Today, bitcoin has shown that it can be a viable investment tool for investors.
Its almost zero correlation to the stock and bond market between 2012 and 2020 means that bitcoin can help investors further diversify their portfolio, thereby reducing their portfolio risk. This is in part why Sarwa has decided to introduce Sarwa Bitcoin, allowing investors to include up to 5% of their portfolio in bitcoin.
However, despite bitcoin’s diversification potential and the outsized returns it sometimes gives to investors, it remains a very volatile asset. Consequently, while its prices can go up fast, they can also come down even faster.
Warren Buffett once said that the first rule in investing is to never lose money — and the second rule is to remember the first.
But how then do you obey this rule with an asset as volatile as bitcoin?
To protect your money while trading bitcoin, there are some time-tested tips (do’s and don’ts) that you should consider.
In this article, we’ll take an in-depth look at some of these tips and how research shows they can help you potentially grow your money rather than lose it. We’ll look at:
- The main bitcoin problems today
- The do’s of bitcoin trading
- Have a long-term perspective
- Invest in bitcoin as part of a diversified portfolio
- Use a safe wallet
- Do your research
- Consider using a bitcoin trust
- The don’ts of bitcoin trading
- Don’t go beyond 5%
- Be careful of leverage
- Don’t time the market
- Don’t follow the crowd (Avoiding FOMO)
1. The main bitcoin problems today
The primary challenge with buying bitcoin is the volatility of the asset.
From January 6, 2018 to February 6, 2018, the price of a bitcoin fell by 65%. More recently, it fell by 36% between May 1, 2021 and May 31, 20121.
This volatility is “the price that bitcoin investors pay for its limited supply and its lack of a central bank to control that supply — precisely the features proponents say give it value,” said MacKenzie Sigalos, a technology reporter with CNBC.
Bitcoin has a fixed supply (21 million coins), therefore price movements are based almost entirely on movement in demand, which is almost entirely based on people’s speculation about what the price will be in the future.
This is one advantage that fiat money has: central banks can reduce or increase supply of money in view of demand to prevent prices from moving too rapidly. With bitcoin, there is no such control and prices can rise or fall very rapidly.
[To understand the differences between bitcoin, and other cryptocurrencies,and fiat money, read “What is Cryptocurrency? A Beginner’s Complete Guide”]
We have heard stories of investors who lost their passwords and those who lost their crypto wallets to hackers. So, when trading bitcoin there is the risk of misplacing your password and, more importantly, losing your money to hackers.
“With a currency that is 100% technology-based, bitcoin owners are more vulnerable to cyberthreats, online fraud and a system that can be shut down,” said Greg Herlean, a member of Forbes Financial Council.
This is another instance where the decentralisation of bitcoin ends up becoming its Achilles’ heel. There is no central agency that you can report and appeal to when you have been defrauded.
Trading bitcoin can become expensive due to the high fees that many bitcoin exchanges charge for transactions. Coinbase, one of the popular bitcoin exchanges, charges a minimum of 1.49% per transaction for customers in the US.
The more transactions you make, the more the fees multiply, eating into your potential investment capital and reducing your profit.
Bitcoin is still relatively new both as a currency and as an investment asset. While bitcoin came on the finance scene as a new currency, its limited supply has led many to adopt it as an investment asset.
However, the debate as to whether bitcoin has any intrinsic value or not rages on.
Bitcoin was supposed to derive its intrinsic value from its use as a medium of exchange. But the adoption of bitcoin as a medium of exchange either by merchants or by governments has been slow.
If its use as a medium of exchange does not materialise, it remains to be seen whether bitcoin simply remains a merely speculative asset whose value is absolutely subject to the emotions of buyers and sellers.
[For more on bitcoin as an investment asset in relation to its limited supply and its use as a medium of exchange, read “Why Invest in Bitcoin: Understanding The Value Of “Digital Gold”]
The purpose of identifying the main challenges of bitcoin trading is not to totally discourage bitcoin trading, but rather to set the stage for why the following pieces of bitcoin trading advice are essential.
Let’s start with the do’s.
2. The do’s of holding bitcoin
In light of the above four challenges of bitcoin trading, what should a prospective investor in bitcoin do?
