Digital currencies hold great promise, and investors may be drawn to drawn to Bitcoin as a speculative asset that could potentially deliver some very promising returns. However, those who are just starting out investing in Bitcoin, which is the first digital currency to scale, could potentially benefit from keeping several key considerations in mind.
Do Your Homework
This may sound obvious, but investors should conduct thorough research before getting involved with Bitcoin. This adage of "do your homework" is true for all assets. However, Bitcoin is a highly complex investment, and building up expertise surrounding this digital asset can take time.
As a result, doing one's homework may be even more crucial for those considering Bitcoin. There are countless resources available, among them many websites delving into the digital currency and its underlying technology.
In addition, interested investors would benefit from reading the original Bitcoin whitepaper. Potential investors should keep in mind that because the blockchain provides the underlying basis for Bitcoin, it is crucial for them to understand this distributed ledger.
Risk Is Inherent To Investment
Risk is inherent to investment. In other words, an investor could potentially generate some very compelling returns by putting their money into any asset. However, they could also lose everything they invest.
Market observers, analysts and even regulators have warned about risks that are specific to Bitcoin. William Galvin, secretary of the commonwealth of Massachusetts, spoke out regarding this digital currency, warning that "Bitcoin is just the latest in a history of speculative bubbles that most often burst, leaving the average investors with a worthless product." In addition to noting the cryptocurrency's sharp volatility, he elaborated: "Going back to the 1600s with tulip mania to the present Bitcoin craze, chasing the next best thing will, more often than not, end in disaster for the average investor."
Considering the highly risky nature of Bitcoin, investors may benefit significantly from following the wisdom that they should refrain from investing any funds they cannot afford to lose. Leveraging this approach can be helpful for a few different reasons.
An investor could potentially lose everything they invest into a security, so even if they lost all the money they invested in an asset like Bitcoin, it wouldn't be a loss they couldn't handle.
By only investing money that one can afford to lose, an individual can avoid behaviours like "panic selling"—selling that takes place while markets are suffering sharp declines—that can cause an investor to miss opportunities.
When the price of an asset crashes, investors could instead decide to hold, a decision that may be better than selling at a loss and then buying after the asset's price has risen.
Bitcoin Is Highly Volatile
Investors thinking about getting involved with Bitcoin should keep in mind that, at times, the digital currency has suffered severe price fluctuations of robust gains and notable declines.
Bitcoin surged in 2017, rising from less than US$1,000 at the start of the year to around US$20,000 in December, only to lose close to half its value when to fell to nearly US$11,000.
CryptoCompare CEO and co-founder Charles Hayer described this sharp fluctuation as: "A manic upward swing led by the herd will be followed by a downturn as the emotional sentiment changes." He added, "A lot of traders have been waiting for this large correction."
The sharp volatility that Bitcoin encountered in 2017 was certainly not an isolated incident. It climbed sharply in 2013, rising to more than US$1,000 in the autumn before dropping to less than US$500 near the middle of December.
As for why Bitcoin is so volatile, market analysts have pointed to several factors, including the size of its market. At the time of this writing (March 2018), Bitcoin had a total market value of roughly US$180 billion. This is far smaller than the markets for stocks, which was worth US$76.3 trillion in July 2017, and also the market for bonds, which had a value of US$127 trillion in late 2016.
Because the size of the Bitcoin market is very small relative to that of stocks and bonds, it is more susceptible to manipulation. Technically, the "market" for bitcoin consists of several smaller markets, including those that exist on exchanges.
Further, individuals holding large amounts of this digital currency—known as whales—have triggered serious fluctuations in Bitcoin markets by making large transactions. In December 2017, it was reported that roughly 40% of Bitcoin was held by maybe 1,000 investors.
Many of these major Bitcoin holders know each other, which makes it easier for them to work together to push the price up or down. "I think there are a few hundred guys," said Multicoin Capital managing partner Kyle Samani. "They all probably can call each other, and they probably have."
Diversification Is Key
One good way to manage the aforementioned risks is to diversify. The basic idea behind diversification is combining assets in such a way that a decline in the value of one component is offset by gains in others.
