Do your research before adding cryptos to your portfolio.
Billionaire investor Paul Tudor Jones recently named bitcoin as his top bet for a hedge against post-pandemic inflation. Average investors likely don’t know much about bitcoin – or any cryptocurrency for that matter – other than what they see in the news. Bitcoin, the first cryptocurrency, is a form of digital currency invented in 2009 by an anonymous founder using the pseudonym Satoshi Nakamoto.
Cryptos aren’t managed by a bank or public agency. Instead, transactions of cryptocurrency tokens are recorded on a public blockchain – comprised of digital information stored on a database. Their future remains uncertain. “Tokens or coins used in a decentralized network are not the same as shares in a company,” says Michael Anderson, co-founder of Framework Ventures. “As such, growing and proliferating these networks requires new models for success, and we’re still in the first inning of proving them out.” Here are seven things to understand before investing in cryptocurrencies.
Cryptos are risky.
Investing in cryptocurrencies is very speculative. “Like the majority of startup companies, most crypto assets will fail and therefore become worthless,” Anderson says. “Non-professional investors should only invest an amount they’re willing to lose.” Despite stories of investors making millions, investing at an inopportune time can result in rapid and extreme losses. As late as May 2017, one unit of bitcoin (BTC) traded for roughly $1,500. At its peak in December 2017, bitcoin got as high as $19,800. Recently, BTC has ranged in price from $6,600 on April 15 to $10,000 on May 7. Although the chance of striking it rich by investing in cryptos is enticing, this market is extremely volatile and there’s a real possibility of great losses.
The uses for cryptos vary.
Cryptocurrency is known for funding illegal transactions. Yet legal businesses also accept cryptos for transactions. Cryptos offer speedy, low-cost money transfers. This makes using them for international money transfers popular. In fact, a $99 million litecoin (LTC) transaction took only two and a half minutes and cost the sender less than one dollar in transaction fees. Cryptos are free from authorities and can’t be frozen. That’s because only an owner with a private key to the wallet has access to the asset. Investors can also speculate in listed cryptocurrencies, betting on which ones will succeed and which ones will fail.
Cryptocurrency investors use many strategies.
Simple speculation is one approach to cryptocurrency investing. But just like investing in the stock market, there are specific strategies for cryptocurrency investors. Marcus Swanepoel, CEO at Luno, a global cryptocurrency company, says you can day-trade cryptos, buy and hold and evaluate the assets with fundamental and technical analysis. Despite the difficulty of predicting lows and highs in digital currency, Swanepoel claims there are methods of market analysis that can inform investors when to buy and sell. Strategies for evaluating cryptocurrency include concepts such as the supply, demand and future uses of the asset. For example, bitcoin’s supply is fixed at 21 million units, which implies that demand can drive prices due to the fixed supply. “Global economic events can exert a powerful influence on cryptocurrency prices,” Swanepoel adds.
The IRS doesn’t consider cryptos to be currency.
In the U.S., the Internal Revenue Service considers cryptocurrency as property. The tax rules that govern property investing also apply to cryptocurrency investing. “This ruling imposes extensive record-keeping requirements and the IRS is making tax enforcement of cryptocurrencies a high priority with steep penalties,” says Robert Elwood, partner at Practus, a Philadelphia law firm. “So transactions in taxable accounts should be undertaken only when the record-keeping burden is worthwhile.” If enacted, the Virtual Currency Tax Fairness Act of 2020 could encourage more cryptocurrency use because taxes would only be levied on the digital currency if the gain of a transaction is greater than $200. This would enable individuals to easily pay for smaller purchases with digital currency. That said, cryptos held in retirement accounts are protected from tax, as are other assets owned within these accounts.
Cryptos may fail.
As for any market, the future of cryptocurrency is not guaranteed. “I believe that cryptocurrencies will implode and no longer exist in any meaningful sense in a few years and that the entire cryptocurrency market is a bubble,” says Robert R. Johnson, professor of finance at Creighton University. Johnson thinks the cryptocurrency market is driven by the “greater fool theory,” as investors rely on new buyers to bid up the price. If Johnson is wrong and the cryptocurrency market doesn’t fail, there still remains the question of which digital currencies will survive. With thousands of entrants in the market, and new offerings emerging, not all will last. Investors who want to speculate in this market should probably stick with the most well-known names, such as bitcoin, ethereum and litecoin. It’s also wise to learn a bit about the market for each before investing.
Cryptos can vanish.
Blockchain is popular with a variety of financial institutions and other users. Since cryptocurrencies are virtual and lack a central storehouse, it’s possible for an account balance to be wiped out. For example, a computer crash without a backup could destroy a stash of cryptocurrency. If a user loses the private key to their wallet, the cryptocurrency they own is unrecoverable. Scammers can also hijack someone’s mobile account by impersonating an account holder. Thieves contact the carrier and request the user’s SIM card to be transferred to a new device. This gives scammers access to the cryptocurrency accounts. It’s incumbent upon investors to keep track of their private key and use a wallet from a well established firm. Professionals also suggest backing up your cryptocurrency private keys and using strong passwords.
Cryptocurrency prices can be driven by emotion.
Asset class bubbles have occurred over and over again throughout history. From the Dutch tulip bulb mania in the 1600s to the dot-com bubble in 2000, it’s not uncommon for popular assets to be bid up by enthusiastic investors. FOMO, or fear of missing out, can cause investors to jump on the cryptocurrency investing trend at the wrong time. Calculating the intrinsic value of cryptocurrency may be more difficult than for a publicly traded company, but learning about the asset and how it performs might help prevent you from investing at a peak. By incorporating industry knowledge and developing an understanding of the digital currency market, you will become a more educated cryptocurrency investor. Unfortunately, the fact remains that, unlike buying tangible assets with a long history, bitcoin is simply an entry in an online log with 11 years of history.
Keep these seven things in mind before buying cryptos:
- Cryptos are risky.
- The uses for cryptos vary.
- Cryptocurrency investors use many strategies.
- The IRS doesn’t consider cryptos to be currency.
- Cryptos may fail.
- Cryptos can vanish.
- Cryptocurrency prices can be driven by emotion.
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