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Investing in cryptocurrency: Here's what you need to know
It’s no secret that digital currencies such as Bitcoin and Ethereum are gaining popularity. The cryptocurrency market’s valuation has grown to trillions of dollars in nearly the blink of an eye. It’s not just young, tech-savvy investors fueling this growth either. Investment banks, pension funds, and even university endowments are investing in cryptocurrency these days. After all, with such tremendous upside potential, few can resist the temptation to grab a slice of this pie.
Despite the seemingly widespread appeal, though, there is no single answer as to whether digital currencies represent a good investment or not. It doesn’t help that the underlying topic is extremely divisive either. While some believe that cryptocurrencies are worthless because they aren’t backed by anything tangible, others consider the lack of authorities as a key selling point.
So in the following sections of this article, let’s investigate the digital currency asset class’ growing appeal from the perspective of retail and institutional investors. Towards the end, we’ll also discuss the merits and risks associated with the market and what new investors can do to preserve their capital.
Why do cryptocurrencies have value today?
The first thing you should know about cryptocurrency is that the asset class is highly volatile. Unlike the stock market, which typically sees prices fluctuate by a few percentage points each day, a cryptocurrency could easily gain or lose 20 to 30% of its value within a few hours.
This is not to say that such movements are witnessed every day — just that they are far more frequent than you’d perhaps expect. If you have any experience with investing, this will likely not come across as a surprise — most assets with high reward potential carry some risk as well.
Like many other asset classes, the cryptocurrency market has a notorious history of cyclical behavior. These cycles tend to revolve around Bitcoin — the largest digital currency by valuation. We’ll discuss this effect on the overall market in the following section.
Bitcoin has a storied history and accounts for half of the entire market alone, so some correlation is expected.
For now, you may wonder why digital currencies have any value at all, high or low. After all, most assets aren’t backed by anything and have no “intrinsic value.”
However, value is incredibly subjective. Cryptocurrencies don’t have cash flow or a labor force behind them but have still managed to deliver value in the form of a disruptive new technology. And as with any nascent technology, volatility is par for the course. Just look at the dot-com bubble in the early 2000s — several companies crashed, but some, like Amazon, Google, and even Yahoo, lived on.
As long as cryptocurrency offers something unique to the world, either in the form of an anti-inflationary hedge or an inexpensive way to transact internationally, it will likely continue to appeal to some individuals. And that’s all an asset needs to establish its presence.
Is the cryptocurrency market a modern-day bubble?
If you asked this question only a few years ago, most people would agree and compare investing in cryptocurrency to the real estate bubble of 2008. Of late, however, that sentiment has changed. Former critics of the asset class have now either embraced it or, at the very least, acknowledged that it has a place.
For instance, JPMorgan’s CEO, Jamie Dimon, famously said in 2017 that he would fire employees if they admitted to trading Bitcoin. However, a mere two years later, the company announced JPM Coin — a stablecoin that uses the same underlying technology as most cryptocurrencies. The key difference here is that JPM Coin is backed by an investment bank, while decentralized stablecoins like DAI are not.
JPMorgan leadership’s blatant disdain for the market also hasn’t stopped the financial services firm from offering its customers direct access to cryptocurrency investments. This can only mean one thing — large investors are clamoring for crypto-related instruments, and institutions are responding to this demand.
Indeed, institutional investors have embraced cryptocurrencies at a staggering pace. It’s impossible to know precisely how much institutional money is invested in the cryptocurrency market, but even conservative estimates peg the number in the billions. After all, companies like Tesla and MicroStrategy alone hold upwards of $5 billion worth of Bitcoin on their balance sheets.
From the general public’s perspective, cryptocurrency popularity is on the rise, with millions of new retail investors pouring in every year. According to data collected from blockchain intelligence firm Chainalysis, global cryptocurrency usage has grown by at least 2,300% since 2019.
