You may be hearing a lot about cryptocurrencies like Bitcoin and Ethereum lately. And it all sounds complicated! Money Girl breaks down what crypto is, how it works, and whether investing in crypto is the right move.
Jimmy Y. says:
Cryptocurrency seems to be mentioned more in the news lately. Have you podcasted about cryptocurrency as an investment option?
Thanks for your question, Jimmy! You've probably heard that the value of Bitcoin recently skyrocketed. It was valued at just over $10,000 in October 2020 and is worth more than $50,000 as of March 3, 2021. That's 50 grand for one Bitcoin!
Every year we hear that cryptocurrencies, such as Bitcoin and Ethereum, are getting more popular for making purchases. While it's still far from mainstream acceptance, many businesses, such as PayPal, Microsoft, and Overstock.com, have added one or more cryptocurrencies to their platforms and take it as a form of online payment.
But does that mean you should invest in cryptocurrency? Let's talk about what cryptocurrency is, whether you should invest in it, and how to do so if you choose.
What is cryptocurrency?
Let's begin with a primer on cryptocurrency, which is digital money that runs on blockchain technology. (Stay with me and I'll explain what blockchain is in a moment.) Cryptocurrencies are exchanged directly online without a middleman, such as a bank, credit card company, or government.
One coin of a cryptocurrency is simply a line of code, not something you can see or put in your wallet. Think of a blockchain as a global checkbook created by computer algorithms.
A cryptocurrency is encrypted and decentralized, which means there isn't any central authority (such as the Federal Reserve) to manage its creation or value. Instead, transactions get recorded in code via a digital and open-source ledger called a blockchain.
Think of a blockchain as a global checkbook created by computer algorithms. Once a cryptocurrency verifies a transaction, it keeps a record of it in "blocks" that get linked together on a "chain" of previous transactions. One coin of a cryptocurrency is simply a line of code, not something you can see or put in your wallet.
Bitcoin was first created in 2009 by an unknown person who goes by the name Satoshi Nakamoto. While it's the most well-known cryptocurrency, there are thousands of different types in circulation. Bitcoins are created or "mined" by various people and companies worldwide using powerful computers that organize and validate the currency.
It would take a massive amount of resources for a cybercriminal to change the blockchain ledger and steal cryptocurrency.
What many people love about cryptocurrency is that it verifies transactions while keeping users anonymous. Plus, there's so much verification for each transaction that it can't be hacked, stolen, or duplicated. It would take a massive amount of resources for a cybercriminal to change the blockchain ledger and steal cryptocurrency.
Once you own crypto, you store it in a digital wallet and use it to buy goods and services. However, most people buy it as an investment. Like buying a stock, investors want to purchase it for a relatively low price and sell it for a higher price to make a profit. Or, investors buy and hold crypto with hopes that the value will go up, and then they'll spend it in the future.
Should you invest in cryptocurrency?
While the value of Bitcoin has risen steeply over the past few months, it remains a highly speculative investment. For the average investor, buying any cryptocurrency comes with lots of risks.
Don't even think about buying crypto unless you have a healthy emergency fund, no consumer debt, and are regularly investing 10% to 15% of your gross income for retirement.
Yes, I know it seems tempting to get in on an investment class that's poised to increase in value. While it could have massive gains, it could also have huge losses. Not only is crypto in its infancy, but like most mainstream currencies, it's incredibly volatile.
Another downside to investing in crypto is the lack of regulations governing it. In other words, it's the wild west. That means you should only invest money in crypto that you'd be willing to lose if the value plummets. Don't even think about buying crypto unless you have a healthy emergency fund, no consumer debt, and are regularly investing 10% to 15% of your gross income for retirement.
Remember that investing in crypto is like buying an individual stock, which is risky because you're putting money into one security. A much wiser investing strategy is to own thousands of securities, such as buying shares of a mutual fund or an exchange-traded fund (ETF).
How to invest in cryptocurrency
If you have money or a portion of your investment portfolio that you can afford to risk with crypto, there are various ways to buy it. One is to use a crypto exchange, such as Coinbase, which is easy to use even for novices.
Coinbase charges fees based on how you make a purchase and the amount. For instance, if you're in the U.S. and want to buy $100 of Bitcoin using your bank account or digital wallet, you'd pay $2.99. If you're going to use a debit card, the charge would be $3.99.
The bottom line is that average investors should always avoid unnecessary risks.
You can also invest in crypto funds, such as the Grayscale Bitcoin Trust (GBTC) or the Bitwise 10 Index Fund (BITW). However, some are only available to accredited investors who have income and net worth above a set threshold.
There are many companies in the crypto industry, such as Microsoft and IBM. So, investing in stock funds that own underlying shares of those companies allows you to get exposure to crypto at a fraction of the risk.
The bottom line is that average investors should always avoid unnecessary risks. The best strategy is to max out a retirement account, such as an IRA or a 401(k), every year. By making consistent contributions to a retirement plan using its diversified investment funds, you'll build wealth and create financial security in a slow but reliable way.