An investment adviser's take on trading bitcoin

An investment adviser's take on trading bitcoin

This is a guest blog post by Chris Brycki, Founder and CEO of Stockspot, an Australian online investment adviser and fund manager. Previous to this, Chris was a Portfolio Manager at UBS and BlueLake Partners. Here’s his take on trading bitcoin.

As big believers in the opportunity for technology to reshape financial services, we’re excited about Blockchain. Blockchain’s potential to transform the asset management industry, reduce trading frictions and make holding investments more secure and cost effective is, to use a much overused term, a real game changer.

In the future, online investment advisers (robo-advisers) like Stockspot are likely to use some form of Blockchain technology to transact and administer holdings rather than the current system of Holder Identification Numbers (HINs) on the CHESS subregister system. This could help us further drive down costs which ultimately benefits clients.

However, as an investment adviser assessing if Bitcoin should form part of the Stockspot portfolios as an investment, we are less excited right now and here’s why…

Bitcoin as an investment, two sides of the debate

Since it was created there’s been no shortage of critics to call its rise a bubble and argue that Bitcoin has no intrinsic (measurable) value.

Yet the people actually working in Blockchain say that focusing on the price of Bitcoin is missing the point. Its real value is as ‘proof of concept’ as a new form of payment system not reliant on middle parties like governments, banks or credit-card businesses.

The truth may be somewhere between. Blockchain is starting to be more widely accepted, however the value of the technology and its ‘tokens’ as a store of wealth is very much up in the air.

Ultimately it’s this debate that is driving the price volatility in Bitcoin and other cryptocurrencies.

When it comes to recommending an investment strategy our job at Stockspot is to provide clients with carefully tested investment strategies based on evidence. We don’t provide opinion on if a new innovation will succeed or how much it could be worth.

That’s the difference between speculation and investment.

Could Bitcoin be worth 10 times its current price in the future? Sure. Could be worth one tenth? Absolutely. The nature of any speculative bet is that it could pay off handsomely or be next to worthless.

Or there’s a good chance it could be both at some point.

Take Amazon shares (AMZN) for example…

Today Amazon trades at US$1,200 per share but let’s pretend you predicted it would dominate online shopping back in 1999. In December 1999 Amazon traded at $110 per share and everyone was excited about it.

But in 2000-2001 the share price fell from $110 to $5. That’s a whopping 96% fall. Would you have had the nerve to hold the stock all the way down?

Would you have then continued to hold it from $5 back to $110 in 2009 and to $1,200 in 2017? The chances are, probably not.

Bitcoin has already had several speculative ‘hype cycles’ like Amazon had back in 1999-2000.

In 2011 Bitcoin rose from $1 to $31 before falling to $2. It then rose to $250 in 2013 and fell back to $50. After that it rocketed to $1,100 before falling back to $180. Each time Bitcoin has risen rapidly it has fallen 80% to 95% from its peak before continuing on a longer term journey higher.

If you’re buying Bitcoin at any point in time you should be aware that the value of your investment may fall by more than 80% at some stage.

Many of today’s buyers of Bitcoin aren’t thinking about the value of Bitcoin in 20 years. They’re chasing momentum and hoping to sell to someone else at a higher price. These speculative ‘cycles’ are ultimately what has sent Bitcoin up and down so dramatically.

Feeling Bitcoin FOMO?

Last year the price of Bitcoin rose from US$1,000 to over US$19,000. The total value of all Bitcoin now exceeds US$300 billion. 2017 was a very good year for those betting it will succeed!

It can be easy to lose sight of what’s smart when you see people making tonnes of money in short periods of time. The same happened in other speculative manias like the tech bubble of 1999-2000 and in the mining boom of 2003-2007. In both periods plenty of shares rose by more than 1,000% before falling or vanishing entirely.

Rapid gains can be exciting, and quickly lead to FOMO if others are making easy money and you’re missing out, but as a general rule, ‘easy money’ is just a mirage.

Even if one Bitcoin is worth $100,000 in 10 years, the odds that you’ll make money are not good. Successful speculation requires you to enter and exit at the right points as well as having nerves of steel to manage your emotions along the way. It’s much harder than you think to get your market timing right and have the discipline to not sell on the way up – or during dips along the way. And that’s just assuming you’re eventually right with your bet.

However, we know Bitcoin probably got mentioned at least once at your office Christmas party this year. It did at ours.

