Cryptocurrency risks: Share market lessons for investors in bitcoin

The information in this article is market commentary only and reflects Lincoln's views and beliefs at the time of preparation, which are subject to change without notice. To obtain up-to-date information, please contact us.

Investing can be a battle of ideals, particularly when we have boom runs in asset markets. The dotcom boom, or more recently, property prices in Australia, will see the naysayers and true believers pit their wits against one another in a battle of investment good versus speculative evil. The latest battle which has not only caught the interest of investors, but governments and the world’s largest financial institutions and companies, is that over cryptocurrencies, including bitcoin.

Cryptocurrency and the peer-to-peer electronic cash system that we know today was first created by an unknown person or persons under the pseudonym “Satoshi Nakamoto” in 2008. The cornerstone of the technology is block chain, an environment where digital information can be distributed but not copied, shared — and continually reconciled — using peer computers across the world to maintain database security.

Block chain stands to revolutionise financial markets, as it removes the need to have a centralised point of asset control.

The network also has no single point of failure and most importantly, as it is not corruptible or changeable, transactions such as stock trades can potentially occur instantaneously between counter parties without the need for a third party to settle the transaction. This fundamental strength is a key reason why the Australian Securities Exchange is considering a blockchain-based clearing and settlement system. A decision will be made in the next three months.

Game changer

The goal of creating “digital cash” has been tried many times in the past. A key reason for failure had been the need for a centralised entity to manage money flow. However, blockchain technology with its strong cryptography around the creation of tokens (bitcoins), proved that a secure decentralised consensus database that could act in an orderly manner, was indeed possible.

While cryptocurrencies such as bitcoin can be used for payments, the recent interest in them is dominated by speculators. The price of bitcoin has risen more than 230,000 per cent in seven years it has been in existence. To provide context, the Australian share market has risen 130,000 per cent (ex-dividends) in over 140 years.

Bitcoin’s success has given rise to other cryptocurrencies such as Ethereum and Litecoin, and has seen many “investors” open accounts with bitcoin exchanges to trade the currency, or alternatively invest the central processing unit power to mine bitcoin for themselves and help build the blockchain.

We focus on equities and therefore cannot comment on the likely direction of bitcoin or its fundamental qualities. It is a complex process and requires in-depth knowledge and expertise. However, there are lessons that can be drawn from the share market that are easily translatable in the world of “crypto” that investors could learn from.

Know the risks

Notwithstanding the technical genius of the technology, if it looks like a bubble, and smells like a bubble…then it probably is a bubble. So, if you decide to play the cryptocurrency game, understand that we are still in the infantile days of a completely new and novel store of wealth. This may mean the price of bitcoin, or another cryptocurrency, is susceptible to extreme volatility. Failing to understand these inherent risks means you are purely speculating and seriously risking loss.

Know when you will exit

If you are lured to the huge potential gains cryptocurrencies may deliver and are looking for “easy money”, then have a defined exit strategy before you buy in. Protect your downside as the pursuit of a short-term gain can become a long-term loss if left unchecked.

Don’t believe everything you read and look out for propaganda. For example, recent headlines quoting JP Morgan Chase chief Jamie Dimon stating that “Bitcoin is a bubble” and he would sack any staff member who held bitcoin, were indeed sensational. What he neglected to mention was that his company is neck-deep in a competing cryptocurrency, Ethereum, along with other partners such as Microsoft, ING and Thomson Reuters to name a few. Vested interest perhaps?

If the lure is too strong and you still want to play despite the risks, then feel free to do so. However, it would be remiss of us at Lincoln not to remind you on the need to have the vast majority of your savings in quality investments with strong Financial Health. Be sure you only have what you can afford to lose on the table. If the expected gains are as lucrative as some people are saying, then only a small “investment” will return a jackpot in the game of crypto-lotto.

Our guide to establishing and implementing a successful investment strategy
The Golden Rules for successful share market investing
How the Financial Health Model can work for you

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