In a word, cryptocurrencies are VERY risky.
Nobody truly knows how this new technological application will develop. It could be that cryptocurrency is the future of money, destined to replace national fiat currencies partially or even wholly, as outlined in the previous section. If this happens, the value of fiat currencies will continue to fall against the more popular cryptocurrencies, which will become excellent investments. On the other hand, will powerful national governments accept a total loss of control over the money supply, or will they move to restrict or even ban the operation of cryptocurrencies as a means of exchange? If this comes to pass, then cryptocurrencies might be little more than a passing fad, with 2017’s new high prices representing a bursting “bubble”.
There is also the question of which cryptocurrencies will be dominant over the long-term. Bitcoin has a clear leading position today, but that might not be the case one year from now. For the sake of comparison, let’s look at the early years of the internet. Back in the day, the most popular search engine was ask.com, before Google arrived and completely overtook it! If you’d speculated on the fact that ask.com was the future of the internet, you’d have been right in the short run, but terribly wrong in the long term.
It is also possible that a cryptocurrency might develop unforeseen technological issues which can impact its reputation and value, either negatively or positively. For example, when “The DAO”, a decentralized venture capital fund linked to Ethereum, was hacked on 21st June 2016, its value fell within a single day by more than 60%. A few days later, there was a “flash crash” on one exchange which moved the price from $300 to $0.10 (yes, ten cents!) in seconds, although the price quickly recovered. Needless to say, due to the possibility of this type of price fluctuation, investors with a low risk appetite should strongly consider whether cryptocurrency’s innate volatility will fit with their trading styles.
Both Ethereum and Bitcoin have also been subjected to “hard forks”, a situation where some of the participating nodes adopt a software change which is rejected by a significant section of the other nodes, which persist with the older version. If left unresolved, it results in the cryptocurrency splitting into two different currencies, a move which has come to be known as “forking”. Owners of a cryptocurrency are compensated after a “hard fork” takes place, losing some of their original holding, but receiving the equivalent current value in the new currency.
Before investing or speculating in ANY cryptocurrency, it is important to fully understand that the price could collapse to almost zero, at any time, in a matter of seconds. We said in the previous section that speculative assets with soaring volatility are prone to suddenly dropping in value. Simply put, what goes up fast, may go up fast again, but can also come down just as fast. Bitcoin, for example, was worth $570 one year ago. It has since risen by almost 900%. It could drop to $570 again, or an even lower price per Bitcoin, very quickly. Some analysts argue that Bitcoin and other cryptocurrencies may be in “price bubbles”, which can burst rapidly, leaving investors stuck with losing almost all of their investment.
We will talk more later about some possible methods that can be used to manage the risk of sudden, sharp falls in price that may occur. Sign up for our Android and iOS app to get future articles in this series directly to your cell phone.