What Bitcoin teaches us about risky investing
Whether you believe Bitcoin is inherently worthless or could eventually head for $650,000, there is little doubt that it has become an asset class of great interest to investors (though perhaps for different reasons than the financial world’s latest obsession: GameStop).
Whether you believe Bitcoin is inherently worthless or could eventually head for $650,000, there is little doubt that it has become an asset class of great interest to investors (though perhaps for different reasons than the financial world's latest obsession: GameStop).
Last month a leading asset manager featured in Investors' Chronicle magazine even recommended that a reader include a small allocation to the cryptocurrency as part of their retirement savings. Bloomberg Wealth has also written a couple of “how to” guides on Bitcoin investing.
But if Bitcoin really has gone mainstream, what does that mean for your personal finances and investments? On the face of it, Bitcoin is neither intrinsically valuable, nor is it a reliable store of wealth. It certainly does not produce an income. It does, however, possess two characteristics that could make it a good fit for even the most conservative portfolio.
The first is its volatility. Many view Bitcoin's volatility with horror. Indeed, the U.K.'s Financial Conduct Authority has repeatedly warned investors off cryptocurrencies for precisely that reason. Between Dec. 2017 and Dec. 2018 the price of Bitcoin fell by almost 85%. But since that nadir it has risen more than tenfold, demonstrating that volatility can cut both ways. The greater an investment's volatility, the larger the losses but the larger the potential returns.
If I had invested one percent of my retirement savings in a company in the FTSE 100 a year ago, I would pretty much have been wasting my time. My investment would have been too small to add much upside, even had the stock risen 20% or 30%. Indeed, the FTSE actually fell last year. However, had the worst happened and the company declared bankruptcy, I would have only had one percent at stake.
Also read: India plans to introduce law banning cryptocurrencies, create official digital currency
Bitcoin's volatility offers a greater possibility of meaningful gains, while still only committing the same small, manageable sum. Over the past year, its price has more than quadrupled. Had I invested the same one percent of my retirement (full disclosure: I don't currently hold any Bitcoin), it would have contributed much more to my portfolio. Thanks to Bitcoin's volatility, as long as you don't bet the ranch, there is still the possibility of making a real gain without too much loss.
Its other key characteristic is that it is not a leveraged investment. Unlike the foreign exchange trading programs, which allow inexperienced investors to apply large leverage to trading currencies, your losses with Bitcoin are limited to your initial stake. Most other get-rich-quick schemes, including contract for differences or CFDs, rely on debt to some degree.
With leveraged investments you lose borrowed money almost the instant your investment falls in value. With Bitcoin you generally stand, at worst, to only lose your initial stake — unless, of course, you've borrowed to trade in the cryptocurrency too.
It was a relative absence of leverage that was the difference between the bursting of the dot-com bubble in 2001, which resulted in a mild recession, and the 2008 financial crisis, which almost wiped out the entire banking sector. Although some debt was involved in 2001, most of the losses were made by “real money” investors. During the 2008 crisis, many banks and professional investors were unable to refinance the borrowing behind supposedly safe AAA assets, forcing them to sell those assets to avoid escalating losses.
Where investments are unleveraged you live to fight another day after even the most severe losses. For example, people often bemoan missing out on buying shares in tech giants such as Amazon.com Inc. when they were at bargain basement prices. At the turn of the century, Amazon's share price was $113. Today those same shares are worth more than $3,300 apiece.
But what is commonly forgotten is that between 2000 and October 2001, you would have lost 95% of your money as the price plummeted to $5.51. Only by continuing to hold through the dot-com downturn and to now would you have reaped your 2,740% reward. And you wouldn't have been able to do that had you held shares using leverage.
Of course, routinely losing 95% of your initial stake is not a sustainable investment strategy. Nor is Bitcoin for everyone, as underlined by its $10,000 fall since Jan. 8. Most financial advisers are certainly far from keen.
But to point out, as some are doing, that crypto assets are unlikely to be able to access protection like the UK's Financial Services Compensation Scheme — which pays consumers in the event of a financial services firm going under — is something of a red herring. You wouldn't have that protection if you invest in any FTSE 100-listed company or GameStop and either fail.
So, if you have a couple of pounds that you can afford to lose, there are probably worse things to buy right now than the world's most popular cryptocurrency.
Written by Stuart Trow.
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