Love it or hate it seems to be the approach to Bitcoin. It will be the best investment ever or it is just a bubble controlled by the few people who can pull the strings, rumoured to be the Chinese.
Bitcoin in your investment portfolio – what is Bitcoin, how to use it and what it will do
Let’s start with “What is Bitcoin?”. Bitcoin is a piece of computer software with the ability to share pieces of the software with other people. Of course, the other people have to pay for their share of the software and the price varies according to supply and demand. In principle, there is nothing wrong with this. It worked for Bill Gates.
To get a better of understanding of Bitcoin it is worthwhile making that comparison with Microsoft. With Microsoft we know who owns the product, the products have set prices and perform a function that makes something happen, e.g. run our computer, allow us to write letters, make presentations and do our numbers on spreadsheets. Bitcoin has none of these attributes.
The way Bitcoin pricing works is much more like a commodity. If you go to Starbucks today and buy a coffee, let’s say you pay 4€. Next week you want a coffee. The same coffee now costs 5€. The coffee has not changed, only the price. The difference may be due to shortages, logistical difficulties during a pandemic, many more people wanting a Starbucks coffee, exchange rate movements etc. Bitcoin works in the same way. The price of Bitcoin is primarily set by demand as the supply is fixed. There are only so many Bitcoins in the World. At least you can do something nice with a coffee bean. Bitcoin’s primary purpose is just as something you can sell to someone else. It has no other purpose at the moment.
You would now have a valid point if you were to pull me up on this analysis. “You can use it to buy goods and services” is a fair comment to make, however, there is a ‘but’ that should follow that statement. Whilst the number of places you can use Bitcoin to make a purchase is increasing it is not widespread.
Bitcoin is super volatile, which is great on the way up and terrible when it falls after you have just bought it. Here are some important figures which tell you about Bitcoin’s volatility.
2009 – 2017 little price movement
Autumn 2017 the price rises
October 2017 $5,000
November 2017 $10,000
17th December 2017 $19,783
April 2018 $7,000
November 2018 $3,500
14th March 2020 $5,165
It has bounced again in recent weeks and is now at $40,714 as I write this article (9th Jan 2021). Institutional investors (fund managers, hedge funds etc) are now buying Bitcoin. Increased demand of a fixed supply commodity pushes up the price. Will this last? I do not know. Is it a bubble? Again, I do not know. However, what I do know is that institutional investors invest to a plan. They systematically take profits i.e. sell some of their holdings. They are disciplined. They manage risk by keeping a balance of different investments. Should these institutional investors take profits, other fund managers will follow and sell so as not to get caught out by a large price fall. Their careers depend on getting it right. The ability to feed their family depends on it. They analyse, have large teams doing research, watch and wait before buying and sound out other professional colleagues to ensure they sell in a timely manner. The field of behavioural finance has shown that as individual investors we use the part of our brain driven by emotion when making investment decisions, especially when there is a big price movement in an asset. This emotion based decision making often leads to poor decision making.
There is a body of opinion from Bitcoin exchanges and advocates that is putting forward the theory that Bitcoin is going to become a national currency in some countries and therefore the price is going to go ballistic (their phrase). It is unlikely that a non regulated, very volatile commodity will be used as a national currency.
Here is an example from me of the practical problems. A solicitor practice in Barcelona started to accept Bitcoin for settlement of their fees. It looked like a superb idea to show they were a forward-looking firm.
The problem comes with the volatility. Between issuing the invoice and payment by the client there is a delay. Having charged 1.03874 Bitcoins, for example, they had no idea how much they would get in the currency that would pay all the bills of the firm, such as their staff (Can we pay you in Bitcoins Mrs staff member? Ah, no!), electricity company etc. So having chosen 1.03874 Bitcoins as the fee because that would generate 4,000 in Euros, at the date of payment it could have been just €2,000 value. For this reason it is very unlikely that Bitcoin will become a national currency!
If you wish to invest in Bitcoins, it is worthwhile separating them from your primary investments. Bitcoins will then not influence your investment decisions on your main portfolio in the way that they might be if they are on the same investment platform. How much should you invest in Bitcoin? Set aside a percentage of your savings and only invest that much. Whether it is 1% or 10% will depend on your overall circumstances. However, with Bitcoin it is very worthwhile applying the rule that only invest what you can afford to lose. That way, if you lose it all it has not damaged your financial wellbeing. If it goes up 400% next week, you will be able to take some profit and perhaps spend your winnings on something frivolous.
Bitcoin profits will be taxed. Remember to put money aside from your winnings to pay tax. The amount of tax will depend on your country of residence. The annual declaration can be very difficult so keep track of all your transactions. A figure of 23% of the profit is a good guideline as the amount to put aside if you live in Spain.
Practical Tip. A more mainstream alternative to investing in Bitcoin is the technology that Bitcoin is based on called blockchain. Blockchain has lots of uses and is good news. Uses include electronic voting in national elections, supply change management, payment systems, and anti-counterfeiting software. It can also allow companies to work together and share only what they need to for a specific project.
As an example of what is possible, there are also many Blockchain propositions for supply chain management for Covid 19 vaccines and contact tracing. For more information on blockchain, you could read “Blockchain Revolution” by Don and Alex Tapscott. You can already find many investments to include in your main portfolio such as ETFs and funds. For more information on these funds email email@example.com
A final point on Bitcoin. When someone sells a Bitcoin what does the buyer pay with? It is one of the major currencies. Sellers still want good old fashioned US dollars, Euros or Sterling when they part with their coin. That tells us something!