3 Secrets to Bitcoin Investment Success

3 Secrets to Bitcoin Investment Success

This week the bitcoin ecosystem got a lot of great news – investors are pouring millions into the ecosystem, the IRS clarified the U.S. tax situation, and Stripe announced they will support bitcoin this year. However bitcoin investors got a serious jolt yesterday when bitcoin dropped 20%. Quick drops like that can hurt bitcoin investors by causing them to buy high and sell low or sell low and miss big gains. Successful bitcoin investors need to do three things: have a plan, expect drops, and secure their bitcoins.

Have a Plan

Bitcoin investors need to have a strategy: It could be day trading, trying to pay off student loans, trying to retire, etc. These different strategies will provide a framework to make a risk reward tradeoff decision.

For example a student wanting to pay off loans can decide it makes sense to invest $100 now with the potential to pay off their student loan debt in 4 years where as a young software developer can invest $10,000 looking to retire in ten years. If their bitcoin holdings increase to $100,000 the student has realized their goal and knows it makes sense to cash out where as the software developer knows $100,000 is not enough to retire on. Without a framework like that one can always be questioning should I get out now?

Expect Drops

Bitcoin's price will drop. It's price will probably drop more and faster than any other investment you've held. Bitcoin is primarily held exclusively by speculators and early adopters at this point. This is normal. In fact bitcoin is more stable than it has ever been. No one knows if this nascent technology we don't know if it will disrupt finance with the same magnitude the internet disrupted communications or be displaced and relegated to the dust bins of history like the pager. It is volatile like a tech startup and that is where the potentially massive financial upside comes from.

Around noon on Wednesday October 2^nd 2013 I was sitting on a nice 25% gain having bitcoins for about two months. Around noon I got an email from a friend letting me know the FBI had caught the guy suspected to be running Silk Road, an online marketplace selling illegal drugs through bitcoin. Curiously wondering if that would affect the price and I casually opened a web browser to watch the price.

As I watched my computer screen the price start to tick down a bit. I greedily pondered buying more. Almost before I could complete the thought my screen turned red as the price went into free-fall. I stared into my computer screen like a deer frozen in headlights watching my 30% gain plummet into a loss. I wondered should I sell? Why didn't I sell? How low will it go? Should I buy? What happens if it goes to $0?

The stress was awful.

My stomach hurt, hands were clammy, my brain abuzz with regret at the thousands vaporized through my inaction. I wanted to look away, to think about something else, but couldn't – hypnotized by all the red pixels in front of me. Then the price reversed! Almost faster than it fell it rocketed back up 25% getting me back into positive territory! Relief rushed over me.

Talking to bitcoin veterans I found out this had been a relatively small drop given the magnitude of the news. Prior crashes had resulted in much larger losses. The veterans viewed this flash crash as a chance to pick up bitcoin on sale. I found out they were right as bitcoin surged 1,000% over the following 8 weeks. I feel bad because I know some people bought in high, sold in the dip, and then missed out on the subsequent gains. I feel bad because I know how easy it would have been for me to make the same mistake. That is why it is important to expect drops, prepare for drops, and stick to the plan.

Secure Those Bitcoins!

Bitcoin gives owners 100% control over their funds. With that great power comes responsibility. Aside from being your own worst enemy by selling low the next worst way to lose bitcoins are to have them stolen by bad security practices. There have been too many stories of bitcoin investors losing small fortunes through poor investment decisions and outright thefts.

I estimate the root issue for 90% of thefts stem from people trusting funds with another party. This is ironic because the bitcoin creator saw the need to remove trust, stating in his white-paper: “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

Any time funds are held in an online wallet, online exchange, or business those funds are at an increased level of risk. The company can get hacked, run their business poorly, or have an insider steal the funds. The more users of the service, the larger the prize awarded in a successful heist. When evaluating places to put bitcoins it is important to think of trust factors such as: who owns this company, where is this company located, what security features does this company employ, and how does this business make money? Some bitcoin “businesses” entire business model is just to take users money like the bitcoin savings and trust.

Unfortunately storing bitcoins yourself, on your computer or smartphone doesn't eliminate the threat of loss entirely. It does substantially reduce the target, but your computer can be attacked through software flaws, viruses, and phishing attempts. Keep the wallet on the household computer least likely to get infected, ensure it is password protected, and wait for better solutions. Hardware manufacturers like Trezor are rapidly working to make bitcoins much safer for individuals to store.

If a bitcoin investment grows into the tens of thousands of dollars it probably makes sense to explore setting up an encrypted offline paper wallet and storing it in a bank safety deposit box. That eliminates both the risks outlined above but reduces access to all the funds stored on the wallet.

If bitcoin achieves even a fraction of the potential venture capitalists are projecting investors following these three steps: having a plan, expecting drops, and securing those bitcoins are likely to benefit from their early investment in the technology.

Disclosure: At the time of this writing David Smith has a long bitcoin position.