Bitcoin as an Investment: Opportunities and Risks

By Alex Lielacher

Bitcoin’s rally above the $1,000 mark alerted not just the mass media, which was flooded with reports about the digital currency, but also sparked renewed interest among investors looking for new ways to generate high returns in the current low interest-rate environment.

When bitcoin is viewed from an investment perspective, it is more often compared to gold than it is to other currencies. That is because bitcoin and gold have a lot in common as assets. Both are limited in supply, have functional use and are considered by many, despite their volatility, to be good stores of value. When gold and bitcoin were compared as investments over the last five years, bitcoin greatly outperformed the precious metal, generating an annualized return of 155 percent compared to gold’s annualized loss of 6 percent during the same period. These exuberant returns indicate that bitcoin is getting investors excited about the prospect of placing funds into a brand new asset class.

Bitcoin’s soaring value and its proven investor performance compared to the gold standard, are indicators that it is high time to weigh the opportunities and risks that come with investing in the world’s leading digital currency.

Opportunities

Many argue that bitcoin, like other currencies, has value only because people perceive it to have value. It is for this reason that many critics view bitcoin’s price development as nothing more than a bubble. However, there are drivers behind bitcoin’s excellent returns that have nothing to do with hype or speculative opportunism.

Move Toward a Cashless Society

It is no secret that we are moving toward a cashless society as electronic payment services, such as debit and credit cards, mobile payments and mobile money are increasingly prevalent. This isn’t just a phenomenon in the U.S. and the U.K., where mobile payment systems Apple Pay and Android Pay are experiencing an increase in use, but also in developing nations such as India, where Prime Minister Modi has recently reduced the circulation of cash notes to push the country toward electronic payment adoption.

In an increasingly cashless society, bitcoin fits nicely into the equation as it can be used to make payments and international money transfers from any smartphone across the world. This is one of the reasons why the digital currency has seen such strong increase in demand in India over the last few months.

Increased Demand Out of Emerging Markets

As mentioned above, there is an increased demand for the bitcoin in developing countries. That demand comes in a large part from countries that are experiencing economic distress and weakening currencies. Countries such as Venezuela, Bolivia, Brazil, Colombia and Turkey have all witnessed a spike in demand for the digital currency as an alternative store of value and as a means to make digital payments as their sovereign currencies have lost substantial value.

There is real demand for a truly international currency that anyone with an internet connection can access.

Similar to gold, whenever there is large-scale economic distress or uncertainty, the price of bitcoin has the tendency to rally. That rally, then, is at least partly driven by genuine demand and not purely by price speculation.

Individuals Want to Handle Their Money Without Need for a Bank

Another reason for the increase in global Bitcoin demand is a desire for individuals to be their own bank. By storing part or all of one’s capital in a bitcoin wallet and using it to make payments for goods and services, anyone can become their own bank without the need for traditional banking intermediaries to conduct financial transactions. This development has been amplified by the growth of the Bitcoin economy, which now includes Bitcoin savings accounts, prepaid Bitcoin debit cards, Bitcoin peer-to-peer lending and a range of other services.

Risks

Despite Bitcoin’s impressive annualized returns since its inception in 2009, the reality is that the currency is still in its infancy and no one knows whether it will really become globally accepted or whether it will eventually disappear. This uncertainty surrounding Bitcoin’s future is reflected in its price volatility.

When it comes to investing in Bitcoin, there are a few risks investors need to be aware of:

Regulatory Risk

Probably the biggest risk to the future success of Bitcoin as both a currency and as an investment class is regulatory risk. If China, for example, decides to ban its citizens from holding bitcoin, the price of the digital currency would crash. China is by far the largest market for bitcoin trading, with over 90 percent of trading occurring in the People’s Republic. Hence, any negative regulatory changes would have a direct impact on the world’s bitcoin investment.

The same goes for leading Bitcoin startup hubs like the U.S. and the U.K. Should any large economy ban Bitcoin the price will collapse and struggle to recover.

Bitcoin Scalability

Another risk to Bitcoin is the failure of the network’s participants to come to an agreement on how to handle scalability issues. For Bitcoin to succeed, the blockchain needs to be able to handle much higher transaction volumes than it is currently processing and it must be able to do so within a shorter period of time. Currently, Bitcoin transactions usually take 20 to 40 minutes, which is fantastic when making international money transfers but not so great when trying to pay for coffee.

Ideas on how to scale Bitcoin have been presented by the Bitcoin Core development team and are currently under consideration for implementation. However, the vast majority of Bitcoin miners that support the blockchain need to agree with these changes before any significant implementation can be done. If no agreement is made, Bitcoin’s scalability challenges may lead to bitcoin struggling as a transactional currency in the long run.

Large-Scale Hacks on Bitcoin Companies

The potential of large Bitcoin companies and digital currency exchanges suffering losses from cyber attacks are a viable risk that has proven to have a strong impact on the price of bitcoin in the past. The hack of Mt. Gox in 2014 and the Bitfinex hack in August 2016 have both pushed down the price of the digital currency.

Research has shown that since the inception of Bitcoin in 2009, about one-third of bitcoin exchanges have been hacked. Despite efforts to improve cyber security at exchanges and Bitcoin startups, the risk of large-scale hacks is real and one that will most likely occur again in the future. However, high profile hacks should only have short term effects on the price of bitcoin and should not really affect its long term price development.

Altcoins Taking Over

Another risk often cited is that one or more superior digital currencies could overtake bitcoin and become the leading investment option. Bitcoin has some challenges, such as its scalability issue, which could be improved or alleviated by a new digital currency that could then go on to take bitcoin’s place. However, bitcoin’s first-mover advantage and the growth of its ecosystem have positioned it so firmly as the leading digital currency that this possibility seems rather unlikely.

Furthermore, research has shown that the price of bitcoin has actually outperformed a basket of the most popular altcoins so even from an investment point of view, holding bitcoins might be better than betting on altcoins overtaking bitcoin.

51 Percent Attack

One risk that not every investor is aware of is the potential for a so-called 51 percent attack. A 51 percent attack refers to one centralized Bitcoin mining operation gaining over 50 percent control of the blockchain, at which point it could reverse transactions, which would make the entire blockchain unusable as no trust would be left in the network. At this point in time, mining operations are spread out across the world and the Bitcoin network is fully decentralized. However, should one mining operation gain a significant amount of control over the blockchain close to 50 percent, the future of Bitcoin’s existence could be at stake.

Should You Invest in Bitcoin Now?

In the first week of this year, we witnessed the price of bitcoin shoot past the $1,000 mark and inch close to its all-time high. However, shortly after peaking at $1,153.38 the price dropped by over 20 percent in only 24 hours after the People’s Bank of China issued a warning to its citizens about the riskiness of investing in Bitcoin and urged caution when investing. As China is the biggest market for Bitcoin, any announcements or action by Chinese authorities will have a strong impact on the global price. This correction spooked quite a few investors who had just jumped onto the bandwagon.

The abrupt 20 percent correction acted as an excellent reminder that bitcoin is still a very volatile asset and is only something for risk-loving investors. If you are looking for a stable store of value or a steady price increase over the course of a specific time period, then bitcoin is not for you. If you are looking, however, for the potential to double or triple your investment and are able to take potentially steep losses, then investing part of your portfolio in bitcoin might be the right move.