Cryptocurrency, once an obscure corner of the financial world, is going mainstream.
Artists are making millions selling “tokenized” digital works. And crypto exchanges are advertising on prime-time TV alongside banks and insurers.
But individual investors considering crypto are likely to encounter a world different from what they’ve seen in traditional finance. Prices can fluctuate wildly amid rapid trading in assets backed only by blocks of computer code.
Despite the complexity, experts following the sector say the approach to investing in cryptocurrency isn’t so different from other investments that have a high-risk profile: Don’t invest money you can’t afford to lose, make sure you’ve got your other financial bases covered and remain patient.
“Most of the information that people come across is about crypto trading. It’s about how to buy the next hot crypto. It’s about how to identify the next coin that’s going to the moon,” says Steve Larsen, a certified financial planner in Washington state. “Crypto investing is very different. It’s about buying something that has some fundamentals that you think are going to have value over the long term.”
Larsen, who trains investment advisors to talk to their clients about digital assets, says he believes that the underlying technology, known as blockchain, has potential. In a blockchain network, computers work together to authenticate transactions without the help (and massive costs) of central authorities such as banks or government regulators.
1. Are you in a position to buy crypto?
Generally, if you decide to buy crypto, it belongs in a cluster of relatively risky assets that make up a small percentage of your overall portfolio — 5 to 10 percent is one common guideline.
Larsen says he doesn’t recommend that anyone invest in cryptocurrency before meeting other goals for both short- and long-term financial health. He says investors should extinguish any consumer debt, for instance, and make sure they’re investing enough to get their employers’ matching contributions to retirement accounts such as 401(k)s.
Beyond that, buying into crypto doesn’t require a substantial financial commitment. Some online exchanges allow customers to buy in increments of a dollar or less.
Mati Greenspan, chief executive of the research firm Quantum Economics, says one way to get into crypto is to put aside a few spare dollars per week.
2. Have you done your homework?
Crypto exchanges in recent years have made buying, holding and selling easier. However, if you don’t want to delegate the security of your funds to the operators of the exchange, you’ll have to do some research into how digital wallets work and which one is best for you.
More broadly, though, it helps to understand what blockchain technology is, how competing products are using it and which ones have a shot at success. In addition, there’s a lot of hype around cryptocurrencies, which means investors should have their eyes open for red flags.
“This industry is riddled with coins that have no use case and in many cases are actual outright scams, meaning that they’re just people that are out to get your money,” says Greenspan, who’s based in Tel Aviv, Israel. The trick, he says, is to find the true innovators.
While you might not need a background in coding, it’s worth the effort to look into how a cryptocurrency can be used. One way to do this is to read the white paper, an often technical document laying out how a network will operate.
Bitcoin, for instance, is built to be actual digital money used as payment for goods and services.
Ether, the second-most valuable cryptocurrency, can also be used as payment or to compensate users who help run the Ethereum network. The network is built to execute “smart contracts” that can be settled automatically when certain conditions are met.
Greenspan recommends looking at how the supply of a cryptocurrency is distributed, including whether there’s a maximum supply that can circulate.
He says such inquiries “might be very tedious, but they’ll certainly give you a major spotlight into what’s going to happen with the price of the coin over time.”
3. How will you diversify?
All cryptocurrency faces one inherent risk: Blockchain technology is pretty new, and no one knows for sure that it will deliver the economic benefits that its supporters are counting on.
“Any investment … in any crypto asset out there is a bet on the future that transactions, assets and information at large is going to be increasingly stored and transmitted on an underlying blockchain,” says Sean Stein Smith, an assistant professor in business and economics at Lehman College in New York City.
And even if blockchain meets the expectations of people investing in the field, there will still be cryptocurrencies that don’t pan out. Greenspan recommends distributing your investments among several assets that you believe have long-term potential.
Regardless of how you approach cryptocurrency, investment diversification should be considered across your entire portfolio, and alternative investments should typically comprise only one small part of that.
4. Are you prepared for the price swings?
There’s no overstating how volatile cryptocurrency is. The price of Bitcoin went from $50,000 to almost $60,000 and down to $30,000 within a few weeks.
Before you buy Bitcoin, think about how you’d react if the price dropped by 50%, or 80%, or 90%. Would you sell in an attempt to salvage what’s left? Or would you stick with it and consider buying more while the price was lower?
Situations like these happen to most crypto investors. That’s why you need to believe in Bitcoin as a long-term investment and have an investing strategy you’re prepared to follow. Otherwise, you may be tempted to sell at the first sign of trouble.
5. Can you afford to lose the money?
Because of the volatility, Bitcoin is not the place to put money you’re going to need any time soon. My preferred approach with Bitcoin and other high-risk investments is to only put in as much as I’m willing to lose.
To be able to afford that, both of the following need to be true:
- You have an emergency fund with enough money to cover three to six months of living expenses. If not, any financial issues could put you in a position where you need to pull out the money you invested in Bitcoin.
- You have a balanced portfolio with no more than 5% to 10% in high-risk investments, including Bitcoin. That way, it’s only a minor setback if Bitcoin doesn’t work out, and not something that ruins your portfolio.
To end off, I have to emphasize that even though Cryptocurrency is a new and exciting way to think about money. The first and most important step is to educate yourself on these emerging digital currencies and the technologies they use so that you can understand the risks and rewards. If one thing is for sure, cryptocurrency is not going away. As more businesses accept cryptocurrency and the blockchain technology that facilitates its operation, you may inevitably have to learn the dynamics of the crypto world and even consider investing in it.