For example, if an investor set up a portfolio that contained 20% Bitcoin, 20% emerging-market stocks, 20% U.S. stocks, 20% bonds and 20% commodities, a 10% decline in Bitcoin would ideally coincide with a corresponding increase in the other components.
While this is the ideal setup, things frequently do not work out this smoothly in practice. Even so, investors can look at the performance of different asset classes to determine how best to combine them into a diversified portfolio.
Incorporating Bitcoin in to a portfolio actually makes diversification a bit easier. A whitepaper written by investment manager ARK Invest and cryptocurrency exchange Coinbase revealed that the digital currency's price does not appear to follow the price movements of other asset classes. When compared to the price fluctuations of gold, oil, the S&P 500 and U.S. bonds, gold seemed to move on its own.
Picking The Right Exchange
Picking the right exchange is very important. Digital currency exchanges have suffered many hacks over time, with more than three dozen of these attacks taking place between 2011 and late 2017. In early 2018, hackers stole more than US$500 million worth of Bitcoin from Japanese exchange Coincheck. At the time, this was the largest hack of a digital currency exchange, surpassing the amount stolen from Japanese exchange Mt. Gox in 2014.
While an exchange's security is one major variable that should be factored into selection, it is not the only one. Another serious consideration is what trading a particular marketplace will offer. For example, an exchange may give investors the ability to buy and sell Bitcoin. However, it may also offer Bitcoin derivatives, such as bitcoin futures.
Another variable that investors should consider is which wallets, if any, they will use. There are many different wallets available, all with varying levels of security, differing features and different eases of use. Would-be investors should keep in mind that the more secure wallets are frequently more technical, while wallets that are less secure are usually less technical.
Investors who are concerned about security may consider hardware wallets, devices that hold one's private keys offline. The simple fact that these wallets store key information offline instead of online prevents them from being vulnerable to hackers.
Alternatively, they may look at desktop wallets, which can provide them with full control of their Bitcoin. While these wallets provide users with this control, they are not without their vulnerabilities. Investors using desktop wallets could have their key information compromised if the computer holding the wallet contains a virus.
There are also web wallets, which store one's private keys on remote servers. These wallets have several vulnerabilities, and a user could lose their Bitcoin under many conditions, including malicious code existing in the wallet, a malicious actor hacking a remote server and the company operating the servers declaring bankruptcy.
Some of these web wallets, known as smartphone wallets, exist on the mobile devices of users. These particular wallets have numerous vulnerabilities, and users can easily lose their money if they don't take certain steps to safeguard it. Unfortunately, there are plenty of opportunities for such theft to take place, as there are many malicious software programs that look like seemingly harmless apps.
Another option is a paper wallet, which simply involves printing one's private and public keys in the same place. While wallets like these are completely offline and therefore invulnerable to online attacks, they have their own weak points. Paper wallets contain one's private and public keys, so they could potentially be damaged by water or a house fire. Further, using them can be cumbersome, as harnessing the keys requires entering a long code of numbers and letters.
Additional Security Methods
Once an investor has selected a method of storing their Bitcoin, there are several different methods they can use to make their digital currency more secure. One popular and effective approach is two-factor authentication, which involves providing an extra layer of security by requiring not only a username and password, but also an additional piece of information.
One way to obtain two-factor authentication is by using Google Authenticator, an app that generates codes that are then used to provide the second layer of authentication. Because Google Authenticator is not tied to an individual's phone number, the individual can avoid having their Bitcoin stolen even in the event that they lose their password and their phone number is accessed by a nefarious individual.
Another option is SMS two-factor authentication, which involves receiving a code via text message as the second layer of security. While this layer does provide security over and above the traditional username and password, it can put users at risk because hackers can potentially access these text messages. There are several anecdotes of individuals who had their accounts hijacked as a result of nefarious individuals intercepting codes sent through SMS.
Would-be Bitcoin investors should keep in mind that while this digital currency holds significant potential, there are many different variables they should consider before getting involved. Failure to conduct thorough due diligence could mean losing all of one's money.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…