Small Bitcoin Investments: Are They Worth The Risk?

Bitcoin is a decentralised digital currency, free from the influence of governments, companies or banks. It is a highly volatile asset, with a history of extreme price fluctuations. Given this volatility, investors need to be vigilant in monitoring their profits. Investing in Bitcoin is a risky endeavour, but it can be profitable if investors are willing to weather short-term volatility. With this in mind, is it worth investing $20 in Bitcoin?

Bitcoin's resistance to inflation

Bitcoin is often seen as a hedge against inflation. Unlike traditional currencies, it is issued and managed without any central authority, meaning there is no government, company, or bank in control. This makes it more resistant to wild inflation and corrupt banks.

Bitcoin has a fixed supply of 21 million coins, which gives it an advantage against inflation. The restricted upper limit means that new coins cannot enter circulation, eliminating the risk of inflation. This is in contrast to fiat money, which is susceptible to losing value over time due to central bank money printing.

The COVID-19 pandemic is an example of how the value of Bitcoin can increase during inflationary periods. As governments printed more money to provide stimulus packages for their citizens, the value of fiat money decreased, while the value of assets with limited supply, such as Bitcoin, increased. This attracted traditional investors who saw the cryptocurrency as a hedge against inflation, driving a historic price increase of over 250%.

Bitcoin's value is also not tied to a specific economy or currency, making it inherently diversified and able to serve as a recession-resistant asset. Its value is based on global demand and is not limited to the gains or losses of any one country.

However, it is important to note that Bitcoin is not completely immune to inflation. It is currently an inflationary currency, as its supply is increasing over time through mining. The rate at which new Bitcoin is issued is reduced by half every four years, and it is projected that the supply will reach its hard cap of 21 million coins in 2140. At this point, Bitcoin will become disinflationary, with a constant monetary base and an unchanging supply.

In summary, while Bitcoin is not entirely resistant to inflation, its fixed supply, decentralised nature, and global demand make it a relatively strong hedge against inflation when compared to traditional currencies.

The volatility of Bitcoin

Bitcoin is a decentralised digital currency, with no central authority, government, company, or bank in charge. This means that it is more resistant to wild inflation and corrupt banks. However, it is still considered a volatile asset. Volatility is a measure of how much the price of a financial asset varies over time. The volatility of Bitcoin is measured by how much its price fluctuates relative to the average price in a given period.

Bitcoin's volatility is driven by speculation and bets from crypto investors, which cause sudden price increases or decreases. This volatility means that Bitcoin is a risky asset to hold, as its value may substantially increase or decrease on any given day. The more volatile an asset is, the more people will want to limit their exposure to it. Volatility also increases the cost of hedging, a major contributor to the price of merchant services. If Bitcoin volatility decreases, the cost of converting into and out of Bitcoin will also decrease.

Bitcoin's volatility has been declining and is expected to continue to do so. In fact, Bitcoin is currently less volatile than 33 S&P 500 stocks, and as of October 2023, there were 92 S&P 500 stocks more volatile than Bitcoin. Bitcoin's volatility is also less than some prominent individual securities, such as Netflix stock over the last two years.

Bitcoin's volatility can be measured by its standard deviation, which is calculated based on daily log returns multiplied by a factor of the square root of 365 to yield annualised daily realised volatility over a rolling window of 365 days. Bitcoin has historically exhibited high volatility or high measures of standard deviation, but its returns have been disproportionately skewed to 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.

Bitcoin's low volatility environments have often been followed by steep rises in price. For example, in 2023, Bitcoin's market cap rose amidst a downward trend in realised volatility. This may indicate a growing belief that Bitcoin is maturing, further accelerated by the approval of spot Bitcoin exchange-traded products in the US.

How to calculate potential gains and losses

Investing in Bitcoin can be a risky move due to its volatile nature. However, if you are keen to invest $20, you should know how to calculate your potential gains and losses.

Firstly, it is important to note that you will not be taxed for simply holding Bitcoin or other cryptocurrencies. You will be taxed when you dispose of your existing cryptocurrency or earn new cryptocurrency.

There are two common ways to calculate your crypto gains or losses: using your local currency or measuring your gains in Bitcoin value.

If you are buying Bitcoin with your domestic currency, this is a straightforward way to calculate your gains. For example, if you buy $1000 worth of Bitcoin and the price increases by 50%, you will have made a profit of $500.

However, if you are buying other cryptocurrencies with your Bitcoin, you will need to take into account the opportunity cost of holding Bitcoin instead of exchanging it for another currency. This can be done by measuring your gains or losses in Bitcoin value, taking into account the smallest unit of Bitcoin, which is called a 'satoshi'. There are 100,000,000 satoshis in one Bitcoin.

