Bitcoin and Cryptocurrency – three things to consider

Bitcoin is a digital cryptocurrency based on blockchain technology, where new units are generated by solving complex mathematical problems. Unlike a conventional currency, it’s not issued or controlled by a central bank.

However, we remain highly sceptical about the cryptocurrency as an investment and see very significant risks. In particular, we think there are some important questions investors should ask themselves when buying any cryptocurrency.

Do I understand bitcoin and cryptocurrencies?

We always say investors should only invest in things they understand. That’s as true of bitcoin as shares or funds.

Without an understanding of your investments and what’s driving performance, you stand little chance of making informed decisions.

Cryptocurrencies are highly complex animals and require a fairly detailed understanding of coding to get your head around properly.

Adding to the complexity is the fact the rules of the game can change. Although all users must use the same software for bitcoin to function, with no central authority overseeing potential changes there’s no-one to ensure these changes are in the interests of ordinary bitcoin holders.

Since bitcoin doesn’t pay dividends or interest, its price is driven entirely by supply and demand.

It seems likely that a lot of the demand has been from people hoping to benefit from future price rises rather than use bitcoin as a means of exchange. In other words it’s purely speculative.

In that regard cryptocurrency bears some resemblance to speculative bubbles we’ve seen in the past – most famously tulipomania in the 17th century, when a single tulip bulb changed hands for the equivalent of 10 years’ wages.

We certainly don’t understand the bitcoin price – except as a classic speculative mania. If that’s the case, predicting the point at which demand subsides and prices begin to fall is very difficult, if not impossible. That makes buy and sell decisions just as challenging.

Am I comfortable with the ups and the downs of bitcoin?

It’s easy to look at the bitcoin graph and see the ups. But don’t lose sight of the downs.

The most recent price increase means it’s barely a blip on the chart now, but between 17 December 2017 and 15 December 2018 the price of bitcoin fell from $19,783 to $3,195 – an 83.8% decline. It didn’t return to its 2017 high until December 2020. Bitcoin is certainly not a one-way bet.

Bitcoin has also been very volatile. Daily swings of 10% or more, up and down, are not uncommon. It’s worth asking yourself how you would feel if you lost 20% or even 50% of your money in a matter of days, because this is perfectly possible.

These price swings happen because there’s no widely accepted way to value bitcoin. Unlike shares, bonds or cash accounts, bitcoin doesn’t pay dividends or interest. With no underlying ‘value’, price is driven only by the interaction of supply and demand. From a purely theoretical point of view, a price tag of $2 makes as much sense as $200,000.

The Financial Conduct Authority (FCA) – responsible for regulating financial services firms in the UK – recently said that cryptocurrencies “have no reliable basis for valuation” and that’s a view we wholeheartedly support.

That makes bitcoin a speculative bet rather than an investment in the conventional sense. It’s important not to confuse the two.

Is there a way to invest in bitcoin that works for me?

There are several different ways to invest in bitcoin. However, it’s important to be aware of the risks associated with each.

The most obvious way to invest is to buy the currency directly. However, that makes individual investors responsible for the security of their bitcoin – since the key is stored on your computer.

There have been lots of examples of hackers stealing keys from bitcoin exchanges and miners. With the increasing value of bitcoin, individual investors are becoming more attractive targets, especially as they lack the sophisticated internet security of large companies.

Again the FCA has actively warned about the “prevalence of market abuse and financial crime” in the market. Crucially, because cryptocurrencies are unregulated those who buy them cannot apply to financial regulators for help should something go wrong – either in terms of compensation or to take action against mis-selling.

We also have worries about liquidity.

This is the ability to change investments back into cash when you want too. Over the last year it’s been common for less than $200m of bitcoin to be traded worldwide in a given day. By comparison $6bn of Microsoft shares can trade in a day. This means in a big sell off you could struggle to find a buyer for your bitcoin, leaving you stuck with it even as the price tumbles.

Where does that leave bitcoin?

Given how difficult it is to value bitcoin, it’s almost impossible to make a call on the current price or its future direction.

However, cryptocurrencies in general are clearly subject to their own risks, over and above those of more mainstream investments. It’s important investors are aware of them.

As with any highly speculative investment, if you do decide to invest we would suggest that cryptocurrency shouldn’t make up more than a very small proportion of your total portfolio. Nor should you invest any money you can’t afford to lose.

Ultimately, we think the FCA sum it up nicely. “If consumers invest in these types of product, they should be prepared to lose all their money.”

This article isn’t personal advice. If you’re not sure if an investment’s right for you, you should seek advice.

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