The advantage of long-term perspective
Research suggests that the first piece of bitcoin trading advice you should consider is to invest with a long-term perspective.
Data shows time and again that there is an inverse relationship between volatility and time spent in the market. That is, the longer you stay in the market, the less the risk of losing your money.
In the long term, short-term fluctuations are evened out and an asset better reflects its intrinsic value.
Therefore, investing with a long-term perspective will help you minimise the effects of the high volatility of bitcoin.
A second advantage of investing for the long term is that you can save a lot on transaction fees. The more often you trade, the more fees you incur, and vice versa.
Similarly, long-term investing helps you to save on taxes. Generally, when you buy and sell an asset within a year, you pay ordinary income tax on the profit.
Invest in bitcoin as part of a diversified portfolio
The best way to reduce the risk of an investment, according to the Modern Portfolio Theory, is to have a diversified portfolio that includes various non-correlated assets.
While bitcoin helps to diversify investments in stocks and bonds, the reverse is also true. Therefore, just as it is not optimal to invest in only stocks and bonds, it is likewise suboptimal to invest only in bitcoin.
A portfolio of stocks, bonds, REITs, and bitcoin, such as one that Sarwa Bitcoin provides, is an optimal way to enjoy the benefits of bitcoin while reducing the risk inherent in it.
[For a better understanding of the value of diversification, read “Learning The Importance Of Portfolio Diversification Can Prevent Huge Loss. Here’s Why”]
That’s what safe wallets are for
One of the ways to protect your bitcoin from hackers is to ensure you have a safe wallet.
There are two ways to store bitcoin: hot storage and cold storage.
Hot storage is basically online storage. While online storage makes your bitcoin readily available for trade, you are exposed to cyber threats. This is true of any digital bank, but the cyber threats facing bitcoin are these days more directed and pronounced.
Cold storage is offline storage. While it protects you from cyber threats, your bitcoin is not readily available for trading. Moreover, cold storage is more expensive and might be implausible for retail investors like you.
If you use hot storage (like many retail investors do), ensure your wallet is with a trustworthy bitcoin exchange that provides adequate security. In fact, security should be your primary concern when choosing a bitcoin exchange.
Research is a start
Generally, we should avoid investing in anything we don’t understand at a basic level. A basic understanding of what bitcoin is, how it works, why it appeals to people, its advantages and disadvantages, is essential.
Before trading bitcoin, try to understand the asset. Do some fundamental analysis to decide if it’s good for your risk profile.
A good place to start is the complete guide to cryptocurrency and the other articles on bitcoin in the Sarwa blog. .
Using a bitcoin trust
A trust aggregates money from various investors and invests in an asset on behalf of those investors. Instead of purchasing the asset directly, the investor purchases a portion of the trust which corresponds to a value of the underlying asset.
For example, SPDR Gold Shares (GLD) is a gold trust where a share of GLD gives investors a corresponding value of gold.
Grayscale has created something similar with bitcoin — Grayscale Bitcoin Trust (GBTC). Instead of buying bitcoin directly, you can buy through a trust where each value of the trust corresponds to a value of bitcoin.
“How does this make any difference to me?,” you may ask.
The first benefit is that GBTC uses cold storage. Remember that cold storage is not feasible for everyday individual investors because it’s expensive. However, for a trust that aggregates billions of dollars from various investors, cold storage is feasible.
Another relevant advantage is that GBTC charges only a 2% annual fee. Instead of paying fees on every transaction, you pay 2% of your assets under their annual management expense ratio. This expense ratio, though high compared to a common ETF, is still considerably better than trading bitcoin on a crypto platform, which not only charges high transactional fees but also high fees for taking out your money.
To provide you with these advantages (among many others), Sarwa uses GBTC for the bitcoin portion of Sarwa Bitcoin. When you choose Sarwa Bitcoin, you’ll be able to include 5% of your total investment in GBTC.
[For more on the benefits of a bitcoin trust, read “How To Buy Bitcoin in the UAE: A Simple Way To Diversify Your Portfolio With Bitcoin]
3. The don’ts of holding bitcoin
Don’t go beyond a 5% allocation
One main finding is that a 5% of total investable assets in bitcoin provides the right diversification.