All of this paints the cryptocurrency market in a highly favorable light. However, it’s worth noting that this change in attitude took several years, and not everyone is on board yet.
What factors fuel cryptocurrency prices?
Digital currency prices are sometimes affected by economic growth or downturn, exemplified by the 2020 market crash during the COVID-19 pandemic.
However, the market’s larger price momentum generally comes from abrupt changes in supply and demand, along with a gradual shift in investor sentiment. What does this look like? Take a look at the following chart.
This chart depicts Bitcoin’s price on a logarithmic scale since 2011. The three vertical lines here represent Bitcoin halvings — or times when the rate of new Bitcoin entering circulation is cut in half. These halving events occur once every four years, and they’ve all been historically followed by bull runs.
Every time a halving event takes place, the supply of Bitcoin drops all of a sudden. Assuming investor appetite and demand does not drop, this naturally causes the asset’s price to inch upwards. Besides that, other factors such as growing public adoption and improving public sentiment also tend to spark a price rally.
And it’s not just Bitcoin; the rest of the crypto market is strongly correlated to this as well. However, the extent to which they rise or fall can vary dramatically, as some small-cap tokens have failed to reach their former highs due to abandonment or false marketing.
If Bitcoin performs poorly, so do other assets and vice-versa.
Does all of this mean that we will witness bull and bear market cycles every four years in the future as well? Of course, nobody knows for sure, but it is something to keep in mind if you invest in cryptocurrency. If the market has surged non-stop over the past few months, you should acknowledge the possibility that a bear market may be on the horizon.
Besides halvings, cryptocurrency prices are also often affected by regulation, broader acceptance, endorsements from famous personalities, and software updates.
Afraid of missing out? Don’t make a hasty decision
If you’re just getting into the cryptocurrency market, you may feel Bitcoin is “overvalued” or expensive at its current trading price. After all, there are thousands of other, smaller cryptocurrencies trading in the single or double digits, right? No, it’s not that simple.
While this is a very common sentiment among investors new to the cryptocurrency market, it is extremely misleading for several reasons. For one, the market price of a particular cryptocurrency represents the cost for one unit.
The important bit here is that you don’t have to buy one whole Bitcoin. The smallest possible fraction in Bitcoin is 0.00000001 BTC, worth only 0.00048 USD at the time of publication. The same applies to other cryptocurrencies as well. In practice, exchanges will allow you to purchase as little as one dollar worth of digital assets.
You don't need thousands of dollars to invest in the cryptocurrency market. Just buy a fraction of a token instead.
On the other hand, you may think that long-standing cryptocurrencies such as Ethereum have already reached high valuations. Their prices have already come such a long way, and they may only witness relatively modest gains in the future, right?
Again, it’s not that straightforward. Think about the alternative cryptocurrencies you would invest in — they aren’t as proven or battle-tested as the big names. The risk of losing a portion or the entirety of your capital is much higher in small-cap tokens. Whether that’s a risk you’re willing to take is up to you, but know that chasing 1000x gains is viewed as a moonshot or gamble, and not a sound investing strategy.
Claims that large-cap cryptocurrencies are overvalued have existed for several years at this point, and will likely continue to permeate. As you may know by now, though, these fears haven’t stopped established tokens from growing incrementally each cycle. And don’t forget that modest price increases in cryptocurrency still exceed record-breaking growth in other asset classes such as precious metals and equity.
How does investing in cryptocurrency work?
As you’d probably expect, investing in cryptocurrency is a bit different than buying stocks or gold. In contrast to equity, there aren’t any approved brokers or regulation-bound trading platforms like Charles Schwab or TD Ameritrade. Still, the crypto market is no longer a “wild west,” and there are plenty of reputable platforms where you can buy and sell digital assets.
You’ll quickly find that most investors use long-established exchanges like Binance, Coinbase, Kraken, and Gemini. Unlike the aforementioned stock-focused platforms, exchanges usually cater to multiple geographies.
