I have previously written about the dangers of investing in cryptocurrencies like Bitcoin. In short, DO NOT invest a single dime or cent you cannot easily afford to throw out the window while speeding down a highway, DO NOT see this as anything but a gamble, and most importantly, with the exception of this sentence, DO NOT listen to any advice I give when making financial decisions.
One reason why investing in Bitcoin, Litecoin, or other cryptocurrencies is complicated is that you need to think doubly about the effect that the price of a currency has. No only will you need to consider all the normal investment considerations, but you add what is often a completely opposite effect of your investment because of the exchange between currencies.
Even if you are a seasoned or even moderately experienced investor, you need to take into account a number of complications with cryptocurrency investments. Let me show you a few examples.
Currency Trade Complications
Let’s start with something that may seem simple, buying and selling cryptocurrencies at one of the virtual currency exchanges.
Most of the world still denominates value in fiat currencies (like US dollars, Euros, Yen, Pounds, and so on). You probably still pay your bills in such fiat currencies. That means that in addition to doing your regular investment planning, you need to calculate the effect that exchange rates have on your investment.
To make matters worse, if you hold a certain amount of currency units, whether that is US dollars, Bitcoins, Litecoins, or any other currency, you need to remember that when one currency goes up, the other currency of the exchange pair effectively goes down. In other words, if you hold your US dollars while the price of Bitcoin goes up, your relative value of US dollars goes down.
Currency speculators know this by heart, but for a novice, it may not be obvious that holding a ‘safe’ currency is almost as dangerous in terms of profit. If you trade, you double the risk and potential profit or loss.
Let’s start out with US$100, and a price of a Litecoin at $2 so you can buy 50 LTC for your money. You decide to hold on to your US dollars, thinking the price of Litecoin goes down. However, the price rises to $2.5 per Litecoin so you can now only buy LTC 40. Effectively, your dollar value measured in LTC has dropped 20% even if you did absolutely nothing. In relative purchasing power, you now have only $80 dollars.
Let’s further assume that the price drops back to $2 per LTC and you sell. You still have $80, right, so the loss hasn’t increased? Wrong! The only thing that changes is that you realized your loss, meaning you took the lost and made it ‘real’ by converting back to whatever value your had at the beginning.
However, you have effectively lost double the amount you think. $100 initial value minus your current value of $80 is your realized loss of $20, right? You can now only buy 40 LTC which is 20% lower than initially.
Let’s say you didn’t buy LTC at all. You would no be left with no realized loss, and $100, which is obvious. If you didn’t buy at $2.5, but waited until the price dropped and purchased when the price fell back to $2, you would now have 50 LTC.
If, on the other hand, you had bought at the beginning and sold at $2.5, you would now be left with $125, and a price of $2 per LTC, meaning you can now purchase 62.5 LTC, or around 56% more than if you had failed to hit the top and bottom (or vice versa) completely. While the price of LTC was rising, your dollar value fell, and while the price of LTC was falling, your dollar value rose.
Even by not trading and just sitting still, you have ‘lost’ 20% profit, even if the price is now back exactly where it was when you began. If you trade and miss completely, your loss is 56%, even if the price rises and falls by only 20%.
Note: I know this can be said for any commodity, stock, or item that rises and falls in value, but it is even more obvious when you trade in currency because both are considered the same thing (money) and your loss becomes immediately visible.
Currency speculation is dangerous and complex, and it’s easy to get scared when you realize that even when you don’t buy in, you lose money. However, making mistakes may effectively double your losses, and unless you know very well how a currency will behave in a market (and frankly, nobody does with cryptocurrencies at this point), you’ll stand a high chance of risking such a loss.
There’s also the psychological aspect of currency values. For example, let’s say you invest in a gaming company that pays our dividends in Bitcoin at an average rate of 0.5% per week and also charges their users in Bitcoin.
Lets now think that the exchange rate of US dollars to Bitcoin rises drastically (meaning Bitcoins become more expensive to buy with US dollars). What happens to your investment? Well, because dividends are paid in Bitcoin, you still reap the same amount of Bitcoins, but because each Bitcoin is more valuable, the dividend is worth more in terms of US dollar.
However, because the price rises, the cost for people playing the game also rises, meaning they will spend less in Bitcoin even if their spending in US dollar is the same. Suddenly a bet or purchase cost more in terms of US dollars and people will likely reduce their spending in Bitcoin. That means the rate of dividend will go down even if that dividend is worth more per coin than previously.
This complication is more difficult to understand than it may seem. The psychological effect that currency values have on people’s perception may completely throw normal investment ideas out the window.
Also, if you plan on investing in stocks denominated in cryptocurrencies, you need to realize that the cryptocurrency market is still very, very immature. There is by nature no government control and thus no government oversight of exchanges. Although there are a few reputable stock exchanges already, anyone can set up a new exchange without requiring any mandate or supervision from anyone.
Further, even the established and somewhat reputable exchanges have very few formal requirements for accepting new assets, and most of the requirements are based on community consensus which can be manipulated. You are essentially trusting the issuer of the asset that they will honor their commitments, and sadly, the short history of cryptostock exchanges have shown that you can’t always trust even those with the most honest of appearances. People have lost a lot of money and so may you.
Lets say you consider investing in coin mining operations, and let’s say you have US$1,000.00 to invest and the current Bitcoin/USD exchange rate is 1 BTC = $100.
Note: Bitcoins, Litecoins, and other cryptocoins based on the Bitcoin code base, can be mined, or minted, by users using their own computers at home.
You may think that the US dollar price of a Bitcoin will rise, so you decide to buy mining equipment to get a piece of the action. You buy a new computer with a few suitable graphic cards, and start mining. Perhaps you mine a couple of Bitcoins over the course of a month.
It turns out, you were right about the price increase, and after the first month, the US dollar price for a Bitcoin has risen to $150. “Great,” you think, “I’ve gotten $300 free and that must have been a great investment”. You still have your new computer, valued at $1,000, and let’s assume it still holds its original value after just a month, and you have two free Bitcoins priced at $150 each for a total value of $1,300.
Not so fast, grasshopper. You have actually lost money on this operation.
Had you purchased BTC for $100, you could have gotten 10 of them, now valued $1,500. In other words, you ‘lost’ $150 on your investment because you paid for your computer in US dollars. Even if you sell the new machine for Bitcoins now, you would only get around 6.6 BTC ($1,000/$150) and even with your mining revenue of 2 BTC, you’d be down 1.4 BTC.
“Ah,” you think, “I can just keep mining and the profit will skyrocket! One more month and I’ll be up 0.6 BTC”
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You may be right in thinking this, but you may also be forgetting that the difficulty of mining increases with time (or rather with effort) so your revenue goes down. In fact, for certain cryptocurrencies, the difficult has doubled, effectively halving revenue, within a week due to shifting and ever increasing effort for the network. What may seem like a great investment in April may be costing you more in electricity than you get back by June.