What You Need to Know Before Investing in Cryptocurrency

Uncovering the next new asset that catches fire can accelerate your wealth accumulation. And, with all the enthusiasm surrounding cryptocurrencies, you may have considered it as a potential asset to provide a portfolio enhancement.

You’re not alone in that thinking. For many, cryptocurrencies hold such an allure. You only have to eye the price of bitcoin, which reached multiple all-time highs in 2021, to understand the appeal people see in the digital currency.

Some millennial investors even view it as a hedge against a volatile economy, with 63% believing it’s safer than gold when investment fears heighten. But it’s also important to understand what you might place money into and determine whether that volatility protection exists before committing any funds. To help with the process, we look at cryptocurrencies, explaining what they do, why people invest in them, and other issues to consider.

What is cryptocurrency?

Cryptocurrencies are essentially software code. They’re created on a technology called the blockchain, or a decentralized online ledger hosted on thousands of computers and servers worldwide. This technology allows, say, two people to interact or conduct business or track money without the need of a third party to oversee the transaction. To track movement, like a transaction, the ledger incorporates code to represent a monetary supplement. This is the crypto coin. As blockchains have grown more mainstream, so have the cryptocurrencies that run on the software.

In some cases, the company behind the cryptocurrency works towards a profit, building the business and encouraging more use of the blockchain technology, which further encourages the use of the cryptocurrency. In other cases, the decentralized digital ledger only serves to discover, buy, trade, or spend the corresponding crypto. Bitcoin functions under this latter design, as the coin's creator—who remains unknown—sought a version of currency that stood outside of central banks, which countries could use to distribute money.

The blockchain and various other altcoins, or digital coins that aren’t bitcoin, grew from that original idea. The options you can choose from range in the tens of thousands. The credibility of these altcoins also spans the entire scale, from outright scams to joke cryptos to legitimate offerings.

Among these altcoin options, you also have choices between what the crypto represents. When the crypto describes currency, it’s dubbed a coin. When it indicates assets outside of currency, like customer loyalty points or even memes sold at auction under the term non-fungible tokens (NFT)s, it’s referred to as a token.

Most cryptocurrencies aren’t backed or supported by an asset of any kind. Bitcoin, for instance, has no assets protecting its value. It’s solely reliant on demand. It’s only worth what another will pay or exchange for it. But other cryptos have cropped up, called stablecoins, which use dollars or gold to support the coin. Because of this asset support, it may reduce volatility in the price of the coin.

Why are people investing in crypto?

When bitcoin first came to market, the investors purchasing the coin were those truly vested in blockchain technology. These investors sought a way to gain access to an asset that stood outside the scope of interest rates and other aspects of the financial system, which central banks command.

That has changed in recent years. Now investors of all ilks have joined the dialogue around crypto. Theoretically, cryptocurrency has no relation to interest rates, which the central bank uses to encourage or discourage lending. Due to this, some suggest it may provide an inflation hedge since it doesn’t have a relation to the dollar (except for some stablecoins).

Of course, this doesn’t mean that cryptocurrencies don’t have risk. Since it doesn’t have a tie to an asset, there’s a question of what could occur if demand for the coin plummets or if regulation from the central banks kicks in. Central banks from China to the U.S. have indicated that they may—or have—taken steps to limit cryptocurrencies. In some cases, central banks have even considered issuing a state-run cryptocurrency.

What are the most popular cryptocurrencies?

Owning cryptocurrencies require unique steps that you don’t have to take with other assets. For instance, as an owner of a coin, you should consider taking steps to securely exchange or spend the crypto using a crypto wallet. These wallets provide a code called a private key, which only you have access to. This key is what unlocks the ability to spend or sell your coin. Unfortunately, if you lose the code, then it means you lose your cryptocurrency for good.

Because the crypto space remains a hotbed for hackers, without the right security in place, your coins could be stolen, and there’s little to nothing you can do to get them back.

Luckily, tools have come to the market, making it a slightly safer and more easily accessed investment. Platforms, like the exchange Coinbase, provide a place that users can easily buy, sell, trade, and store many cryptocurrencies. Here you can buy the most popular names, including bitcoin (BTC), ethereum (ETH), tether (USDT), and binance coin (BNB), as well as many lesser-known altcoins. However, it remains on you to store your private key where only you can access it, and you’ll never lose it.

Caveats to consider when you want to invest in cryptocurrency

Unlike most investments you’ve probably made, cryptocurrency works differently because you can also spend it. PayPal, Microsoft, Starbucks, and The Home Depot all accept bitcoin in some way or another. This adds complexity to your investment in the US. The IRS labels crypto as personal property instead of a currency, so whenever you spend bitcoin or ethereum, it acts as an investment sale, resulting in a capital gain or loss. If you didn’t own the coin for more than a year, its capital gain is taxed as regular income.^[i]

It’s one of the issues that investors face when buying bitcoin, as many of the tools used in regular investing are still coming into form within the crypto space. When you’re buying or selling, for instance, due to the volatility of the coin, the price you buy or sell at can shift dramatically by the time you secure the purchase or you sell. It’s an important consideration while investing in cryptos since you’ll face complexities that other investments lack.

To learn more about new and emerging trends, turn to Private Client for insights and information that can help guide your financial decisions.