Several of my friends keep talking about investing in cryptocurrencies like Bitcoin and Dogecoin. I’m thinking about jumping in too, but am concerned about the risks. What do you think?
When I first wrote about cryptocurrency in 2018, the concept of a digital asset was still foreign to most Americans. Some of my children’s friends were getting excited about trading Bitcoin, but I didn’t consider cryptocurrency as a serious investment, something that I would trust or recommend to others.
Today, cryptocurrency has become much more mainstream, but remains controversial, with both ardent supporters and critics. On one side of the debate, investors like Elon Musk are open about owning Bitcoin and view it as the way of the future. Squarely on the other side is Warren Buffett, who has famously described cryptocurrency as “rat poison squared.”
Personally, for the time being I remain extremely wary of the multitude of risks involved with trading cryptocurrency, and think of it as speculating, not investing. That said, as digital currency matures, if increasing numbers of companies accept it as a form of payment, and especially if it becomes regulated, it's very possible my opinion will evolve as well.
In the meantime, the best advice I can give you is to arm yourself with the facts. Let’s take a look at what cryptocurrency is and some of the issues involved with owning and trading it.
What cryptocurrency is, and how it works
Cryptocurrency is a form of digital currency that lets you make online payments directly to other people or businesses without having to go through a third-party like a bank. Records of these transactions are logged onto a public ledger called a blockchain, which is stored and duplicated on thousands of computers around the world. Essentially, this means that when you buy Bitcoin, it creates an entry in the blockchain ledger, which is on the internet for everyone to see, but isn’t editable. This is how the system aims to remain relatively accountable and transparent.
There are currently thousands of types of cryptocurrencies, including Bitcoin, Ethereum, Dogecoin, and Tether. You can buy units of cryptocurrency or “coins” in a variety of ways, including paying cash for them on an exchange like Coinbase; providing goods or services in exchange for the currency; or purchasing them from a Bitcoin ATM that you might find in a gas station or convenience store (similar to a bank ATM). After you buy cryptocurrency, you store the coins in an "online wallet."
You may have also heard of Initial Coin Offerings (or ICOs), which involve an investor purchasing cryptocurrency coins (sometimes called tokens) that can later be exchanged for the new cryptocurrency once the startups create their own “coins” to sell to investors. It is important to recognize that such offerings are not registered with the SEC. Any startup can launch a new cryptocurrency, and no one has the authority to approve or deny it.
I know cryptocurrency sounds like it's super modern, but digital currency has actually been around in one form or another for years. Loyalty programs like airline frequent flier miles, hotel points, and credit card points are all forms of digital currency. The benefits you receive from these programs aren't in dollars, but in the company’s self-created currency. So digital cash is something a lot of us are familiar with already. Cryptocurrency is simply a newer—and more complex—form.
Beware of extreme price volatility
We’ve all heard of people making staggering sums off of cryptocurrency, but that only tells part of the story. Let’s take Bitcoin as an example. When Bitcoin launched in 2010, the price of one coin was $0.01. It then rose more than 1,900 percent from $975 in March 2017 to $20,000 in December. Fast forward to 2021, and Bitcoin rallied over 100 percent between January and April, reaching a high of $60,000. But it then proceeded to fall 50 percent over the next two months, wiping out all of the gains for anyone who didn’t own it before 2021.
Part of the reason for this dramatic volatility is that Bitcoin and other cryptocurrencies have no intrinsic value. Plus, unlike other traditional currencies, they aren’t backed by a government or central bank. As a result, their price is driven purely by supply and demand. As their value increases, this success (often hyped by social media) attracts new investors—and prices can soar. But on the flip side, a single negative event or even a tweet can drive prices down just as quickly.
Understand the risk for fraud and cybercrime
Even though cryptocurrencies have been designed to be theft-proof, there’s also a very real chance of fraud and cybercrime. In June of 2011, for example, the Japan-based Mt. Gox (which was then the largest Bitcoin exchange) experienced a security breach in which $450 million worth of Bitcoin was stolen. And in January of 2018, hackers stole almost $500 million from the cryptocurrency exchange Coincheck Inc.
In addition, because of its intrinsic anonymity, cryptocurrency has been associated with the more unsavory side of finances, like money laundering, the black market and ransomware attacks. A recent example was the Russian ransomware attack on Colonial Pipeline in which the FBI was thankfully able to recover most of the stolen assets.
On a more personal level, if you forget your login ID or password to a cryptocurrency exchange—or they’re stolen in a hacker or phishing scam—you can lose your access to your virtual wallet, and your currency. Unfortunately, with no issuing or regulating country or authority for cryptocurrencies, there’s very little recourse in cases of fraud or theft. The Federal Deposit Insurance Corporation or the National Credit Union Share Insurance Fund typically protects your funds if a bank or credit union fails. But there's no comparable protection for virtual currency accounts.
Proceed with caution
As my longtime readers surely know, I’m a big believer that everyone needs to build their investment portfolio to suit their individual needs, taking into consideration their goals, time frame, and personal feelings about risk. Therefore, I’m not going to tell anyone to completely avoid cryptocurrency. However, I want to be clear that for the reasons I’ve cited above, I consider cryptocurrency to be a speculative asset, placing it at the far, far end of the risk spectrum.
If you're an experienced investor with a diversified portfolio, the ability to take on the risk and a long-term investing plan, you might consider allocating a small percentage (not more than 1 percent) of your holdings to cryptocurrency.
On the other hand, if you're a newer investor and are tempted by cryptocurrency simply because of its buzz or because you want to make a quick profit, I’m waving the red flag. Instead of jumping on the bandwagon, I advise you to take a step back and educate yourself not only about cryptocurrency, but also about more traditional assets like stocks, bonds and cash, as well as timeless investing principles. Then, and only then, should you consider trading cryptocurrency—and hopefully only with money you can afford to lose.
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