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Beware the bitcoin bubble

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.

Why has the value of bitcoin risen?
A 2017 report by Cambridge University confirms the main use of cryptocurrencies like bitcoin is speculation.1

For those who got in early impressive gains were possible. At the start of 2017, bitcoin was trading for around $US1,000. By November 2017 the trading price had risen to $US11,0002 (about $AUD15,000).

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 – and which could just as easily go belly up as rise 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. This alone makes me very uneasy.

The bottom line
Any asset that’s poorly understand 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. We recommend that this is exactly what you should look for in an investment, and frankly, bitcoin doesn’t cut the mustard.

 


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

2 https://charts.bitcoin.com/

3 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

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