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Bitcoin Value Investing Part 3 - Risk And Reward

|About: Grayscale Bitcoin Trust (BTC) (GBTC), Includes: BTC-USD
Summary

Risks of Investing in Bitcoin.

Some useful tips to protect yourself.

Bitcoin price, the long (correct) view.

Introduction

I don't think I need to tell you that investing in Bitcoin is risky. It seems like every other article on the subject is a hit piece or hype. But, we also know that there is a relationship between risk and reward

So today I'm going to cover some of the systematic risk, and some risk factors that emerge from actions we take, namely things we do to raise or lower the level of our own information security. These steps are necessary because existing entry points have downsides or just don't exist yet (like an ETF if you're in the US).

Then we're going to look at why some people have weighed the risk and reward and dove into the market anyway. 

The risks

I think Bitcoin is revolutionary and presents a rare opportunity, but we need to also understand the risks of being in the space. You wouldn't buy a stock without assessing the risk. So, let's talk about it. 

There are two kinds of risk. Those that emerge from the cryptocurrency space itself, and the second kind of risk that we have to take on in order to be custodians of a digital currency.

Systematic Risks

  • Bitcoin relies on advanced cryptography. If someone were to discover a weakness in the underlying cryptographic functions, the network could be compromised. 
  • Bitcoin is open source, which invites competition. There's always the possibility that some other technology is developed that can outperform the Bitcoin protocol (or just becomes more popular).
  • Many cryptocurrency exchanges operate in unregulated markets, and as such they have become breeding grounds for just about every type of scam that was used in the past, ranging from pyramid schemes, exit scams, hacks, bots creating fake volume, Ponzi schemes, you name it and it's happening right now in the cryptocurrency space. Breaking news of this type could temporarily tank the price.
  • Entire countries might ban Bitcoin outright. 
  • Bitcoin lives in a regulatory grey area in the USA, which creates additional uncertainty.
  • Many people still think that Bitcoin is primarily used by criminals and many shy away from the technology because of its erstwhile connection to the Silk Road.
  • Massive price swings are the norm. You might make 80x returns over the course of three years or lose 60% of your investment in just a few months.
  • Some people believe that cryptocurrencies have no value at all. Maybe they're correct? It is possible that the whole space could simply implode.

Smart people and respected institutions on both sides have weighed in on this, from Warren Buffet to the St. Louis Fed and the IMF.

Non-Financial Personal Information Security Risks

A Bitcoin ETF does not yet exist in the United States (although several people are trying to get one approved), so if you plan on buying some Bitcoin you will need to know where to make the purchase and how to store it. Futures contracts are not my thing, but if it happens to be your thing, you can get them from CBOE or CME.  Another alternative is the Bitcoin Investment Trust GBTC, but that almost always trades at a premium, so I recommend avoiding it.

  • Bitcoin itself is very secure, but many weak points still exist in the ecosystem. If you get hacked, you could lose your Bitcoin.
  • If the exchange that you buy your Bitcoin on gets hacked, you could lose everything. Since many exchanges are overseas, you might never get your money back and have no legal recourse. 
  • Storing and using Bitcoin necessitates some level of comfort with technology. 

Now the question is, what can we do to take some of these risks off the table?

Rules for reducing risk of being in the Bitcoin space

When it comes to the systematic risk, the only thing you can do is to only invest an amount you're willing to lose. The cryptocurrency market just isn't large enough or mature enough yet to diversify this away in the traditional sense.

However, when it comes to the information security risks there's a lot we can do, and it starts with you. You either control your private keys, or you don't control the Bitcoin. The purpose of these rules is to make yourself less visible to hackers, essentially more difficult to hack (just like cat burglars will avoid a house with a noisy dog, hackers avoid or won't notice as often people who follow basic information security practices). 

Rule #1 - Don't talk about how much Bitcoin you own or where you bought it on social media.

They say, you can't hack what you can't see, and we know that social media is a breeding ground for information collection. I call this automatic collection of data "the sweep." The idea is that so much communication goes unsecured, that we should assume that unless we've taken steps to protect our information, it's already for sale on the dark web somewhere. It just gets swept up by the bot armies without much effort.

Rule #2 - For the love of God, stop using the same password on every site you visit.

The reason this is so bad is that when one company gets hacked, you don't find out about it until much later. Then that password you used gets entered into a dictionary and it's curtains. 

I hear you saying, "yeah right, I can't remember hundreds of different passwords, that's never going to happen." Get yourself a password manager and thank me later.

Rule #3 - The phone system is older than dirt and poorly maintained. All communication that passes through it should be considered compromised.

