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  • Cryptocurrency – three things to consider

    Nicholas Hyett shares some questions to ask yourself when considering an investment.

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    • We believe investors should only invest in things they understand
    • Cryptocurrencies are speculative bets rather than conventional investments
    • Many cryptocurrency investments have limited track records and are complicated in their own right

    Most cryptocurrencies are based on blockchain technology, where new units are generated by solving complex mathematical problems. Unlike conventional currencies, they’re not issued or controlled by a central bank.

    They have made headlines in recent years, thanks to the strong performance of Bitcoin in particular, which in 2019 has surged from a little under $3,000 per coin to around $10,000 at times. Similar surges in recent years have helped to raise its profile with investors.

    However, we feel there are some important questions investors should ask themselves when trading in cryptocurrencies.

    This article is not personal advice. If you are unsure of the suitability of an investment for your circumstances seek advice.

    Do I understand it?

    We always say investors should only invest in things that they understand. That is as true of cryptocurrency as shares or funds.

    Without an understanding of your investments and what is driving performance, investors stand little chance of making informed decisions.

    This is particularly true of crypto assets. They are highly complex beasts 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 a cryptocurrency to function, with no central authority overseeing potential changes there’s no-one to ensure these changes are in the interests of ordinary holders.

    It seems likely that much of the demand for cryptocurrencies is from people hoping to benefit from future price rises rather than use currencies like Bitcoin as a means of exchange. In that regard it 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.

    Predicting the point at which demand subsides and prices begin to fall is very difficult, if not impossible, making buy and sell decisions equally challenging.

    Am I comfortable with the ups and the downs?

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

    Take Bitcoin – arguably the most popular cryptocurrency. The recent increase in Bitcoin prices mean it’s barely a blip on the chart now, but between 25 November 2013 and 7 April 2014 the price of bitcoin more than halved from $979 to $422. It didn’t return to its 2013 high until the beginning of 2017. 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 were to lose 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 cryptocurrencies. Unlike shares, bonds or cash accounts, most cryptocurrencies don’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.

    That makes cryptocurrencies 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 that works for me?

    There are several different ways to invest in cryptocurrencies. 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 holdings – since the ‘key’ is stored on your computer.

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

    Another option is to invest indirectly through products that track the price of a particular cryptocurrency – exchange traded funds (ETFs), exchange traded notes (ETNs) or investment trusts.

    However, these products are complicated and carry risks of their own.

    Bitcoin investment trusts have been popular in the past. But as ‘closed-ended’ funds with a fixed number of shares, they’re not ideally suited to tracking prices.

    The share price of an investment trust is dependent on the demand for the shares. If demand spikes, the price of the investment trust can be higher than the value of the underlying assets, while a surge in sales could see the price fall below.

    One alternative is to invest through an ETF or ETN. Many providers are relatively new names, specialising in cryptocurrency. They haven’t weathered a full market cycle in the past and have short track records.

    Make sure you know how the fund gets access to its cryptocurrency. It could buy cryptocurrency directly or instead buy derivatives. As importantly, check whether the cryptocurrency is ring-fenced for investors, or if lenders would come first in the event that the fund manager runs into trouble. Investors should also bear in mind that if lots of people were to pull out of the fund at the same time, the fund might have difficulty selling its assets at a reasonable price. Ultimately, investments can fall in value and you could lose everything.

    To make matters more confusing, some ETFs or ETNs are denominated in currencies other than dollars (against which cryptocurrencies are usually benchmarked). That leaves investors exposed to movements in currency markets as well as crypto prices, and means you get a different return from what you might expect.

    Because of the complexity involved in these sorts of crypto investments the UK financial regulator, the FCA, has even considered banning their sale to the general public.

    Where does that leave cryptocurrency?

    Given the difficulty of valuing most cryptocurrencies, it’s almost impossible to make a call on the current price or its future direction.

    However, crypto in general is clearly subject to its 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 small proportion of your total portfolio. The risk of the price falling substantially also means investors should only invest money that they can afford to lose.

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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