Because bitcoin is still relatively new, its value as a medium of exchange is still debatable in academic circles, and it continues to be highly volatile. One can thus advisable start with a small portion of your portfolio invested in bitcoin, but having more than that is considerably risky.
This is why Sarwa Bitcoin limits the exposure of investors interested in bitcoin to 5%. Remember that the first rule of investing is to avoid losing your money. Therefore, given the current challenges that bitcoin faces, 5% is a very reasonable figure to start with while you watch things unfold.
A recent interview of five finance experts by the Times also supports this approach. Generally, analysts tend to advocate a bitcoin investment of no more than 5% of your overall portfolio.
Be careful of leverage
Some bitcoin investment platforms provide investors with leverage — allowing you to buy bitcoin with money that you don’t own.
For example, if you have $100, you can trade with $500 (a 5X leverage — $400 of the platform’s money added to yours). The appeal of leverage is that it multiplies returns. A 10% return on $100 is $10 but it is $50 on $500. The investor can then return the borrowed money with some fees.
The problem arises when the trade goes against the investor. When this happens, the creditor (platform) protects itself by cancelling the trade before the loss starts affecting the borrowed money.
Let’s return to the above example to make it simpler. If an investor loses 20% on his $100, that’s a $20 loss. But if he loses 20% on $500, that’s $100. The problem? The creditor does not share the loss with the investor. The investor is responsible for the $100 loss while the creditor pulls out once the investor’s original $100 is gone.
So a 20% fall that would have been a $20 loss with your money is now a $100 loss on leverage (margin) trading.
Generally, since bitcoin is very volatile and market timing is not a winning strategy, margin trading is not advisable for the average investor.
Don’t time the market
It is a tale as old as stock trading: In an attempt to time and predict the movements of the market, many investors lose tons of money.
A research by Morning Star has shown that an investor who wants to time the market must make the right decision 70% of the time to perform better than passive investors, a feat that only becomes harder and harder to achieve over the long term.
This is why investing for the long term is better than trying to predict short-term fluctuations. While the latter may give some outsized returns some of the time, the risk is higher and outsized losses may be more than outsized returns.
“Timing the market is a fool’s game,” said Nick Murray, author of Simple Wealth, Inevitable Wealth, “whereas time in the market is your greatest natural advantage.”
While lump-sum investing (investing all you have to invest at once) is considered the better approach — longer time in the market means more compound returns — another option that is better than timing the market is Dollar-Cost Averaging (DCA).
With DCA, you spread out the money you have now over some defined period — at the end of every month, for example. Instead of trying to find the best time, you invest once it’s the end of the month and leave the money to grow. DCA is a good option if you are not ready to put money into bitcoin all at once.
[For a comparison of market timing, DCA, and lump-sum investing, read “Dollar-Cost Averaging vs Lump-Sum Investing: How Should You Invest?”]
Don’t follow the crowd (Avoiding FOMO)
Getting control over your emotions is a super power in investing. There’s always the temptation to follow the crowd as they move through the fear and greed cycle. No wonder Warren Buffett said temperament is more important than intellect in investing.
Instead of following the crowd, staying the course is the right strategy. In other words, avoid FOMO — or the fear of missing out.
Buying when everyone is buying and selling when everyone is selling is not a strategy. Instead, as Buffett advises, you should be fearful when others are greedy and greedy when others are fearful.
With a diversified portfolio, you can have peace of mind as your money grows where risk is minimised and returns maximised.
This is what Sarwa provides with Sarwa Bitcoin — a diversified portfolio of stocks, bonds, REITs, and bitcoin (5%).
Now that you know the do’s and don’ts of bitcoin trading, it’s time to start investing. Schedule a free call with a Sarwa Wealth Advisor and we’ll help you get started.
- Bitcoin trading has some challenges: price volatility, security problems, high fees, and the prevailing doubt of bitcoin’s intrinsic value.
- To overcome and minimise the effects of these challenges, hold bitcoin with a long-term perspective, as a part of a portfolio, and in a safe wallet.
- For more security and lesser fees, consider investing in bitcoin through a trust
- Keep your investment in bitcoin equal to or less than 5% of your total investments.
- Be careful of leverage, don’t time the market, and don’t follow the crowd.