You might be feeling down that you missed out or envious others around you have hit the jackpot. That’s a normal feeling. Those types of emotions are the fuel that drives speculation.

Our advice on speculating in Bitcoin (if you can’t resist the temptation) is the same as the advice we would give on investing in any other undiversified risky asset like individual shares, equity crowdfunding or art. You should still follow a sensible investment process to give you the best chance of success.

1. Consider your financial position

First, stay well clear if you’re not in the financial position to be speculating in the first place because you have debts or expenses coming up. Do not borrow money to speculate. I repeat: do not borrow money to speculate.

2. Limit your exposure

If you insist on speculating it’s wise to limit your exposure in any bet like Bitcoin to 2% of your wealth or less. If it doesn’t work out, you won’t be devastated financially. And if it does work out then you have our full permission to gloat, be smug and merry. Only betting a small amount of your total savings means you won’t feel forced to sell if there is a big fall.

3. Dollar cost average

With risky investments it’s worth dollar cost averaging rather than buying your entire amount at once. Buying small amounts over time is obviously more difficult with some assets (like art) but can be done with individual shares or Bitcoin.

By dollar cost averaging you can reduce the chance of being sucker who bought at the top because of FOMO. Like the people who bought Amazon in 1999 for $110 had to wait 10 years to get to break-even. It improves your chances of doing well in the long run if you are eventually right, because it reduces the impact of market timing. Trying to time the market is dangerous because the most tempting time to buy is usually the time you shouldn’t be.

4. Know your counterparty risks

In most cases with Bitcoin exchanges you don’t own the underlying instrument, you’re relying on someone to hold and manage it on your behalf.

This adds an extra level of risk – called counterparty risk. Some bitcoin exchanges have gone bust, many bitcoins have been stolen and little protection exists in this area for consumers.

Fast rising markets like Bitcoin and other cryptocurrencies attract fraudsters, financial cowboys and hidden dangers. If it sounds too good to be true, it almost certainly is. You should know whether you own the underlying instrument or a derivative over it like a futures contract, CFD or fractional unit. Understand your ‘counterparty risk’ and what protections you have (if any).

5. Rebalance

Rebalance – aka lock in some of your profits. If you’re lucky enough to make outsized gains in any speculative investment, don’t forget to rebalance. It’s one of Stockspot’s core principles for managing and growing wealth over time.

Investments grow at different rates and then tend to revert back to average over time. When our customers invest with us, we periodically rebalance their portfolio to harvest returns and keep risk in check. Basically, we sell some assets that have done well and buy some that haven’t.

The same should go for Bitcoin or other speculative investments. Let’s say you bought at the start of 2017 when Bitcoin was trading at $1,000 and allocated 2% of your wealth. With Bitcoin now trading at $19,000 it has probably grown to around 26% of your savings which is a much bigger part of your portfolio. Great work! To ensure you keep a good level of diversification and reduce your risk, it’s probably a smart time to rebalance.

If you’re holding out for a higher price, our advice would be don’t wait – at least sell some to minimise the potential for regret.

One way to think about it is to consider how you would feel if it fell 80%. If that would make you feel regret for not selling some, then you should. Remember, nobody ever went broke taking a profit.

Trying to time the market brings human emotions into play. That’s why we automate the rebalancing process for clients – to remove the dangerous tendency to ‘follow the crowd’. It’s always hardest to sell when markets have risen because that’s when everyone is most optimistic.

6. Ignore short term market movements

Ignore the daily moves.

Watching prices go up and down on a daily basis will almost certainly cause you to buy and sell too often and destroy any long term gains. If you’ve followed the above rules, be confident in your process and ignore the daily noise because it’s irrelevant in the long term if Bitcoin is successful. Put it in the bottom drawer, so to speak, and get on with your life.

Res tantum valet quantum vendi potest

(A thing is worth only what someone else will pay for it)

Speculation can be fun to watch and exciting to participate in because it shares more in common with gambling than investing.

If you want to speculate on Bitcoin or any risky investment, stick to a disciplined process. Have a small position size, dollar cost average, rebalance to reduce your risk over time, and ignore the noise along the way. Following these steps will give you the best chance of long term success and prevent your investment from becoming a financial catastrophe.

This is an excerpt from ‘How to invest in bitcoin (if you insist)’, originally posted by Chris on LinkedIn on 26 December 2017.

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