Should I Invest in Crypto?

Cryptocurrencies have been a hot topic in the investing world lately. As a financial advisor, who works with younger clients, I’m constantly asked whether people should invest their money in Bitcoin or Ethereum or the latest NFT craze.

Here’s my personal take. Cryptocurrency and the related endeavors (DeFi, Web 3, etc) are an interesting development with a number of very promising possibilities. But like any relatively new, highly volatile pursuit, it entails considerable risk.

But, the question of whether you should invest isn’t a question I can answer for you as everyone has different financial goals and risk tolerance levels. Instead I’ll try to provide some information about cryptocurrencies that might help you make your decision easier.

What are Cryptocurrencies?

Let’s start with the basics.

Cryptocurrencies are digital or virtual tokens that use cryptography to secure their transactions and to control the creation of new units. Every transaction is recorded in a public ledger for all to see. Of course, all they can see is a string of code — so the transaction is anonymous.

Cryptocurrency was introduced in 2009 by a pseudonymous Satoshi Nakamoto. Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security or encryption. Pair “encryption” with “currency,” and you’ve got cryptocurrency.

It was designed to be a new form of digital currency that was peer-to-peer built on a new technology called a blockchain. It was decentralized and eliminated the need to trust any third party in order to work. Everything was on the ledger for all to see. There was no way to cheat the system.

With Bitcoin as the foundation of an entire decentralized world of trustless protocols begins to emerge. Bitcoin created a revolutionary system and Ethereum — and other protocols that came later — let us put anything we wanted onto it. Within just a few years we began to get a glimpse of how blockchain technology could disrupt finance, music, commerce and so much more.

What’s a Blockchain?

Using Bitcoin to illustrate, a block is essentially a bitcoin transaction waiting to be settled. Think of it as being like a written, but uncashed check; it’s not real money until the transaction is verified and added to a permanent ledger.

Except there is no bank to complete the transaction. Instead, bitcoin “miners” compete against one another for the role. Each block is secured with a complex mathematical equation. The first miner to solve the equation gets to add the new block to a blockchain. The winning miner is then rewarded handsomely for their effort. They are paid with bitcoin, which can currently be valued at tens of thousands of dollars for settling a single block.

The CFA Institute’s Cryptoassets Guide describes cryptocurrency security as follows:

“This is the real breakthrough of blockchains: creating timely, bad-actor-proof consensus across all copies of a decentralized and distributed database. … Today, more than 40,000 computers are independently verifying every single bitcoin transaction.”

In other words, blockchains create a strong, yet globally decentralized check-and-balance system. The competition among thousands of miners keeps everyone relatively honest, as any attempted “cheating” by cryptocurrency holders or miners should be promptly detected. This is known as proof of work. Proof of Work is the algorithm that Bitcoin and Ethereum originally used. In order for new blocks to be created on the blockchain, miners need to solve a complex mathematical problem. The first miner to do so is rewarded with new coins and transaction fees. This process consumes large amounts of energy, which has led to criticism that Bitcoin’s Proof of Work model isn’t good for the environment. Although, some very smart minds claim this doesn’t have to be the case.

Proof of Stake replaces miners with “validators.” In order to validate a block, the validator needs to have skin in the game. In Proof of Stake, miners commit a certain amount of tokens to be used as collateral in order to validate blocks and mine coins. If they do not follow protocol rules (for example: validating two conflicting transactions), then their stake is at risk and they could lose all their skin — i.e., money or tokens staked.

Proof of Stake can be less energy-intensive than Proof of Work, which is why some coins are moving to the model (for example: EOS). It also allows smaller players to participate in the rewards because it’s relatively easy to stake your coins.

But, back to our original question…should you invest in cryptocurrencies?

Well, it depends.

Is crypto risky?

Over the past couple of years, cryptocurrencies have experienced unprecedented growth in value. Bitcoin went from being priced at pennies per coin to a recent high of nearly $65,000. But, there have been some incredible drawdowns and stomach-churning volatility on the road to $65,000.00. Because of the volatility in cryptocurrency, coins can experience large swings in price daily.  It is not uncommon for there to be 10-15%+ daily moves in some of the more established coins — smaller coins are even more volatile. This means if you don’t have the stomach for risk — I’d stay far away from cryptocurrencies! It’s not for the faint of heart.

If you invest, you need to be okay with losing all of your investment. In my estimation, cryptocurrency remains more of a speculative venture than a disciplined investment. And remember this, cryptocurrencies are not regulated by any government or financial institution. You could see the lack of regulation or centralized authority as a benefit, but that also means there is no guarantee — nobody is backing your investment. If it all comes collapsing down (and I can guarantee you much of what currently exists, will disappear) — no government agency is coming to your rescue.

But, what if I really want to invest in Bitcoin…

If you’re still set on investing. Where should you start?

Again, this isn’t investment advice and I cannot tell you what to do. But, if you are going to invest in cryptocurrencies, I would suggest looking at Bitcoin (BTC) and Ethereum (ETH).. They’re some of the more established protocols out there and have less risk than some of the lesser-known coins. All three of these coins have been around for a while and have shown some resiliency.

But, I wouldn’t take a big position and instead, I would dollar cost average into your position. For example, let’s say you want to allocate 1-3% of your net worth into cryptocurrencies. Instead of buying the coins all at once, I’d buy a bit more once or twice a month over twelve months whenever there’s a significant dip. You may miss out on some upside, but you could also limit your losses and lower your cost basis if there’s a big drawdown.

I’ll write a follow-up post explaining some of the various ways you can begin investing in cryptocurrencies. And if there’s enough interest, maybe I’ll do a YouTube video where I walk you through the process.