream, most people do not actually understand the technology that underpins cryptocurrencies – blockchain technology. They’re jumping on the bandwagon, hoping to sell higher than what they paid for. JPMorgan Chase CEO Jamie Dimon said it himself, ‘the only value of bitcoin is what the other guy will pay for it.”
The latest all-time highs of Bitcoin are causing people to check their judgement at the door. Don’t let the fear of missing out influence you to make risky decisions, especially when you do not understand it.
It’s not protected or regulated
Most legitimate investment avenues have some level of regulatory protection to protect you from unscrupulous operators – banks have the APRA and exchanges such as the ASX and New York Stock Exchange have their own rules. Bitcoin is the wild west when it comes to investments.
When you have a problem with Bitcoin, there’s no one to complain to – because the market is completely decentralised and unregulated. This means that if the platform fails or is hacked, you are not protected and have no statutory recourse. Hacking of bitcoin exchanges is becoming more and more attractive as the price increases.
Think of it like your credit card: if you get ripped off, you call the bank and most likely get your money back. With bitcoin, if you lose it, it’s gone forever.
It’s not investing, it’s speculation
Bitcoin has no reasonable basis for its value. It is speculation on steroids. We have seen such speculative manias before and sadly, they do not end well. In 17th century Netherland, tulips (yes, the humble flower tulip) got caught up in the speculative mania as new ‘futures’ trading markets were introduced.
As word spread that one could make ridiculous amounts of money simply by buying and selling tulip bulbs, prices skyrocketed. At its peak, a single tulip bulb reportedly cost more than 10 times a person’s annual salary. Suddenly, within the space of a single week – the world of valuable tulips collapsed completely.
Why? Because futures demand was artificial, and investors were therefore not investing but speculating on unsustainable price increases. As is often the case with such speculative manias, at some point, the absurdity of tulip prices became all too obvious to enough people and prices collapsed. It’s known as the first financial bubble that spectacularly burst.
Cornell Law School professor Robert Hockett is a former adviser to the Federal Reserve Bank of New York and to the International Monetary Fund. According to him, Bitcoin is 21st-century tulips.
“I’m not skeptical about cryptocurrencies in general or blockchain technology. It’s just insofar as people are speculating on bitcoin in particular, they are buying simply because they expect other people to buy. That is the definition of an asset bubble.”
It’s extremely volatile and risky
While there is always some element of risk when you take your hard earned money out of the bank to invest it, that risk is on a wide spectrum – and Bitcoin is sitting at one extreme end.
Although cryptocurrency newcomers will only see the soaring value in today’s headlines, bitcoin prices have historically been all over the show. The biggest price fall bitcoin has experienced was in April 2013 when prices fell nearly 70% overnight. Even in 2017, when bitcoin has experienced some its most spectacular price gains, bitcoin price fell nearly 25% from early June through mid-July.
When seasoned financial and investment experts are asked what they think of it, they’ll almost always say “I have absolutely no idea”. Why? Because they really have absolutely no idea. But what they do know is that buying Bitcoin is not so much about investing – it’s about speculating.
Do not confuse investing with speculation. Investing is based on careful analysis of risk vs potential return and tends to have a direct link to underlying business or economic activity.
Speculation typically involves buying something with a hope that somebody else will be willing to buy it at a higher price in the near future. The difference between investing and speculation isn’t black and white. For example, buying a stock after careful analysis of the longer term earnings prospects of the company and its valuation would be considered investing. Buying the same stock at 10am with a view to sell it at a higher price at 11am is speculation.
There is little doubt that bitcoin is the wild west of speculation. Whilst bitcoin is called a ‘cryptocurrency’, its actual use as a currency i.e. medium of exchange for goods and services is unsuitable given its very high volatility. For the most part, nowadays especially, bitcoin is traded with a view to hold it as an asset and sell it at a higher price.
Speculating in bitcoin is speculating on other people’s belief in bitcoin. Just like a tulip bulb, you hope that there is somebody else who believes that its price will rise higher than you do.
Nevertheless, if you are considering trading bitcoin, here are some final things to think about.
What are you actually buying
Bitcoin is a piece of software. Understand what holding bitcoins actually means. How will you buy and store bitcoins is a very important consideration you can not afford to take lightly. A software bug or security vulnerability at a broker, exchange or a wallet service could mean that your holdings can disappear overnight. Do your research into reputable service providers.
Know your risk appetite
Take into account your attitude towards volatility and risk of loss.
Diversify your investments
Don’t put all your eggs in one basket. If considering a highly speculative instrument such as bitcoin, only put in monies you are prepared to lose. For your broader investment portfolio, spread your money over a range of different asset classes (so various stocks, bonds and securities) according to your risk profile. This way, you’re substantially minimising your risk of loss.
Sacrificing your time and energy
Do you have the patience and emotional control if the bitcoin price drops and your hard-earned wealth is at risk?
Think long term
Plan your investments holistically and with the future in mind. What’s going to be best for you in the long run?
Also published on Medium.