Investing in cryptocurrencies
Cryptocurrencies are in the news again – for all the wrong reasons. After spectacular rises in value in late 2017, this year has seen the opposite, with plummets of over 50% for some so far this year. So are they an opportunity for investors to seize, or a personal finance disaster waiting to happen?
What are cryptocurrencies?
A cryptocurrency is a digital or virtual means of exchange. Unlike pounds, dollars and so on, which are backed by banks, financial institutions and governments, cryptocurrencies are decentralised by design: they are created and tracked in a shared public record of anonymous encrypted transactions, or blockchain, according to set rules.
Because they’re not issued or controlled by a central authority, cryptocurrencies are considered immune to political manipulation. Other advantages include that it’s much cheaper to transfer funds between two parties compared to a wire transfer between banks, and an online ledger of all transactions ever made in a cryptocurrency can be copied across all computers with the relevant software, making it close to impossible to forge transactions.
Bitcoin, established in 2009, was the first and is the most well-known cryptocurrency, but there are now estimated to be more than 4,000 others, with the likes of Litecoin, Ethereum, Ripple and more also gaining attention in recent years.
By their very nature, cryptocurrencies come with serious risks. The anonymity of owners and transactions are considered a huge draw for those seeking to escape ‘big brother’, but that also makes cryptocurrencies ideally suited to money laundering and tax evasion. And because they’re exclusively digital, they’re prone to hacks and thefts.
In 2014, the world’s largest Bitcoin exchange – trading marketplace – was Mt. Gox, which at the time handled around 70% of all Bitcoin transactions. A hack at the exchange saw $473m worth of Bitcoins stolen, amounting to around 7% of the global supply at the time. Mt. Gox went bankrupt, and the value of Bitcoin plummeted. This was the most well-publicised hack, but many others have followed since.
Lessons have professed to have been learned by those in the business from the mistakes made by Mt. Gox and others in the past. If you are looking to trade in cryptocurrencies, Coinbase is currently one of the most trusted exchanges to buy and sell them.
Ups and downs
From a potential investment perspective, the enormous volatility in their value is where the risks in cryptocurrencies lie. The value of Bitcoin has fluctuated wildly up and down, especially in the last 12 months when it was regularly making headline news.
In early 2011, 1 Bitcoin was worth $1; by November 2013, that same Bitcoin could be exchanged for $1,000. After peaks and troughs, in September 2017 it had reached $5,000, and started gaining widespread media attention. Incredibly, that helped drive the value up to nearly $20,000 in December 2017 amid a frenzy of people anxious not to miss the boat and become ‘Bitcoin millionaires’.
This month, the value dropped to a little over $6,000, and those that bought in at the height of the buying frenzy are left holding something worth around three times less.
It was a classic case of so-called tulip mania, named after a similar rise and overnight fall in the price of exotic new tulip bulbs in the Netherlands in the seventeenth century. By the time everyone had heard about Bitcoin’s rise in value, the early ‘investors’ were ready to sell and the new money coming in to inflate the value dried up.
Invest or avoid?
I believe Bitcoin and other cryptocurrencies are a commodity, not an investment. Investments produce something: shares, dividends or profits from a company, rent from tenants from property investment, and so on.
Commodities on the other hand go up and down based on consumer sentiment, like oil, gold, and cryptocurrencies. That doesn’t mean you can’t try and make money on them, but you can’t plan for what will happen to their value in the way that you can take a long-term view on investing to ride out the ups and downs of the market.
In the long-term, Bitcoin or other cryptocurrencies may become widely used, but that still doesn’t mean you’ll necessarily make money from them. If you think that we’re heading towards a cashless society, then I think there are better areas for your investment focus: companies like Visa, Mastercard, PayPal and so on.
The most important rules for your investment strategy remain to have a very widely diversified portfolio of index funds, and to think long-term. You should only be investing if you don’t need the money for at least five, and preferably seven years. This way, you can overcome the peaks and troughs which are inevitable.
Of course, sometimes it’s easier said than done to stick to your beliefs: a wealthy person I know asked me to arrange the purchase of cryptocurrency in January. When I asked why, he said he didn’t want to be the only person not enjoying the ride. Plenty of others were thinking the same.
I respect him and found myself questioning my own investment philosophy. I wondered, ‘Should I get on board?’ I gave it a miss, because when you live by your values in life, you may miss out on things but you’ll always be happy. The value at the time was about $19,000; today it’s around $6,000. He’s still holding it and hoping the tulip times come back.