The rapid declines and rises of bitcoin prices draw more attention and queries about the value of the cryptocurrency, especially for financial advisors with clients who are unsure about allocating money to the digital currency.
Bitcoin remains the world’s largest digital currency by market capitalization and reached an all-time high of $41,940 on Jan. 8. The extreme volatility of Bitcoin and lack of regulation has kept the majority of institutional investors, such as pension and hedge funds and retirement companies, at bay.
Between 2017 and 2018, billions of dollars of market cap were erased from hacking, regulatory orders and massive volatility. Bitcoin reached a high of nearly $20,000 in December 2017, but it plunged to about $8,500 in March 2018 and hit lows of around $6,000.
Interest in the cryptocurrency — which launched January 2009 in the aftermath of the Great Recession — increased as the deficit in the U.S. grew to $3.13 trillion in fiscal 2020 and government debt rose to a total of $27 trillion. Renewed interest from some investors is driven partly by the hopes that Bitcoin could be a better currency compared to ones such as the U.S. dollar that have depreciated in value.
As Bitcoin matures, the digital asset has attracted a small percentage of capital from institutional investors, including a handful of pension funds, hedge funds and insurance companies, such as Massachusetts Mutual Life Insurance Co. that bought $100 million worth of bitcoin through NYDIG, a New York-based fund management company.
Financial advisors can explain to clients that they should avoid focusing only on the daily price swings and instead determine how much of an allocation works for an investor’s retirement goals, says Grant Easterbrook, a fintech analyst and co-founder of Dream Forward, a New York-based low-cost 401(k) plan.
Advisors can help investors determine the amount of risk that is appropriate and what the opportunity costs are compared to investing in assets such as stocks or exchange-traded funds, Easterbrook says. Bitcoin has the potential for large returns and losses that are common with venture capital funds, he says.
“Predicting whether a dollar you invest in a cryptocurrency today will outperform investing that same dollar in more traditional investments like an S&P 500 fund over a five-year period is difficult, and clients need to manage their risk accordingly,” Easterbrook says.
[Read: The History of Bitcoin]
What Advisors Are Telling Clients About Bitcoin
Since Bitcoin and other cryptocurrencies such as Ethereum remain extremely volatile, some investors should limit their investment to 2% to 5% of their portfolio and consider it an alternative asset like real estate, says Daren Blonski, managing principal of Sonoma Wealth Advisors in California.
“Some clients find it difficult to experience volatility in their portfolio,” he says. “Although Bitcoin can be volatile, its risk-adjusted returns are promising. It’s important investors do their research. During the bull cycle of Bitcoin, investors should expect multiple periods where it pulls back over 30%.”
Investors who are wary of owning bitcoin directly because of the volatility in prices can obtain exposure to the asset by investing in the Grayscale Bitcoin Trust (ticker: GBTC), which is similar to owning shares in a closed-end fund that are traded on the exchanges after an initial public offering. These funds invest in stocks, bonds and alternative assets, and the shares are bought and sold by their current investors.
Since the U.S. Securities and Exchange Commission has not approved a bitcoin ETF, investing in GBTC, a trust that owns bitcoin itself, is one strategy for investors to add cryptocurrency exposure. This strategy allows them to avoid having to own the asset outright and buy it from a cryptocurrency exchange such as Coinbase or have a digital wallet that requires a lengthy password.
Advisors recommend owning shares of GBTC because it can be invested in an individual retirement account or Roth IRA. Individuals who sell shares and receive gains might have less of a tax consequence in a tax-advantaged account compared to a brokerage account.
“Owning GBTC in an IRA can help you mitigate tax damage,” Blonski says. “Otherwise, you might have a large tax bill.”
Bitcoin is an alternative asset that presents potential value and opportunity since demand appears to be increasing and supply is slowing. Bitcoin is limited to a maximum of 21 million as the digital asset is mined electronically. The halving cycles limit supply and occur every few years until all 21 million bitcoins are in circulation — the last cycle occurred in May 2020.
“Each halving cycle cuts the supply of the market in half and that creates a supply shock, paired with an increase in demand,” Blonski says.
Investors can use the dollar-cost averaging method to invest in bitcoin like they do with stocks or ETFs, says Cathy Curtis, CEO of Curtis Financial Planning in Oakland, California. Dollar-cost averaging is a strategy where an investor allocates the same amount of money every month to an asset. Over a longer period of time, the investor can buy more shares when prices are low and fewer shares when prices are high.
“The best way to invest would be to dollar-cost average with a contribution each month — set it and forget it,” she says. “I tell clients that if they do invest in bitcoin, it should be a very small percentage of their overall portfolio since its potential future price is unknown and it is a high-risk investment.”
Investors who are comfortable with the risks should slowly build up a position in bitcoin, says Alex Chalekian, CEO of Lake Avenue Financial in Pasadena, California.
One problem with buying bitcoin or ethereum in an IRA is that if there is a large decline in prices, and investors sell, they can not take advantage of the loss and write it off on their tax return, he says.
“There is some future use with Bitcoin and Ethereum, especially if more countries with more volatile currency fluctuations like Argentina adopt crypto and make it mainstream,” Chalekian says.
Investors should limit themselves to a small allocation of 1% to 3% as a diversified asset and view Bitcoin as investing in gold or another alternative asset. While bitcoin prices have recently correlated to the stock market and mirror the rise and decline in the S&P 500 or Nasdaq, “eventually it will be noncorrelated,” he says.
Risks of Investing in Bitcoin
The amount of money invested in bitcoins should be what an investor is “willing to risk” since it can easily quadruple in price, but also dip back to less than $3,000, Chalekian says.
Trading bitcoin is challenging and focusing on month-to-month movements is not a good strategy, Easterbrook says.
“There has been insane volatility and it will continue,” he says. “It’s better to not actively trade it, but instead build a position over time.”
Investors should also be aware that “black swan” events can occur such as a major hack of a bitcoin exchange or digital wallet or the possibility of the federal government opposing individual ownership of bitcoin, such as when gold ownership by citizens was banned for a short time in 1933, Easterbrook says.
“You can support Bitcoin but need to understand the risks — some are short-term,” he says.
Some investors are buying bitcoin directly and using centralized platforms such as Coinbase and PayPal for their cryptocurrency investment since they are easier for retail investors to use.
Linking an individual’s bank account and buying bitcoin at the touch of a button is now as easy as shopping online. If investors follow poor security practices, then the “threat of an attack on either the exchange or their own wallet address will remain a consistent threat,” says Thomas Beek, senior cyber security specialist at Digital Shadows, a San Francisco-based provider of digital risk protection solutions.
Retail investors commonly buy cryptocurrencies either through a centralized or decentralized exchange.
“The question arises of whether it is safe to keep funds within the exchange or look at alternative means,” he says. “The short answer is: consider the latter. The unregulated nature of the cryptocurrency landscape means any exchange is at risk from attacks and, from 2019 to 2020, there were several high-profile breaches of cryptocurrency exchanges, including DragonEx, Cryptopia, GateHub and Altsbit.”
The amount of money sent back and forth over the exchanges “makes them an attractive prospect for any attack, especially with the market value of such currencies continuing to rise,” Beek says.
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How Financial Advisors Should Advise Clients on Bitcoin originally appeared on usnews.com