In the last month, the value of Bitcoin has doubled. Just last night when I went to sleep, Bitcoin had hit $4,400, but was down to $4,000 when I woke up. For every Bitcoin millionaire story out there, there are countless people who invested at the wrong time and lost money or lost it all during the Mt. Gox hack. How do you invest in digital currencies without falling into the trap of a bubble?
Create Your Own Rules of Investing
This advice isn’t specific to Bitcoin. If you have a set of personal rules for all investment decisions you make, it’ll be easier to limit the downside if things go wrong. Here are my personal 5 rules for investing.
- 5% of my portfolio can be played with — never risk more than that.
- For the other 95%, don’t buy anything you don’t plan on holding forever.
- Rebalance assets every year by investing more into areas that are below the target percentage.
- Always buy things in the most tax efficient account (401k, Roth IRA, etc).
- Invest as much as possible each month.
Given these guidelines, the most I could possibly lose from Bitcoin is 5%. That’s just my personal risk tolerance. It means if I make a bad decision and invest during a bubble, the downside is 5%. This limits the upside of course, but I’ve decided to be OK with that. I won’t be an instant millionaire, but I will be a slow one.
Dollar Cost Average
If you do want to invest in a highly volatile asset like Bitcoin, the best thing you can do is dollar cost average your deposits.
Take a look at this chart. This is what would happen if you invested $1,000/mo starting 12 months ago in Bitcoin. You would have turned $12k to $32k — not too bad.
Investing at the top of a Bubble
But what if you invested at the peak of a bubble instead? What if you invested $12k on 12/1/2013 vs DCA over the next 12 months? On 12/1/2013, BTC was $946. A year later it was $377. If you’d invested this all at the top of the bubble and waited a year then given up, you’d have converted $12,000 to $4,782.
But what if you DCA’d it instead? If you put your $1,000 in on the first of the month for a year, you’d have $7,229 at the end of the first year — 33% more than if you’d invested it as a lump sum.
Dollar cost averaging is great advice for normal investing, but for Bitcoin and digital currencies, it’s much more essential due to the volatility. If you were to invest today in Bitcoin, there’s no way to know if it would follow the first graph or the second. I plan for the second.
This is the same advice as investing in the market in general, but don’t look at the price constantly. That won’t help the price change, and if you’re constantly looking at the price, you’re probably just become more anxious.
Invest Long Term
Investing in anything for under a year is often a bad idea. You’ll be paying a lot of taxes when you cash out. Instead, plan for the long term, and don’t buy anything you won’t hold for at least a year. I try to only invest in things I could see myself holding until retirement.
Rebalance and Prepare
Rather than just taking this irrational exuberance and investing in Bitcoin, if you really think there’s something there and want to invest, what about instead rebalancing your portfolio to fit your goals? This can be a great time to get money in a place to get dollar cost averaging in place to take advantage of the next 5 years. I’m planning on moving some money to a cash account on Coinbase, with the intention of dollar cost averaging no more than 5% of my total investments over time.
Beware of Selling Stocks and Paying Taxes
The worst case scenario for people with Bitcoin right now would be something like this:
- You sell a bunch of stocks today, that had appreciated value.
- You buy Bitcoin at the top of the bubble.
- Bitcoin loses half its value.
- Next April you pay a bunch of taxes on those stocks.
Between taxes and Bitcoins uncertainty, it’s not unrealistic to think that a sudden change could range from losing nearly everything to multiplying your funds over the next few years. Not me or anyone could say which way it’ll go, but you can choose not to make decisions that’ll have tax implications today.
What do you think about the digital currency bubble? Is it merely speculation or the future of currency?