Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

If you’re anything like me, it wasn’t long ago that you were dismissing Bitcoin as pure investment folly. Over the past few months, however, it may have piqued your curiosity. Bitcoin, long the preserve of maverick investors, has muscled its way into most people’s line of sight.

Bitcoin's growth over recent months has been remarkable. Its price rose more than 300% over 2020 (by comparison, the S&P 500 rose 18%). In less than a month, it doubled its value to pass the $40,000 (£29,500) mark for the first time. Please remember past performance is not a reliable indicator of future returns.

Those numbers are making the cryptocurrency almost impossible to ignore. So, what exactly is Bitcoin? Is it a simple get-rich-quick scheme, best avoided by those who are serious about their investments? Or is it a legitimate alternative asset that warrants a place in any well-diversified portfolio?

Let’s begin with what’s happened today. The major UK financial regulatory body, the FCA, has said that investors should be prepared to “lose all their money” invested in the asset. Any money held in it is unlikely to be protected by UK schemes that help investors reclaim losses made when companies collapse. The FCA also warned that some cryptocurrency investment firms may understate the risks and overstate the gains involved. These comments come off the back of Bitcoin falling almost 20% earlier today after its historic rally through 2020.

According to the crypto community, a correction of sorts has felt inevitable. The last time Bitcoin enjoyed this sort of run, back in 2017, it fell from $20,000 to around $3,000. It’s those concerns that may have fuelled today’s reversal as investors look to lock in their profits.

As those fluctuations illustrate, Bitcoin is not for the faint-hearted. Only a tiny part of the market is traded, making it illiquid and volatile. That’s compounded by the fact that it offers no income and so no yield to benchmark it against, making it hard to value. It’s also highly risky. The FCA is right to highlight the dangers involved in an essentially deregulated market.

For most investors, however, much of the difficulty lies in deciphering exactly what purpose it serves.

Bitcoin was created in the aftermath of the Global Financial Crisis by Satoshi Nakamoto (who may or may not exist). This mysterious figure designed it to be a decentralised currency free from government and central bank control.

In this sense, Bitcoin has played out as something of a damp squib. Bitcoin is not widely used in transactions, and may never be. The process is costly and slow when compared with established methods, and efforts to denominate in new currencies are invariably met with a barrage of regulation.

That’s the first thing prospective investors should be aware of. Bitcoin is not equivalent to cash. Money put into a cryptocurrency should be treated as you would any other risky asset - money that can be lost as well as grown.

Take the currency out of cryptocurrency, and what do you have left? Maybe a get-rich scheme. That’s certainly what the lucky souls who invested at the start of 2020 are thinking. Like any risky asset, when things are good, they’re very good. In conditions of market frenzy, there’s a lot of money to be made.

But the other side to the asset is far more conservative. Bitcoin can, in theory, serve as a safe haven in such times of frenzy.

Its rise in recent months has been driven primarily by concern over the sums that governments have thrown at the pandemic and the prospect of inflation that looms in their wake. To protect against the value of their investments being eroded by inflation, investors often like to hold a real asset (e.g. gold), to serve as a hedge.

Bitcoin can serve a similar role. Its supply is finite - only 21 million coins will ever exist. You can’t just print off more Bitcoins like you can US dollars (or mine more gold). It’s easy to transact - not as easy as established currencies, but easier than gold. In times of uncertainty, this gives it value.

Yet that all comes with a big ‘but’. We’ve seen global markets soar to new heights this year, but all this fervour is founded on unease. The pandemic is rife; US democracy appears shaken; much of the world flounders in recession; many are not working. Yet optimism abounds.

This strange cocktail has brewed something of a perfect storm for stock markets and cryptocurrencies alike. If it all feels too good to be true, that’s probably a good instinct to trust. When it looks like something’s entering a bubble that’s destined to burst, chances are you won’t be the only person thinking it.

Let’s not get too carried away too by its sudden acceptance into the investment industry. Much has been made of the fact that Ruffer, the investment manager, has invested in Bitcoin for the first time. In truth, Ruffer only invested around 2.5% of an otherwise conservative portfolio which is well protected if the currency falls. There’s plenty of talk of mainstream houses getting in, with little action so far. For every institution that’s interested, there’s one that’s staying well clear.

Most importantly, this is a highly risky, highly speculative market. There are little in the way of fundamentals behind it, and next to nothing in terms of regulation. The underlying narrative of Bitcoin - that of a decentralised currency free from central bank tampering - is an uneasy one. It’s an asset that’s profited as much from an environment of incredulity as financial sense. Often such speculation serves as the basis for a good investment - often it backfires.

Five year performance

(%) As at 31 Dec 2015-2016 2016-2017 2017-2018 2018-2019 2019-2020
Bitcoin 123.9 1339.3 -73.2 94.0 302.2
S&P 500 12.0 21.8 -4.4 31.5 18.4

Past performance is not a reliable indicator of future returns

Source: Refinitiv, total returns as at 31.12.20

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics Covered:

GlobalInvesting ideasInvesting for capital growthVolatility

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