Do you remember "the sweep" that we learned about earlier? Well, someone is most likely scooping up every text message and phone call that's ever made in real time and storing it permanently. And I'm not talking about the government, I'm talking about anyone with a laptop and the willingness to visit the dark web.

What can you do? Start by downloading Signal, and start getting your friends to switch over. Signal is open source and uses end to end encryption on your text messages and phone calls. This will reduce your digital footprints, meaning that someone would have to spend actual effort to get into your encrypted texts or phone calls.

Why would hackers care about your text messages? Well, if I was a hacker I might be interesting in finding cryptocurrency newcomers by searching for a phrase like "I just bought my first Bitcoin on shady platform X," so that I could target that person with a phishing attack constructed especially to look like "shady platform x."

Rule #4 - On any cryptocurrency site you use (like an exchange) you need to enable 2FA AND use Google Authenticator instead of SMS.

This will require an extra step when logging in, but it will also give you another layer of protection for coins you might have on an exchange. Someone would have to get both your login information AND your phone to sign in as you or move funds (make sure you enable that option if it's not on by default). The reason we don't use SMS is becayse the phone system is only as secure as the lowest paid employee of your cell phone company.

Protip: Remember to back up your Google Authenticator seed. If you lose your phone you will need that seed to get back into your accounts.

Rule #5 - Get yourself a hardware wallet.

A hardware wallet is the best way to store your Bitcoin. There are two companies that I trust, Trezor and Ledger. Either one of these will work fine. Follow the instructions in the box and make sure you buy from the manufacturer directly, not some schmuck on Craigslist or eBay (EBAY).

Rule #6 - Never leave Bitcoin on an exchange for longer than you can help it.

Exchanges get hacked every other day. You may or may not get your funds back. This is serious business, move your Bitcoin from the exchange onto your hardware wallet.

Rule #7 - Only use large, local, regulated exchanges.

In the United States I would suggest you use Coinbase (or their exchange Coinbase Pro), Gemini or Kraken. These exchanges observe the necessary regulatory requirements and best security practices as far as I can tell. Stay away from smaller, shady, overseas exchanges.

If you follow these rules you will be ahead of the information security curve and you will sleep better. These rules don't provide perfect 100% protection, but I see them as the necessary prerequisites to getting started in the space.

Bitcoin price - where we came from and where we are now

Does anyone remember my previous article when we talked about thinking in log scale over a long term? Below I will show that much like the network hash rate, the Bitcoin price should also be viewed over the long term and in log scale.

I took a sample of the Bitcoin price once a month to reduce signal noise, and went back as far as we have data, eight years. On the left side you see what most people are working with, and on the right is a view that I use.

Bitcoin price linear and log scale side by side Data Source: Blockchain.info 

The chart on the right reveals exponential growth for eight years running. This is not what most people are talking about but they should be. When we think about Bitcoin data, we need to think long term and in log scale or we're missing the forest for the trees.

This long term trend is one reason that so many investors have decided to dip their toes in the Bitcoin waters, and so many others are rushing to copy Bitcoin's technology from companies to governments across the globe. Even the IMF's chief has stated:

"Ignore Bitcoin at your peril."

- Christine Lagarde, 2017

In Q1 2018 the St. Louis Federal Reserve published an article entitled "A Short Introduction to the World of Cryptocurrencies." This was the conclusion.

The Bitcoin creators’ intention was to develop a decentralized cash-like electronic payment system. In this process, they faced the fundamental challenge of how to establish and transfer digital property rights of a monetary unit without a central authority. They solved this challenge by inventing the Bitcoin Blockchain. This novel technology allows us to store and transfer a monetary unit without the need for a central authority, similar to cash. Price volatility and scaling issues frequently raise concerns about the suitability of Bitcoin as a payment instrument. As an asset, however, Bitcoin and alternative blockchain-based tokens should not be neglected. The innovation makes it possible to represent digital property without the need for a central authority. This can lead to the creation of a new asset class that can mature into a valuable portfolio diversification instrument. Moreover, blockchain technology provides an infrastructure that enables numerous applications. Promising applications include using colored coins, smart contracts, and the possibility of using fingerprints to secure the integrity of data files in a blockchain, which may bring change to the world of finance and to many other sectors.

- Berentsen and Schär Federal Reserve Bank of St. Louis REVIEW First Quarter 2018

Summary

Many risks exist for being involved with Bitcoin. There are some steps that you can take to protect yourself. Before you even think about buying Bitcoin you need understand what they are.

Bitcoin's price, much like the hash rate of its network, did not suddenly spring into existence like a modern tulip mania to the nth degree, rather it has been growing exponentially for eight years. 

Bonus reading material 

Disclosure: I am/we are long BTC-USD.