I am hearing from a few investors who wonder if now is the right time to invest in cryptocurrencies, the most common of which, is bitcoin.
Bitcoin smells a lot like tulips to me. In fact, digital currencies are just the latest example of a speculative craze.
During the 1600s, speculation drove the value of tulip bulbs sky-high. At the height of the market, the rarest bulbs traded for as much as six times the average person’s salary. In the 1920s, another investment mania took hold: a handful of investors saw the potential of land appreciation in Florida. Speculators quickly piled in. But there were a series of unforeseen events: a rail traffic embargo, a shipwreck in the port of Miami, and then the Great Miami Hurricane.
It’s not that these things have no underlying value – tulips are some of the prettiest flowers around and yes, if you bought the right pieces of land in Florida 100 years ago, you’d be rich. But in the early stages of any market, product or technology, no one can predict the outcome well enough to make an investment-quality bet.
Many people, from LinkedIn founder Reid Hoffman to heavyweight CEOs, are investigating and endorsing the concept of digital currencies and the technology that makes them possible, called blockchain. Yet, we are so far from knowing the winners and losers among digital currencies that buying any one of them is speculation, not investing. Here are four unknowns that should give you pause before you put investment money into digital currencies:
1. Which currencies will survive, or whether any of the current ones will, is an open question. There are hundreds of digital currencies now, and dozens of platforms where you can trade them. Bitcoin has risen in value more than 200 percent this year. But all the digital currencies are volatile. And it is easy to issue a new currency, so there are more coming out all the time, in so-called ICOs, or initial coin offerings.
“Anyone participating in sales such as these will receive tokens, theoretically usable in the future in the markets they create. Like all currencies, any value they have will come from the willingness of people to treat them as a medium of exchange, or to see them as a store of value,” wrote Richard Waters in The Financial Times.
2. The currencies are extremely volatile. News reports show digital currencies, even bitcoin, rising and falling as much as 10x within months. Because they are relatively unknown, cryptocurrency prices are vulnerable to bad news or to incidents of fraud. They are also at the mercy of governments, which could step in to try to block the adoption of any of them and cause prices to plummet.
3. What investment vehicles will eventually exist to trade currencies, if any? What are the diversification strategies of those vehicles to manage the volatility? In the United States, the Securities and Exchange Commission rejected a bitcoin ETF this spring. The regulators aren’t certain yet how to keep investors safe. At some point, someone probably will develop an investment vehicle, to enable you to invest in a basket of cryptocurrencies. That time hasn’t come yet.
4. How well will you be protected from fraud? In late June, in the latest example of regulatory action, the SEC filed fraud charges against the New York City-based operator of a supposed bitcoin platform. Traditional currencies are issued by governments. Anyone can issue a cryptocurrency and set up a mechanism – which could even be a special ATM – to dispense it onto your mobile phone.
Some people enjoy the excitement of speculating of getting in on the ground floor. That idea is as much a classic as It’s A Wonderful Life, where the main character gets an invitation to “get in on the ground floor of plastics.”
You might be one of early movers, and might find the idea of digital currencies appealing. If so, put aside a tiny portion of your assets, and have fun. But don’t be fooled into thinking of what you’re going as investing; it’s speculating. A tiny handful of speculators make money, but many more of them lose, as new markets, with all their uncertainty, develop over decades.
In a universe of unknowns, the odds are stacked against you.
To help you decide how much you can afford to bet on the highest-risk, alternative investments – or speculations – consider talking to a CFP® professional.