Investing in Bitcoin

Published on January 31st, 2014 by John Light

One topic I am often asked about by clients is investing in Bitcoin. Not just bitcoins the currency, but Bitcoin, the network and technology ecosystem. The conversation usually starts like, "I have X amount of money to invest in Bitcoin, how should I invest it?" After giving the disclaimer that I am not a licensed financial advisor and this is strictly my personal opinion, this is what I tell them:

Diversify your assets.

It is tried and true investment advice, and this is no different in the Bitcoin ecosystem. Putting all your eggs in one basket can be risky, for if something goes wrong with that basket, you stand to lose everything you've worked so hard for. While each investor's risk tolerance is different, this advice is practical and proven for investors of all types of risk tolerance, from the conservative to the daredevil. If you have an investment portfolio which constitutes 100% of your personal investment income, I would consider a conservative investment in Bitcoin (or cryptocurrency more broadly) as being between 1-5% of this portfolio, a moderate risk tolerance being between 5-10%, and more aggressive being 10%+. What I recommend to my clients is, first, after doing basic research into the fundamentals of the Bitcoin technology, invest in the bitcoin currency itself. Buy a small amount of bitcoins locally or from an exchange, spend some at a merchant you trust, send some to friends and family, practice storing some securely offline and bringing it back online, really get a feel for what you're investing in so you can understand for yourself why this technology is gaining popularity and confidence in smart circles. If you come away believing in the long term viability of cryptocurrency as a technology and an asset class, put between a third and half of what you were planning on investing in Bitcoin into the currency itself. After gaining some experience using the technology, explore the startup ecosystem. In the past few years, many innovative companies* have sprung up to serve the burgeoning cryptocurrency markets. There may even be one based near you, giving you an opportunity to meet the founding team and understand what motivates them to take what seems like a big risk on a new technology. After getting to know the space, begin your due diligence on the most promising companies. You can choose your investments based on your own criteria, whether its a service you personally want to exist, a service you see the market clamoring for, or something truly innovative that you can imagine being used for many purposes in the future. You might even just like the founders, and want to support them for personal and financial reasons. Maybe you even have a startup idea of your own that you want to invest time and money into. Whatever your criteria, another third to half of your allocated investment capital should be put into Bitcoin startups. That way, even if the price of bitcoin drops or Bitcoin itself fails, the company is still likely to survive, either because their business model isn't wholly dependent on the price of Bitcoin or because they can adapt and adopt the next best cryptocurrency technology. Just keep in mind that startup investments are illiquid, long-term, and very risky commitments, and therefore aren't appropriate for everyone. This leaves some investment capital left over. When I ask my clients what they would invest the remainder in, the first choice is usually Bitcoin mining hardware. It seems like a sure bet; after all, it's practically like owning a money-printing press, right? Well, not quite. When the Bitcoin network was first started, mining was very easy. Any computer with a CPU chip could do it, and early miners earned most of the coins that have ever been produced. As the bitcoin currency gained a monetary exchange value, there was more of an incentive to mine and innovate, which led to GPU mining and, more recently, ASIC mining. While GPUs are more commonplace (they power the graphics that computers produce on your screen), ASICs are not - this acronym stands for "application specific integrated circuit," which is a technical way of saying that these chips are designed for one purpose and one purpose only: efficiently performing the computations necessary for Bitcoin mining (they can also be used for mining altcoins that use the same SHA-256 hashing algorithm). While mining has become more specialized, it's also become increasingly competitive. Whether or not mining is profitable can depend on a variety of factors, including the cost and reliability of the mining equipment, the accuracy of the manufacturer's production schedule, the price of bitcoins, the mining difficulty, the cost of electricity where the equipment will be located while it is mining, and the time it takes for you to maintain these systems. If you have a reliable source of mining equipment and cheap electricity, it could be worth the investment. If not, you're probably better off investing elsewhere. Some companies enable customers to offload a lot of these concerns to hosted mining operations that manage the equipment and maintenance costs (for a fee of course). The services of these companies often cost many times more than the cost of buying the hardware itself, making an already uncertain investment even more uncertain. I've had clients who profited from an innovative business model which allows you to trade mining capacity in real time similar to any other commodity exchange, but this is not quite the same as profiting from the mining itself and was likely due to sheer luck more than anything else. The short answer for mining: caveat emptor. A final category that I would be remiss for leaving out is alternative cryptocurrencies, better known as "altcoins." I've mentioned them a few times already, but they're worth going into a bit more detail here. Altcoins are cryptocurrencies that people have created for fun, profit, or experimental/ academic reasons (often these motivations overlap). Many are "forks" or modified copies of the Bitcoin code, with several core parameters changed, such as the amount of coins that will ever be produced, the production schedule, difficulty retargeting, and/or the proof-of-work function. Others are more innovative, coding their own system from scratch, creating decentralized autonomous organizations, or even building application protocol layers directly on top of Bitcoin itself. Whatever the differences, these altcoins have been gaining increasing amounts of attention as people learn about Bitcoin and then discover that there's a whole other ecosystem of over 100 altcoins. It's worth investing at least 5-10% of what you're allocating to cryptocurrencies in your investment portfolio into altcoins directly. No particular coin, use your best judgement with an altcoin as you would for any investment. Look at the community, the development team, traction in the market, features etc. Or maybe have a broad strategy where you put a little bit into everything, some a little more than others. Either way, many investors have made incredible gains in the altcoin market so it's worth exploring. As with all investments, cryptocurrency investing is risky. Because this sector is so new, it can be even riskier than others. Disruption can occur at a moments notice, and technological advancements mean things are constantly changing, at a seemingly faster pace than ever. But with great risk comes great potential reward, so if you're excited about change, ready to shake up the status quo, and looking to capitalize on innovative new technology, cryptocurrency just might be the right investment for you.

Shameless plug, this is my Bitcoin startup. Learn more about us in this episode of Let's Talk Bitcoin.

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