Bitcoin: A Smart Investment Idea Or Risky Business?

Bitcoin is a fascinating asset. It is simultaneously a transactional tool and a speculative commodity, attracting the attention of investors almost since it first hit the market. Unfortunately, it's also incredibly volatile.

For that reason, while current market conditions are favourable for anyone considering buying Bitcoin, it is an asset you should purchase only at your own risk. Because while Bitcoin may have the potential for significant returns, you may also lose most of your investment.

Bitcoin's volatility

Bitcoin is considered a volatile asset. Its value is influenced by several factors, including supply and demand, media coverage, public interest, and government legislation.

Measuring Volatility

The volatility of Bitcoin is measured by how much its price fluctuates relative to the average price over a period of time. Volatility is often synonymous with risk, indicating that an asset is risky to hold as its value may substantially increase or decrease on any given day.

Sources of Volatility

Bitcoin's value is influenced by several factors:

• Supply and Demand: Bitcoin's supply is capped at 21 million coins, and the rate of release is reduced every four years through "halving" events. The limited supply and reduced release rate can impact demand and cause price fluctuations.
• Media Coverage and Public Interest: Public opinion and media coverage can significantly impact Bitcoin's price. For example, a tweet from Elon Musk in 2021 caused a 30% drop in Bitcoin's price in a single day.
• Government Legislation: Bitcoin is susceptible to government legislation and policies. For instance, China's ban on cryptocurrency in 2021 led to a sharp drop in Bitcoin's price.
• Speculation: The cryptocurrency industry is based on speculation, with investors betting on Bitcoin's price movements to make profits. This speculation can lead to sudden increases or decreases in Bitcoin's price, contributing to its volatility.

Comparison with Other Assets

Bitcoin is less volatile than some prominent individual securities. For instance, over the last two years, Bitcoin has been less volatile than Netflix (NFLX) stock. Additionally, Bitcoin is currently less volatile than 33 S&P 500 stocks, and as of late 2023, there were 92 S&P 500 stocks more volatile than Bitcoin.

Impact of Volatility

Volatility in Bitcoin can increase the cost of hedging, contributing to the price of merchant services. If Bitcoin's volatility decreases, the cost of converting into and out of Bitcoin is expected to decrease as well.

Historical Perspective

Investor Perspective

While Bitcoin's volatility may be concerning, investors have historically been well-compensated for it. Bitcoin has exhibited high volatility or high measures of standard deviation, but its returns have been disproportionately skewed towards the positive side. This is evident in Bitcoin's Sharpe ratio of 0.96 from 2020 to early 2024, indicating that investors have been more than compensated for the risk compared to the S&P 500.

Additionally, low volatility in Bitcoin has historically been a precursor to a price increase. There is a growing belief that Bitcoin is maturing, and instances of low volatility coinciding with all-time highs in price have been observed.

In summary, while Bitcoin is considered a volatile asset, its volatility has been declining, and investors have been rewarded for their risk. However, it is important to remember that Bitcoin remains a risky investment, and its value can fluctuate significantly.

Bitcoin's energy usage

The high energy consumption of Bitcoin is attributed to its proof-of-work mining process, which is highly resource-intensive and requires immense processing power. The energy used is primarily sourced from fossil fuels, contributing to global air pollution and climate change.

The large energy usage associated with proof-of-work mining is an inevitable consequence of the fundamental nature of its algorithms. However, Bitcoin is the only major cryptocurrency that uses this mining method. Ethereum, for example, has moved to a far less energy-intensive proof-of-stake consensus mechanism, reducing its electrical usage by over 99.9%.

To address the environmental impact of Bitcoin, there have been calls for a transition to less energy-intensive consensus mechanisms, such as proof-of-stake. Such a change could significantly reduce energy consumption and mitigate Bitcoin's e-waste problem. Additionally, it is important for Bitcoin mining to be powered by new renewable energy sources rather than drawing from existing capacity.

While supporters argue that Bitcoin is increasingly being run on renewable sources, critics maintain that the benefits do not justify the massive computing power and emissions associated with the cryptocurrency. The debate around Bitcoin's energy usage remains a key consideration when evaluating its potential as an investment.

Bitcoin's use in illegal activity

However, the share of illegal activity in bitcoin has been declining due to increasing mainstream interest and the emergence of alternative cryptocurrencies that offer greater privacy. The majority of cryptocurrency is not used for criminal activity. In 2020, criminal activity accounted for only 0.34% of all cryptocurrency transactions, or $10 billion in transaction volume.

Bitcoin's public and decentralised nature makes it attractive for illegal transactions, but it also provides a digital trail that law enforcement can use to track and seize bitcoin used for illicit purposes.

Bitcoin's value

Bitcoin is a volatile asset, and its value is influenced by several factors.

Firstly, Bitcoin's value is impacted by supply and demand. With a limited supply of 21 million Bitcoins, demand can cause significant price increases. This demand is influenced by factors such as currency devaluation and high inflation in certain countries. Additionally, Bitcoin's utility in illicit activities can also drive demand.

Secondly, public interest and media coverage play a role in shaping Bitcoin's value. For instance, a tweet from Elon Musk in 2021 caused a 30% drop in Bitcoin's price within a single day.

Thirdly, government legislation and regulations can have a substantial impact on Bitcoin's value. For example, China's ban on cryptocurrency in 2021 led to a sharp price drop. Similarly, attempts by the European Union and the US to ban Bitcoin in the past have caused fluctuations.

Lastly, the wider crypto market and economic conditions can influence Bitcoin's value. For instance, the catastrophic failure of the FTX crypto exchange in 2022 left a negative impression on investors, contributing to a period of volatility.

In conclusion, while Bitcoin has risks and volatility, it also has the potential for significant returns. Therefore, it is crucial for investors to understand both Bitcoin and the wider crypto market before making any investment decisions.

Bitcoin's competition

Bitcoin has a lot of competition in the cryptocurrency market. As of August 2024, there are over 10,000 cryptocurrencies in existence.

Ethereum is the most significant competitor to Bitcoin, currently accounting for roughly 14% of the crypto market. Some experts suggest that Ethereum may eventually overthrow Bitcoin as the largest cryptocurrency by market cap. Other altcoins, or Bitcoin alternatives, include:

• Tether
• XRP
• Binance Coin
• USD Coin
• Cardano
• Solana
• Dogecoin
• Shiba Inu
• TRON
• Polygon
• DAI
• Avalanche
• WBTC
• Litecoin
• Chainlink
• Cosmos
• Monero

Altcoins have sometimes been presented as modified or improved versions of Bitcoin, with newer features such as the ability to handle more transactions per second or the use of different consensus algorithms.

Bitcoin's market share has sharply declined over the years. In 2017, it maintained a market share of over 80%. As of August 2024, Bitcoin's market share is just over 56%.

Despite the competition and the fall in market share, Bitcoin remains the dominant force in the cryptocurrency market and is the marker by which many other cryptocurrencies determine their value.

Frequently asked questions