Cryptocurrency Investment - Extreme Risk/Extreme Return

On our site we talk a lot about the risk/return relationship and also about asset allocation and diversification. The essential messages related to bitcoin investing are:

1. The higher return, the higher risk

2. Your risk profile should reflect your investment goals, risk tolerance and investment horizon (how long you plan to let your investments grow).

3. Your portfolio should be diversified and you should avoid having too much of one asset or class of investment.

Bitcoin, as most of us know by now, is a cryptocurrency, also called a cybercurrency. It is not backed by any country, bank or other institution but purely follows a supply/demand model, driven by a limited number of bitcoins in the world. Since there are limits to the total number of bitcoins, if the demand for bitcoins goes up faster than the supply increases, the value of the bitcoin should go up.

And go up it has, from around $1,000 per coin at the start of 2017 and peaking near $20,000 per coin just before Christmas.

As of today (January 19, 2018) it has come down almost 50% from that high and people seem split on whether the asset move rebound and start to head higher again (based on supply/demand) or whether speculation in cryptocurrencies has already pushed the value of bitcoin well above a reasonable level. Given that this type of asset is brand new, it is very difficult for anyone to have any confidence in their predictions making an investment in bitcoins or any other cryptocurrency and extremely risky investment leading to potential huge returns (if you invested in January 2017) or huge losses (if you invested in early December 2017).

Sound financial strategy would say to avoid putting many of your assets in this type of investment - it is far too risky for most investors and very few people really understand what they are investing in if they choose to buy Bitcoin. Reports indicate that there are a very high number of young people investing in Bitcoin and most are investing because of the large returns they are anticipating. Perhaps they are confident because they have never experienced a big downturn. The run up in Bitcoin seems to be driven by speculation and greed rather than any kind of fundamental value.

But if you choose to invest in Bitcoin, make sure to follow the advice you would get for any very risky investment - invest only as much as you can afford to lose, and certainly no more than 5-10% of your overall investment portfolio. While there is the possibility of making a huge return on a Bitcoin investment, as investors in the dot.com era learned, timing is everything and while that investment may lead to huge returns, it is very difficult time time a downturn, as people who invested in Bitcoin right before Christmas now realize.

From the first boom bust cycle (The Dutch Tulip Bubble) to the latest tech and financial services bubbles, people made a lot of money on the way up and lost a lot of money on the way down during these bubbles. Since no one can time the peak, make sure you only invest with money you can afford to lose.