Wealth

Answering the Most Common Questions About Cryptocurrency

Although cryptocurrency is a trendy investment, it’s hard for many people to entirely grasp how it works. 

At its most basic level, cryptocurrency is a type of legal tender or exchange that is entirely digital. It leverages blockchain technology (more on this in a minute) to transfer funds and create units of currency. Bitcoin is one of the most popular forms of cryptocurrency, but many different types of cryptocurrencies are available. 

Proponents of cryptocurrency argue it allows easier financial access to those who may be unbanked or underbanked, and a way for those communities to build wealth they wouldn’t otherwise be able to. Opponents of crypto argue the highly unregulated nature of investments can actually harm the most vulnerable communities and there is no recourse for investors should their money disappear.

In short, cryptocurrency is a type of unregulated, digital money used outside of the traditional, regulated banking and investment system.

Blockchain is a complex technology which acts as a decentralized ledger that stores information securely and indefinitely. Information is recorded in “blocks” or chunks between computer networks, allowing for a secure record of transactions without using a third party. 

In other words, blockchain is used by cryptocurrency holders (for investing or payment) to create a peer-to-peer transfer of money that is secure and transparent. It is this security and transparency that is attractive to cryptocurrency holders because it bypasses traditional financial gatekeepers in favor of crowdsourcing. 

Blockchain also has many uses beyond cryptocurrency, including voting, data transfer, healthcare, and even logistics and supply chain tracking. There continue to be many untapped markets that blockchain may one day ultimately transform.

Cryptocurrency is fascinating to the general public because it’s still relatively new and remains an intriguing mystery to many. There is also an element of excitement around it given its often “rebellious” attitude towards the traditional financial establishment.

But due to the lack of regulation, it can also be an extremely volatile investment. Cryptocurrency is known to have dramatic ups and downs in value. As an example, here’s a brief history of Bitcoin’s value:

Chart of price history of bitcoin over time.

Source: Edwards, John. “Bitcoin’s Price History.” Investopedia, 20 Dec, 2022, https://www.investopedia.com/articles/forex/121815/bitcoins-price-history.asp

There have also been a number of recent scandals related to crypto companies taking advantage of investors, which has also generated media interest. In 2022 alone, reports show that $3.7 Billion was lost by investors to cryptocurrency scams.

Whatever the reasons for the uptick in cryptocurrency media coverage, its reputation regarding unregulated and significant scandals appears to be well earned.

Cryptocurrency is a speculative investment. In other words, it’s an investment that carries a high level of risk and is not guaranteed against loss in any way. Many different forms of speculative investments are available such as gold (or other commodities), GameStop stock, venture capital investing, and some real estate. 

That said, cryptocurrency is one speculative investment that people are drawn to because it has sometimes had rapid value growth. Unfortunately, the same volatility that allows for rapid growth also allows for rapid value decline. Cryptocurrency investors are often on a roller coaster because there isn’t a consistent history or set of data to rely on when making decisions about buying or selling. This becomes all the more relevant when people make or receive payments in cryptocurrencies as opposed to fiat currencies (such as printed, government backed currencies).

Many large financial institutions now offer some form of cryptocurrency option for investing and to grow your portfolio. However, it’s crucial to remember that even though cryptocurrency has become more mainstream, it doesn’t make it a safe investment. There is still a significant lack of regulation in the crypto world that puts investors at risk. 

It’s also important to remember that while cryptocurrency may feel exciting or like a “sure win” investment, the risk of loss – either through scam or a decline in value – could jeopardize achieving your lifestyle goals in the near or distant future. 

If you choose to pursue crypto-assets as part of your investment strategy, it’s wise to treat them like you would any other speculative investment. The bulk of your portfolio that’s dedicated to your long-term goals (i.e. education savings, retirement) should be in more traditional investments that are regulated and secure. Cryptocurrency investments are often viewed as “fun money” and should realistically make up less than 5% to 10% of your total portfolio’s value. 

Cryptocurrency, by design, is not a regulated form of money. It’s a digital currency specifically created to cut out third-party regulators and financial institutions. It operates outside of government regulation as well. Recently, US regulators warned banks and financial institutions against this lack of regulation

The consequences of this “wild west” crypto-asset world was recently exposed with the collapse of FTX in November of 2022. Although Sam Bankman-Fried, founder and former CEO of FTX, formally denied claims that he defrauded investors, billions of investment fund dollars were missing when the company ultimately declared bankruptcy. 

This type of incident may seem like an exception to the rule, however, the world of crypto-assets and investing is still so new that it’s impossible to say what the future holds.

There are many steps you can take to protect yourself in the world of cryptocurrency. The number one thing I tell my clients is this: having a hardware wallet is critical.

A hardware wallet is the same thing as having a real wallet, except that it’s digital. If you lose the password on your hardware wallet, it’s like you’ve lost your real wallet. A hardware wallet helps keep your digital assets with you instead of on a company’s exchange. If stored on the exchange, technically your crypto is under the control of the exchange company. For example, the FTX scandal became unsafe for people who had their money on that particular exchange instead of having it safely in their hardware wallet.

The other significant thing I tell my clients is this: only invest what you’re genuinely willing to lose. The risk of total loss in crypto is far greater than for those who invest in public markets. 

FDIC and SIPC insurance were put in place for banks and public markets after the Great Depression; there are no such guarantees for cryptocurrency exchange institutions. The traditional financial infrastructure is designed and protected by the government in ways crypto isn’t. Because you’re the sole guardian of your own “wallet”, only put the amount of money in that “wallet” that you’re willing to lose.

There’s a few other ways you can also protect yourself:

  • Set up two-factor authentication
  • Use an authenticator app for an extra level of protection
  • Back up your seed words (or your authentication key)
  • Use different passwords for your exchange account and wallet, and change them regularly 
  • Vet the software you’re using to ensure it’s legitimate

Remember, even with these steps, there is no guarantee you will be fully protected against cryptocurrency scams or market fluctuations.

New technology often takes time to establish itself as a safe and reliable means of doing business. As the internet began to appear in the mid to late 1990s, there was a rush to establish a new way for the world to do business. In the volatility of that rush, the dot.com bubble burst before the internet could truly find its way.

Today, the internet is far more stable and integrated into our daily lives than its early history ever suggested it would be. This doesn’t guarantee that cryptocurrency or digital assets will achieve that same level of stability or trust; at the very least, it will likely take much more time for these new ways of doing business to mature into something more reliable.

Above all, if you’re considering investing in digital assets, be sure to reach out to a fee-only, fiduciary financial advisor like Abacus to understand the safest and smartest ways to explore crypto investing.

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