Think carefully before buying Bitcoin

The sharp rise and subsequent fall in Bitcoin’s value makes it among the greatest market bubbles in history. It has outpaced the 17th-century tulip mania, the South Sea bubble of 1720, and the more recent Japanese asset price and dot-com bubbles.

The rapid price rise generated attention from many academics and investment advisers. Some have suggested that Bitcoin improves portfolio performance and can even be used as a potential “safe haven” asset in place of gold.

However, much of this research is flawed and ignored some important attributes that any investor should consider before allocating funds to such a speculative investment.

This is especially important if investing in Bitcoin is considered as a prospective safe haven in times of market turmoil.

Hard to value

The first thing investors consider is how to value Bitcoin. Normally, assets are valued based on the cash flows they produce. Bitcoin lacks this ingredient.

This leads to ongoing discussion as to the true value of Bitcoin and other cryptocurrencies. Some, such as the Winklevoss twins and other Bitcoin entrepreneurs, believe the price will soar far higher. Others, including Nobel prize winner Eugene Fama and esteemed investor Warren Buffett, believe the real value is closer to zero. Another Nobel winner, Robert Shiller, suggests the correct answer is “ambiguous”.

There is the difference in price across the various Bitcoin exchanges. This is common in fragmented markets and it difficult for an investor to find the best market price at any point in time – a process called price discovery.

High price volatility

Bitcoin prices have a high level of variation (volatility) when compared to other types investments including bonds, stocks and gold. Even tech stocks such as Twitter, which are supposed to be relatively volatile, are found to have less price variation. This adds to the difficulty investors face when trying to value Bitcoin and any portfolios that contain it.

This is of great concern given the large daily losses that Bitcoin has experienced in its relatively short life. The largest one-day decline experienced by the popular S&P500 index since 2011 is 4.2%. Bitcoin has had nearly 200 days that were worse (and over 60 days worse than the biggest decline in the gold price of 10.2%).

This means that Bitcoin has had 200 days worse than the worst day on the stock market. This does not seems like a good investment for most.

Low liquidity

Investors should also consider the ease with which they are able to buy and sell any assets in which they invest. One method used to measure this liquidity attribute is the bid-ask spread – the difference in the price at which one is able to buy and sell the asset.

More liquid assets have a narrow bid-ask spread. Bitcoin’s bid-ask spread varies, generally it is much larger than for other assets.

While bid-ask spreads provide one measure of implicit trading costs, investors also consider the explicit transaction fees they are charged when trading. Transaction fees for trading traditional investments are typically well known and have trended down over time.

While Bitcoin fees have recently declined, they are highly variable, ranging from over $30 to under $1. The time taken to process a transaction can also be greater than 78 minutes. This is much longer than for stocks or bonds and creates another layer of uncertainty for investors.

Only for the most risk-loving

Bitcoin is harder to value. They are more volatile, less liquid, and costlier to transact than other assets in normal market conditions. Potential investors should carefully consider whether such highly speculative assets are appropriate additions to any portfolio.

Given safe havens are typically in demand during financial crisis, when markets are more volatile and less liquid, it is highly unlikely that Bitcoin is even worth considering as a safe-haven asset.

Bitcoin price falls are greater than for other assets

The sharp rise and subsequent fall in Bitcoin’s value places it among the greatest market bubbles in history. It has outpaced the 17th-century tulip mania, the South Sea bubble of 1720, and the more recent Japanese asset price and dot-com bubbles.

The rapid price rise garnered attention from an increasing number of academics and investment advisers. Some have suggested that Bitcoin improves portfolio performance and can even be used as a potential “safe haven” asset in place of gold.

This is particularly relevant if investing in Bitcoin is rationalised as a prospective safe haven in times of market turmoil.

So use your own judgement when considering investing in Bitcoin and other crypto currencies.

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