The Analyst: balancing bitcoin risk and potential reward

This year, bitcoin and cryptocurrencies have experienced significant volatility due to a challenging macroeconomic environment, including Trump’s proposed tariff policies, concerns over inflation, and a potential slowdown in US economic growth.

In a major development for the crypto industry last week, Trump signed an executive order establishing both a US Strategic Bitcoin Reserve and a Digital Asset Stockpile. These reserves will consist of cryptocurrency assets that the government has acquired through criminal or civil asset forfeiture proceedings. Crucially, the executive order makes clear that the bitcoin included in the reserve will not be sold.

• Learn with ii: How to become an ISA millionaire | ISA Investment Ideas | Top ISA Funds

Despite the growing popularity of bitcoin and crypto assets, and the increasing ways to invest in them, direct access remains limited for UK retail investors – especially within any kind of tax wrapper. Exchange-traded products (ETPs) that track the price of bitcoin have not been made available beyond professional investors in the UK, while more accessible “bitcoin proxies”, such as blockchain and mining stocks, come with extreme risk and return characteristics and may not match the returns of bitcoin itself. All this makes for a difficult time to include these assets in traditional portfolios.

Bitcoin: a ‘digital gold’

We know bitcoin was created in 2009 by a mysterious figure, or figures, known as Satoshi Nakamoto, introducing the world to decentralized digital money, powered by blockchain technology, which ensures security and transparency. Since its launch, bitcoin has become the most dominant cryptocurrency, making up over 50% of the total crypto market.

Many investors today view bitcoin as “digital gold” due to its scarcity, a fundamental feature driven by its fixed supply of 21 million coins. This scarcity is further reinforced by programmed “halvings,” which occur approximately every four years, reducing the block reward for miners by 50%. It means the rate at which new bitcoins enter circulation slows over time and will eventually cease by 2140.

These halvings not only make mining more challenging but also contribute to bitcoin’s deflationary nature, setting it apart from fiat currencies such as sterling or the dollar which are vulnerable to inflation due to central bank policies. With global central banks devaluing their currencies and eroding purchasing power, bitcoin’s predictable issuance and limited supply enhance its appeal as a long-term store of value and an alternative to gold.

• Bitcoin, cryptocurrencies and blockchain – how it all works
• Bitcoin and crypto stocks: examining the risk
• Bitcoin and crypto stocks: how to invest in them

The most recent halving, in April 2024, follows a historical pattern where bitcoin’s price has typically risen before and after these events, further underscoring its reputation as a scarce digital asset with significant long-term growth potential.

While bitcoin shares some characteristics with gold, it also offers advantages that may make it superior. Unlike gold, which is limited in its divisibility, bitcoin can be divided into units as small as one Satoshi (0.00000001 BTC), enabling seamless microtransactions. Additionally, bitcoin’s blockchain ensures full transparency - every transaction is publicly recorded, reducing the risk of fraud and manipulation, whereas gold markets often lack such visibility.

As inflation continues to erode purchasing power of fiat currencies, both gold and bitcoin are increasingly seen as effective hedges. However, bitcoin’s unique features, such as its divisibility and transparency, position it as a strong competitor to gold.

Bitcoin goes mainstream

In its early years, bitcoin was primarily used by a small group of tech enthusiasts. It was difficult to obtain, had limited use cases, and was accepted by only a handful of merchants.

Today, bitcoin adoption has grown significantly, with an increasing number of businesses accepting it as payment. Social media is now filled with examples of people using bitcoin to buy luxury cars in Dubai, villas in Spain, and even everyday items such as fruit and vegetables at markets in Costa Rica.

In 2021, El Salvador became the first country to recognize bitcoin as legal tender, offering a macroeconomic case study of its viability.

Institutional interest has also surged, with fund managers such as BlackRock recognising bitcoin as a “unique diversifier” due to its independence from traditional risk and return drivers. BlackRock CEO Larry Fink has also reversed his previously skeptical stance, admitting he was “wrong” to dismiss bitcoin. Since its launch in January last year, BlackRock’s physical bitcoin exchange-traded fund (ETF), known as iShares Bitcoin Trust ETF, has gathered nearly $50 billion (£38.6 billion) in assets under management (AUM).  

Bitcoin as an investment: balancing risk and potential

As bitcoin adoption grows, more investors see it as a valuable addition to their portfolios. It has consistently delivered strong long-term returns, outperforming most asset classes over the past decade.

Source: Morningstar. Annualised returns in GBP.

With its fixed supply and decentralised nature, it has become increasingly attractive to investors looking to enhance their portfolio diversification and risk-return characteristics.

A study by Bitwise found that between 2014 to March 2020, a bitcoin allocation of 1-2.5% of a traditional 60:40 portfolio (60% stocks/40% bonds) increased annual returns by between 1% and 2.3% without significantly raising portfolio volatility or drawdowns.

• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

That said, investors should keep in mind that bitcoin is not without risks. Extreme volatility, regulatory changes and security concerns are all significant factors both for investors buying stock-market listed bitcoin proxies, and those buying bitcoin directly to store in digital wallets.

Last month, Bybit, one of the world’s largest cryptocurrency exchanges, was hacked for over $1.5 billion in Ethereum - the largest hack in crypto history. These hacks emphasise the risks associated with direct ownership, while reinforcing the importance of a secure, regulated ETF product for investors.

Bitcoin has undoubtedly established itself as an investable asset class, but investors should approach it with a clear understanding of both its potential and risks.