Investing in Cryptocurrencies: The (Unbiased) Basics
Are you curious about cryptocurrencies – Bitcoin, Ethereum, and others – but confused by the terminology and skeptical about all the hype? We get it. Crypto is constantly in the news, and there is a lot of FOMO (Fear of Missing Out) when we hear about people becoming “crypto-millionaires” overnight. But does it make sense as an investment? There are crypto fanatics whose devotion to the topic is almost cult-like. Some see Bitcoin and the other “coins” as irrational and dangerous. Articles and podcasts (and Super Bowl ads) about investing in crypto are circulating daily. Still, many of the people behind much of what is published have “skin in the game” – in other words, they benefit from promoting the industry. So, it can be difficult to find basic, unbiased information about investing in crypto.
In this article, we strive to be an objective source – sticking to the facts, avoiding the hype. We lay out the basics of cryptocurrencies and why many people (but not everyone) are investing in this new asset class – some cautiously, others with a notable lack of caution. We note that the crypto environment is changing so quickly that some of what is written here may soon become stale. That is unavoidable, but we believe it is worth having a basic understanding of the crypto world as it stands now – we can always update things later.
What is a cryptocurrency?
Briefly, a cryptocurrency is a digital form of cash that is not issued by any government and can be created by anyone, anywhere. Other than Bitcoin, most cryptos are still too small to be viable alternatives to a developed country’s government’s fiat currency, but that is a separate topic. Many central banks worldwide, including the U.S., are considering issuing digital currencies known as… (no clever naming here) Central Bank Digital Currencies, or CBDCs to capture the benefits of digitizing, but we exclude CBDCs from this discussion.
The term “Bitcoin” is often used generically to represent all cryptocurrencies. While there are hundreds of different cryptos, Bitcoin is by far the best known and most widely used, followed by Ethereum, and then everything else (including the intended-as-a-joke Dogecoin that has become popular, partly due to Elon Musk’s social media posts).
Every transaction in a given cryptocurrency is recorded on what amounts to a digital accounting record, copies of which are distributed to and maintained by many entities. It is seen as verifiable because multiple copies of the ledger exist, and this “blockchain” technology is the backbone of the crypto world. Crypto cannot exist with blockchain, but blockchains are employed in other areas and do not “need” crypto to be useful. We do not have the space here to describe the history of crypto. Still, there is general agreement that its seeds were sown by the global financial crisis of 2008 that led many to mistrust the traditional financial establishment. The idea of a type of money not linked to any banking system or government appeals to many. There are some concerns that some people can use Bitcoin for transactions that traditional banks do not allow, such as weapons sales and drug trafficking; however, it remains far below fiat currency in this regard. In its early days, Bitcoin fans predicted we would all soon be buying everything from pizza to airplane tickets with crypto, and while companies are working on solving this problem, that has not happened yet.
How is crypto bought & sold?
Crypto is held in a digital “wallet” – some wallets can hold many types of “coins”, others just a few (if you lose your password your crypto is lost). It is traded on exchanges such as Coinbase and Crypto.com. Traditional brokerage firms such as Schwab and Fidelity do not currently offer crypto trading but may allow investors to buy and sell Bitcoin futures and ETFs that hold those futures. Caution: the prices of Bitcoin futures often do not track the price of Bitcoin itself.
Crypto as an Investment
Should we all invest in Bitcoin or other cryptos? Here is a summary of what you’ve probably heard on this topic:
The fanatics – Absolutely! It’s the future of money! It’s the future of finance! You can make huge profits – maybe enough to quit your job! Future returns from stocks and bonds will be dull, the fanatic’s argument goes. The stock market is overvalued, bond yields are still low, and real returns – adjusted for inflation – are even lower, in many cases negative. Crypto is the way to earn the returns you need to live the life you want to live!
The naysayers – It’s a speculative bubble. Crypto prices rise because people buy more of it, expecting it to increase. Crypto is not linked to anything tangible and does not pay interest or dividends. It is used to conduct illicit transactions such as selling weapons and charging ransomware. There is no logical reason for crypto prices to go up or down other than herd mentality and the testimonials that crypto cheerleaders post on social media.
Our unbiased view – Holding one or more cryptocurrencies may offer an opportunity to turn a small investment into a meaningful amount of money over a short period. Crypto prices are highly volatile, so it would not make sense to invest a meaningful percentage of your nest egg in them, but having a small exposure that you could afford to lose could make sense.
In a recent white paper titled “Getting Off Zero,” Fidelity showed that moving from holding zero crypto to having a minimal allocation (roughly 1% of a portfolio) produced the “most efficient” increase in risk-adjusted returns. Note that this is based on the pattern of historical Bitcoin prices, which may or may not reflect the future pattern of Bitcoin prices. While Bitcoin used to have a low correlation with other asset classes, that appears to be changing. Recently, prices have gone up and down in a fairly consistent pattern with the volatile tech sector of the U.S. stock market.
The emphasis is on risk-adjusted here, meaning “taking risk into consideration.” According to Fidelity’s analysis, the more crypto added to a portfolio, the higher the return, but the higher the risk. Note that Bitcoin prices have leaped and declined 20% or more in a single day.
People worldwide invest in gold because they believe gold will hold its value, especially in periods of high inflation. Bitcoin is sometimes called digital gold because, like gold, there is a limited supply of it, and it is not linked to stock or bond markets. It is certainly easier to store than gold (you do not need a vault to store crypto, although it could be stolen by hackers). However, in a chart comparing the price of Bitcoin to the largest gold ETF in the world over the past two years, Bitcoin looks like the outline of a jagged mountain range while gold is almost a straight line. While two years is not a long time, Bitcoin has not been around long enough to judge how it will perform as an inflation hedge. Recent world events have shown that Bitcoin is not yet a safe haven in times of market stress, but it might be in the future.
The regulatory outlook for crypto is uncertain. Some have concerns about the environmental impact of Bitcoin “mining” (maintaining blockchains often consumes vast amounts of power), while others are concerned about the use of crypto for illegal activities, as mentioned earlier. The U.S. has become the largest Bitcoin-mining center after China banned the practice last year, and Congress has been holding hearings and asking crypto-mining companies for details on their power usage and greenhouse gas emissions. Other countries, including the U.K. and Spain, are tightening rules around crypto advertising, and Singapore has ordered crypto companies to stop advertising to the public. Regulators in the U.S. and elsewhere are trying to crack down on what has been referred to as “mountains” of tax fraud in the crypto space, as these coins are being used to evade taxes. Crypto-currencies offer the potential to generate significant returns in a reasonably short period. If you are interested in holding Bitcoin or another crypto-currency in your investment portfolio, your Gold Medal Water advisor can help you figure out what makes sense for you.