Bitcoin and its cryptocurrency brethren have made headlines for years now. Fortunes have been made — and quite often, lost — investing in cryptocurrency, and that may not change in the near future. Proponents of cryptocurrency see it as the currency of the future, co-existing with or even supplanting government-issued currency, while detractors think that crypto has no future at all.

Combined with the speculative passion with which traders buy and sell crypto, it’s no wonder that crypto prices are constantly engaged in a volatile tug of war.

Against this backdrop, bitcoin is something of an “old guard,” being the first, oldest and by far the largest cryptocurrency. To some degree, this gives bitcoin an added level of “safety,” but that word must be used cautiously. Bitcoin itself has numerous risks that make it anything but “safe” when compared with more traditional investments like bonds or even stocks. 

Here are the most important aspects of investing in bitcoin that you need to know as an investor to help you determine just how “safe” it may be in your portfolio.

Inherent Value

Bitcoin is unique in the investment world in that it has no inherent value. Bitcoin was essentially created out of thin air, and it isn’t backed by earnings or profits — like the stock market — or the promise of a corporation or government that it would make payments — like a bond.

Even options and other derivatives, which technically don’t have their own pure value, derive a value from their connections to other securities.

Bitcoin’s Value

Bitcoin, on the other hand, only has value because investors buy it in the belief that its price will rise in the future. There are many reasons behind this support, from the belief that crypto will become legitimized to pure speculative frenzy.

But as an investor, you have to come to terms with the fact that you’ll be buying an investment that has no inherent value to fall back on.

Volatility

You’ll definitely need a strong stomach to invest in a cryptocurrency like bitcoin. Thanks to a number of factors, the price of bitcoin can fluctuate wildly. A look at the history of the annual returns of bitcoin only shows part of the story, but it’s still telling.

Price Fluctuations

Since its inception in 2009, the smallest annual variation in bitcoin’s price was the 35% gain it posted in 2015. But bitcoin’s biggest annual gain was 2010, when it returned an astronomical 30,203%.

While that sounds like the type of return that any investor would crave, you have to factor in volatility on the downside, as well. In three separate years, Bitcoin’s price dropped by more than 60%, topped by its massive 73% loss in 2018.

Hype, Speculation and Promotion

More than any other asset class, cryptocurrency is subject to hype, speculation and promotion. As cryptocurrencies like bitcoin have no inherent value, they can only gain in price when investors buy more in the belief that others will follow and it will go higher.

Entire message boards are devoted to hyping up cryptocurrencies like bitcoin, with rumors flying fast and furious. It can be hard to determine which message posts or “news items” are real and which are simply the work of speculators trying to manipulate the stock higher. This makes an investment in bitcoin inherently risky.

Taxation

Many of the speculators buying and selling bitcoin — or even those using it for everyday transactions like buying coffee — may not be aware of the tax obligations associated with bitcoin.

Capital Gains Taxes

From the investment side, the IRS considers bitcoin to be a capital asset, the same as a stock. In other words, when you buy and sell bitcoin, you’re responsible for reporting those transactions when you file your taxes — and you’ll owe taxes on any capital gains you generate.

Capital Transactions

Beyond buying and selling bitcoin as an investment, however, the IRS also considers using bitcoin to purchase other goods to be a taxable transaction as well. From the perspective of the IRS, when you use bitcoin to buy a cup of coffee, for example, you are converting your bitcoin into something else of value. In fact, technically you are exchanging your bitcoin for dollars and then using those dollars to buy that cup of coffee.

If the value of your bitcoin at the time of the transaction is higher than it was when you bought it, it’s a taxable capital transaction — the same as if you simply bought and then sold your bitcoin on the open market.

Cybersecurity

Cybersecurity is a serious issue when it comes to bitcoin, and it’s a different type of risk that you’ll have to understand as an investor. As bitcoin is an intangible, digital asset, it must be stored somewhere electronically.

While there are different types of wallets and storage options for your bitcoin, at the end of the day, all digital assets and storage systems are subject to cyber theft. While you can take steps to secure your bitcoin in the best way possible, cybersecurity may always be a concern.

Competition

All capital assets rely on the principles of supply and demand to derive their value. But as bitcoin has no tangible earnings or value behind it, if the hype and hope behind it vanish, the price of bitcoin could plummet. What is one of the things that may draw buyers away from bitcoin? Competition.

Other Cryptocurrencies

There are literally thousands of other cryptocurrencies in existence, and new ones are being created constantly. While bitcoin remains the elephant in the space, if a developer creates an all-encompassing cryptocurrency that meets the demands, hopes and dreams of crypto buyers, it’s possible that support for bitcoin will wane.

In that scenario, bitcoin could be relegated to a historical footnote, a “first mover” that started an industry but ultimately couldn’t keep up with the latest developments.

How Can You Mitigate the Risk?

While there is no way to make bitcoin a completely safe investment, there are a few things you can do to reduce the risk for yourself.

• Store your bitcoin securely. A cold wallet, or hardware wallet, is the safest place to keep your crypto, followed by a hot wallet. Storing your bitcoin on an exchange is the least secure option.
• Don’t invest too much. No matter how tempting it is to pour all of your funds into cryptocurrency when you hear stories of crypto millionaires, never invest more than you can afford to lose — because you just might.
• Avoid scams. If it sounds too good to be true, it probably is. Make sure you do your research before you invest.

The Bottom Line

This list of the risks of bitcoin is by no means complete. For example, numerous governments around the world are discussing creating their own digital coins, and some have even tossed around the idea of making cryptocurrency illegal. The failure of crypto exchanges like FTX are also a big risk.

But as an investor, you’ll have to weigh all of these dangers against the enormous profit potential that cryptos like bitcoin have exhibited in the past. Whether or not those outsized gains will be available to investors in the future is unknown — that is why there is a market, after all — but it’s something to consider if you’re looking into owning or trading bitcoin. 

Amber Barkley contributed to the reporting for this article.