Not long ago, the idea of investing in cryptocurrency was hard to grasp. Instead of a traditional, government-backed currency, cryptocurrency is a digital one. But in a relatively short amount of time, an entire ecosystem has formed, focused on making transactions, trading, and investing in cryptocurrency.
Potential cryptocurrency investors might want to familiarize themselves with the basics before diving in—including how crypto works, how it’s used, the different types of cryptocurrency, and how investing in cryptocurrency differs from other types of investments.
What is Cryptocurrency?
Cryptocurrency (or “crypto”) is digital money. It can be traded, exchanged, and transacted like other types of currency, but the key difference is that it’s a completely digital asset—cryptos have no physical body, whether that be a metal coin or paper bill. Crypto is enabled by blockchain technology, which is more or less a distributed ledger that records transactions and ownership details.
Cryptos can be obtained in a number of ways: They can be purchased with a credit card—thereby exchanging traditional currency for a cryptocurrency—or through a process called “mining,” which generally requires high-end computers. Once cryptos have been obtained, they’re securely stored in a digital wallet, which are offered by many different companies. Some brokerages give investors the option to invest in cryptocurrencies, too.
Because cryptocurrencies are not backed by any government—unlike the U.S. dollar, which is insured by the U.S. government—they’re inherently speculative and riskier than traditional currencies or investments.
This investment type is still new—Bitcoin first emerged in 2009, followed by other cryptocurrencies. With roughly a decade of crypto trading to look back on, and with little or no guardrails, investing in cryptocurrency is far from what experts would call a “safe” investment.
Despite the risks, crypto can be particularly appealing to intrepid investors. Here are some tips for investors who are considering adding cryptocurrency to their portfolio.
1. There Are Different Types of Cryptocurrency
Before investing in cryptocurrency, it’s important to know what types are out there. Those include Bitcoin, the original cryptocurrencies, as well as other “altcoins” like Ethereum, Litecoin, and Ripple.
While most of these cryptocurrencies were built on the same framework as Bitcoin, some have their own separate systems and protocols. Altcoins may claim to have improved on Bitcoin, with attributes such as low or no fees and shorter transaction times.
2. Investing in Cryptocurrency is Risky
Cryptocurrency is still a largely unregulated and relatively unproven sector. For this reason, some say that to call investing in crypto “speculative” is an understatement.
So why invest in cryptocurrency? Certain digital assets and cryptocurrencies, like Bitcoin, have a fixed supply limit—the number of bitcoins that exist in the world will not grow larger. In that way, it is considered immune to inflation, vs investments denominated in fiat currency, like stocks or bonds. It is also considered a “safe haven” asset. For these reasons, it is considered a hedge against inflation.
And then there’s plain old performance. In the decade or so since it was founded, Bitcoin has performed better than any other asset. That said, prices and exchange rates for Bitcoin and other currencies have varied wildly. For example, Bitcoin was valued at more than $14,000 per coin in 2017 before dropping to less than $3,500 per coin by the beginning of 2019. And as always, past performance is not an indication of future success.
Other risks include potential government interference or regulation, and some cryptocurrencies have collapsed already , leaving investors unable to access their investments. There’s always the possibility that could happen again, or that investors might be taken in by a crypto scam .
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3. Crypto Value Hinges on Supply and Demand
Crypto prices fluctuate a bit differently than more mainstream investments. A blockbuster earnings report isn’t going to send crypto prices soaring, as it might in the case of a stock.
The value of a cryptocurrency is largely, if not completely, contingent upon supply, demand, and the public’s faith that it carries value. For example, when demand for Bitcoin increases, the price or value of Bitcoin goes up. Conversely, when demand drops and many people are selling Bitcoins, the price or value falls.
4. Diversification Logic Applies
Many investors know the value in diversifying their investments. That means that an investor’s asset allocation is spread across a number of different investments—stocks, foreign stocks, bonds, precious metals, etc.—rather than, say, solely in a single company’s stock. The basic idea is to reduce risk; a portfolio with an outsized allocation to a single company or commodity is riskier than a diversified one.
The same logic could also apply to crypto investing. There are numerous types of cryptocurrencies available for investment, and sticking with only one, like Bitcoin, may be riskier than investing in several different cryptos.
5. Crypto Investments Are Taxed as Property
When is cryptocurrency not currency? When the Internal Revenue Service (IRS) is classifying cryptocurrency earnings for tax purposes. In that case, it’s considered a “capital asset” , much like a stock or bond, and because of that designation, cryptocurrency is considered property.
As a result, investors may have a tax liability against their holdings, and may owe capital gains taxes if they turn a profit on their investment. For more on this, we’ve put together a comprehensive guide to taxes and cryptocurrency.
6. It Can Be Hard to Predict Crypto Returns
Given cryptocurrency’s speculative nature and the fact that it’s a relatively new option for investors, it’s hard to know just what to expect in terms of returns. Investors don’t have decades of stock performance data to look back on, or quarterly earnings reports to sift through, for example. For that reason, it’s best to keep expectations in check when investing in crypto—profits can be had, but catastrophic losses are also a very real possibility.
Cryptocurrency is an alternative form of currency that isn’t backed by a government or a tangible form like gold or paper money. With the general public and financial world becoming more accustomed to the idea of digital currencies, cryptocurrency may be here to stay.
For crypto investors, getting in early may reap rewards, but in the near-term, those investors are taking on outsized risks. But before investing in cryptocurrency, it’s important to remember that the basic rules and guidelines of investing still apply. To help minimize risk, crypto shouldn’t play an outsized role in a portfolio.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.