If you live in North America or Europe, you should have many exchanges to choose from. For a more in-depth walkthrough, check out our guide on how to invest in cryptocurrency.
Token selection and securing your investment
While cryptocurrency exchanges may look identical to a standard stock-trading platform, their legal compliance requirements are far more lax. Why does this matter? Primarily, investor protections and asset security.
An exchange can list new digital currencies at its own discretion. It’s up to you — the investor — to carry out your due diligence and figure out if the token is worthwhile or not.
See also: How to invest $100?
Take Bitconnect, for instance — a now-defunct token that derived its value from a Ponzi scheme. Several exchanges listed the token, and it wasn’t until regulators stepped in that investors realized the whole scheme was fraudulent.
These days, fraudulent token recommendations aren’t quite as obvious from the outset. You primarily need to be wary of pump and dump schemes. These are usually public chat rooms where a handful of individuals, sometimes aided by social media influencers, encourage coordinated buying at a specific time. Investors are misled into believing they’re increasing a token’s price to a new high when, in fact, the demand is entirely artificial.
As the buying pressure recedes, the scammers offload their tokens at these inflated prices. Everyone else is then left with tokens worth less than what they originally paid. The moral here is to make informed investment decisions and avoid tokens or individuals claiming to offer guaranteed and unrealistic returns.
As for asset security, cryptocurrencies allow you to take personal custody of your holdings, and you should absolutely try doing so. Digital wallets offer the ability to store and transfer your holdings, but more importantly, they are less of a target for hackers.
Hardware wallets are a one-time purchase and offer maximum security.
Simply leaving your cryptocurrency on an exchange, on the other hand, is considered risky because the platform is a much larger target for hackers and could also go bankrupt. Both scenarios have played out countless times in the past, with investors collectively losing millions each time.
Read more: What is a cryptocurrency wallet?
Is cryptocurrency a safe investment?
If there is one thing you should take away from this article, it’s that digital currencies are far from the safest of investments. And depending on the tokens you decide to invest in, the risk can increase exponentially.
So how should you responsibly invest in the cryptocurrency market? This first bit of advice may seem obvious, but it’s worth reiterating: don’t invest more money than you’re willing to lose. This doesn’t mean that you should treat crypto investments as gambles — just that you should never overextend your position by taking out a loan to invest.
If you’re just getting started with cryptocurrency and already have a well-diversified investment portfolio, the expert consensus is to limit your exposure to around 5% of your portfolio. If you’re particularly risk-averse or foresee needing the money in the near future, it may be worth starting with an even smaller percentage. Because the cryptocurrency market tends to perform so well, even a small allocation is worthwhile.
Cameron Winklevoss, the co-founder of cryptocurrency exchange Gemini and Bitcoin billionaire, agreed on this aspect. In an interview with The Motley Fool, he said,
I can’t think of another investment that offers that asymmetric return over the next decade. If that’s 1% of your portfolio, that becomes 10%. That’s a pretty awesome return, a worst-case scenario you’ve lost 1%, but you’ve got that 10% or 10x upside.
On the other hand, if cryptocurrency is your first-ever investment, it’s important not to pile your entire life’s savings into the asset class. Besides building a rainy day fund for emergencies, hedge your cryptocurrency bets with alternative instruments such as index funds. While the potential returns are lower, they’re also much less volatile, and you can’t put a price on a peaceful night’s sleep.
Proper risk management is the hallmark of a good investor, and you should always consider the worst-case scenario before committing to any investment. That scenario can easily look like months or even years of slow price decay in cryptocurrency.
On the flip side, though, if you heed some of the advice mentioned in this article, there’s definitely potential for upside.
Read next: What is a central bank digital currency?
Disclaimer: The author owned some cryptocurrency at the time of publication. The text of this article is meant to reflect general facts and consensus — readers are encouraged to perform their own due diligence before investing.