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Beware of the bitcoin bubble

Chances are, you’ve heard about bitcoin, but is anyone really making money from it?


One of the questions we’re often asked these days is “should I invest in bitcoin?”

Despite living in the information age, many people have only a scant understanding of how bitcoin works, and that in itself is a red flag. One of the golden rules of investing is to invest in something you understand.

With this in mind, let’s take a potted view of how bitcoin works without delving into complex technical details.

First up, unlike, say, Australian dollars, bitcoins don’t present as hard notes and coins. Rather, they are little more than a randomly assigned set of numbers, and while bitcoins can be traded, you may struggle to buy anything with them at most retailers. That’s because bitcoin is neither government- nor bank-backed, and it operates in a substantially unregulated market. Yet another cue to set the alarm bells ringing.

How does bitcoin work?

Bitcoin is a digital, or virtual, currency known as a cryptocurrency. A digital coin is basically just a file – a few lines of coding, so it could potentially be copied many times and sent to multiple people. But there’s a mechanism in place to stop this, and it’s called a blockchain.

Unlike regular money, which is controlled by a central government authority, bitcoin operates by a decentralised peer-to-peer network – a blockchain.

This blockchain is a public ledger of all transactions ever made using bitcoin including records of which users own which coins. When a transaction is made it’s added to the end of the blockchain and confirmed using a series of complex calculations by the computers of thousands of other users, who are on that currency's network. The other computers on the network reach a consensus that this particular coin has changed to a new owner, and in return for letting their computers do this work, the owners of the computers on the blockchain are rewarded with new bitcoins. This is what allows each individual bitcoin to be held by just one person, and it’s all done without a central authority or bank or government intervention.

All cryptocurrencies can be purchased at online exchanges. You can either store the coins on their website or transfer them to a secure digital wallet created by you on your own computer. Both options have risks. If the online exchange gets hacked, your funds can be stolen and there is no way for a transaction to be reversed or recovered if a crook sends your bitcoins to their wallet. Even storing bitcoin on your own PC isn’t completely safe. A number of years ago an IT worker tossed out his old hard drive, forgetting that it stored 7,500 bitcoins, which today would be worth around $69 million.

Why has the value of bitcoin risen?

A 2017 report by Cambridge University confirms the main use of cryptocurrencies like bitcoin is speculation1.

For those who got in early, impressive gains were possible. At the start of 2017, bitcoin was trading for around $AUD1,1892. By mid-December 2017 the trading price had risen to more than $AUD25,4972 - and that’s where it peaked. As at mid-January 2018, bitcoin is currently trading at about $AUD13,0652.

There’s nothing new about speculative investing. The Dutch tulip bulb market bubble of the 1600s saw speculators drive the price of tulip bulbs to extremes – in some cases more than six times the value of an average worker’s annual salary.

We can look back these days and shake our heads at paying that much for a tulip bulb. But a similar process is happening today with bitcoin.

Should you invest in bitcoin?

The chance to make big profits in a short timeframe is always tempting. But another rule of investing is that big gains are always accompanied with big risks that you could lose your money.

As bitcoin isn’t backed by any tangible assets nor regulated by authorities, the bubble can burst just as quickly as it inflated – and there’s no safety mechanism.

In fact, bitcoin is renowned for being highly volatile, having experienced price collapses in the past. In September 2017, for instance, bitcoin dropped 20% in value in a matter of days.

This being the case, ask yourself, is it really worth putting hard earned cash into an “investment” that exists only in cyberspace – which could just as easily go belly up as it rises in value? And all the time your cash is invested, you won’t earn an ongoing return like say, interest, rental income or dividends.

Exposure to security breaches

Worryingly, Cambridge University found bitcoin exchanges continue to be popular targets for criminals3. As many as one in five exchanges have experienced security breaches, in many cases leaving customers unable to recover their money.

The bottom line

Any asset that’s poorly understood by many investors, and which rises in value rapidly without the backing of strong fundamentals, should ring warning bells. When we’re talking about an environment that is unregulated and vulnerable to digital theft, questions need to be asked.

Sure, bitcoin has its uses. But in my books, a good investment comes with the backing of regulators and the research of third party experts like our research partner Morningstar, to ensure best of breed offerings.

For further information on investing to achieve your goals, please contact your local Mortgage Choice Financial Adviser.

 

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1 Global cryptocurrency benchmarking study 2017, University of Cambridge, https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/alternative-finance/downloads/2017-global-cryptocurrency-benchmarking-study.pdf

2http://www.xe.com/currencycharts/?from=XBT&to=AUD&view=1Y

3Global cryptocurrency benchmarking study 2017, University of Cambridge, https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/alternative-finance/downloads/2017-global-cryptocurrency-benchmarking-study.pdf

Posted in: Financial planning

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