To calculate your capital gains or losses, you can use the following formula:

Proceeds (the value received from disposing of your crypto-asset) - Cost Basis (how much money you put into purchasing your crypto-asset, including fees) = Gain or Loss

For example, if you buy 1 Litecoin for $250, and then sell it for $400, your proceeds are $400. Subtracting your cost basis of $250 gives you a gain of $150.

It is also important to consider the different tax rates for short-term and long-term holdings. If you have held your cryptocurrency for one year or less, you will be taxed at the short-term rate, which is the same as your income tax bracket. If you have held your cryptocurrency for longer than a year, you will be taxed at the long-term capital gains rate, which is typically lower.

Finally, remember that trading one cryptocurrency for another is a taxable event, and you should keep records of all your transactions to accurately report your gains and losses to the relevant tax authorities.

The tax implications of investing in Bitcoin

Bitcoin and other cryptocurrencies are subject to income and capital gains tax in the United States. The amount of tax you pay depends on your income and the length of time you hold your crypto assets.

If you earn cryptocurrency or dispose of your crypto assets after less than 12 months of holding, you’ll pay tax between 10-37%. If you dispose of your cryptocurrency after 12 months of holding, you’ll pay tax between 0-20%.

The IRS classifies virtual currencies as property, so you only owe taxes when gains are realised. This means that if you decide to hold your Bitcoin, you won't owe any taxes. However, if you sell your Bitcoin or use it to pay for goods or services, you will need to pay taxes on any profits you make.

It's important to keep records of all your cryptocurrency transactions for the year, as well as the fair market value of your crypto at the time of receipt and disposal. This information will be needed when you fill out your tax forms.

If you sell your Bitcoin for a loss, you can use your losses to lower your taxable income by a maximum of $3,000. Any additional losses can be rolled forward into future tax years.

The importance of risk management when investing in Bitcoin

Bitcoin is a decentralised digital currency, free from the control of governments, companies, or banks. It is considered by many to be the future of monetary exchange, and its value has soared in recent years. However, investing in Bitcoin comes with significant risks that should not be overlooked.

Volatile and Fluctuating Market

The Bitcoin market is unpredictable, with constant ripples and fluctuations. For example, in December 2017, the price of one bitcoin reached over $20,000, but just days later, buyers could not sell for more than $14,626. With such volatility, there is no guarantee of a return on investment, and investors must be vigilant and cautious.

Cyber Threats and Fraud

Bitcoin is a technology-based currency, and as such, it is susceptible to cyberattacks and hacking. There is little recourse for retrieving lost or stolen bitcoins, and many buyers have lost their investments through exchanges and mining losses. Additionally, the lack of regulation in the Bitcoin market further exposes investors to fraudulent transactions and exchanges.

Technology Reliance

As a digital currency, Bitcoin is entirely reliant on technology. Without the technology to support it, Bitcoin has no value. This makes Bitcoin owners vulnerable to cyber threats and online fraud, and a system failure could be catastrophic.

Block Withholding

New bitcoins are created through solving "blocks," mathematical equations generated during bitcoin exchanges. However, this process is vulnerable to manipulation, as a mining pool can use computational power to solve a block and hide it from honest miners, allowing a select few to benefit while others lose out.

Regulatory Uncertainty

Currently, the Bitcoin market operates with little to no major regulations, and governments have yet to take a clear stance on cryptocurrency. The lack of taxation on Bitcoin can be enticing for investors, but it also poses a risk of future problems should Bitcoin compete with government-issued currency. The uncertain regulatory landscape makes it challenging to predict the future of the Bitcoin market.

Given these risks, it is crucial for investors to understand their risk tolerance and develop a robust risk management plan. Here are some key considerations for managing risk when investing in Bitcoin:

• Diversify your portfolio: Don't put all your eggs in one basket. Invest in a spread of different cryptocurrencies and other asset classes to reduce exposure to price moves within a particular market.
• Start with small investments: Making smaller investments in various coins can be more beneficial in the long term, allowing you to navigate the volatile market without taking on too much risk.
• Master your emotions: Trading decisions should be based on analysis and research rather than emotional impulses. Understand your trading mentality and work on curbing poor trading behaviours.
• Research and education: Devote time to researching the cryptocurrency market and understanding the risks and opportunities. Stay informed about regulatory changes, technological advancements, and market trends to make more informed investment decisions.
• Utilise risk management tools: Take advantage of tools such as exchange stop-loss features to manage your risk when away from manual trading.
• Have an exit strategy: Don't fall into the trap of a passive buy-and-hold strategy. Be active in managing your investments, and have a plan for exiting trades to minimise losses.

In conclusion, while investing in Bitcoin offers the potential for significant returns, it is crucial to approach it with caution and a well-thought-out risk management strategy. By understanding the risks and implementing effective risk management techniques, investors can navigate the volatile nature of the cryptocurrency market and improve their chances of success.

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