With frequent mentions of digital assets in the 24-hour news cycle, many investors are curious about this complex topic. This article provides a basic primer on cryptocurrency and discusses the pros and cons that can help lead investors like you to a decision about whether crypto is right for your portfolio.
Crypto 101: The Average Consumers Guide to Cryptocurrency
Cryptocurrencies, or “crypto,” refers to secured digital assets created through decentralized blockchains that can be traded or used as a form of payment, among many other use cases. Since not all crypto are used as currency, we will refer to all crypto as digital assets. There are thousands of different digital assets and associated blockchains in circulation today, though most are not popular and many shouldn’t be considered as viable investments.
Digital assets can offer significant benefits as investments, though they come with more risk than many traditional asset classes. If you’re curious about digital assets and their associated blockchains, or you’re considering adding them to your portfolio, it’s important to carefully weigh the upsides and the drawbacks so that you can arrive at an informed decision.
The Blockchain Trilemma, as termed by Ethereum founder Vitalik Buterin, refers to the challenges developers face in creating a blockchain that is scalable, decentralized, and secure. Currently, developers have succeeded at building a blockchain that excels at two out of three, while compromising on the third. Bitcoin, for example, prioritized security and decentralization and compromised on scalability. Many digital assets and their teams are coming up with innovative ways of trying to solve the blockchain trilemma problem. (For more, check out this salient article: Gemini Cryptopedia – The Blockchain Trilemma)
The Pros of Digital Assets as an Investment
As mentioned above, there are many different digital assets, though they all share important characteristics. For purposes of this article, we’ll stay away from specific assets and share the broader benefits they all offer to investors.
A Truly Un-Correlated Asset
Correlation plays an important role in constructing a diversified portfolio. By adding non-correlated assets to a portfolio, you can potentially reduce overall volatility and improve risk-adjusted returns. What is correlation? It is a statistic that measures the degree to which two investments move in relation to each other ranging from -1 to +1. Positive correlation happens when the performance of two assets moves with each other. Negative correlation happens when the performance of two assets moves against each other. When two assets have no investment correlation, it is when their correlation is close to 0.
Throughout most of its history, Bitcoin has maintained a low correlation to traditional asset classes, including broad market equity/bond indices and commodities like oil and gold. From 2/1/2012 to 12/31/2020, Bitcoin’s highest correlation to any asset was with Oil, coming in at 0.03. We have seen correlations start to rise coinciding with digital asset adoption. However, in times of distress, correlations of all assets rise, including digital assets. In 2020, during the COVID-19 pandemic, Bitcoin’s most correlated asset was gold, coming in at 0.34. While this is still a very good number, it showcases that as these markets gain mass adoption and continue to mature, correlations will likely increase. For the short and intermediate-term, however, digital assets are still an attractive tool for portfolio diversification.
It’s Accessible to Everyone in the World
Digital assets are reshaping global investing and financial access. Anyone with an internet connection can participate in a digital asset network. Being permissionless and decentralized, digital assets bring financial services to people across the world who historically couldn’t access basic financial services. Non-financial use cases including browsers, VPN’s (virtual private networks), and digital art, continue to grow.
Twitter recently enabled “Bitcoin Tipping” functionality where someone in Chicago can instantly transfer Bitcoin to someone in El Salvador in under a few seconds, for free. This is (r)Evolutionary!
Digital assets can be broken down to 0.00000001, otherwise known as Satoshi’s, which means even though Bitcoin’s price may be $45,000 you can get started with just $1.00. This is important because you can get diversified with a small dollar amount owning the assets directly.
Exponential Growth Potential
Generally, early-stage investing is limited to accredited investors through venture capital or private placements. Some think investing in digital assets and blockchain technology is analogous to investing in the early days of the internet. Most blockchain projects are open-sourced, which means they are accessible to everyone, not just a limited set of investors or developers.
As with any important innovation, like the printing press or the internet, the potential for profit by investing early and in the right asset is exponential. It’s important to be mindful that, while great potential for growth exists, engaging in digital assets requires a disciplined process, long-term mindset, and ability to handle large losses.
If you aren’t comfortable investing directly into digital assets, there are a growing number of options in traditional stocks and ETFs that have exposure to digital assets. Examples include MicroStrategy or the BLOK ETF.
Cons of Cryptocurrency as an Investment
While there are plenty of reasons for investors to be excited about digital assets, it’s important to understand their downsides.
Digital Assets are Highly Volatile
What is volatility? Volatility is a measure of both risk and potential returns associated with an investment. If you’ve been watching or reading financial news this year, it may not come as a surprise to you that crypto is highly volatile. While Bitcoin has come with great returns, the journey has not been smooth with short-term volatility being as high as over 100%. To put this in context, the volatility of Small Cap US Stocks has peaked as high as 34% in the last five years. Digital assets are not for the faint of heart, or to be used with funds that are needed to meet expenses in the short term.
Another aspect of digital assets’ volatility is that investors have access to large amounts of leverage through exchanges not usually available in the traditional markets. Leverage is the use of debt to purchase an asset being held as an investment. Leveraged trading allows an investor to gain more exposure to an investment than they would’ve been able to afford if they had used only their available cash. Leverage increases both the upside and downside of a position and the returns on an asset with the potential for losses exceeding the original amount invested.
While these factors drive digital asset market volatility today, this will not always be the case as markets mature and become more efficient. We have already seen some exchanges decrease the amount of leverage individual investors have access to and countries around the world are progressively adding rules to govern how their citizens engage. As the long-term regulations around digital assets become clear, price volatility should decline.
Regulatory Environment in Flux
From a regulatory standpoint, the digital asset space is in its very early stages. Politicians and independent governing bodies are trying to catch up to the pace of innovation happening in digital assets and blockchain. While the United States has a history of being a leader in adopting new technologies, it is still unclear how they, and other developed economies, will approach regulation. China has made its position clear, banning digital assets in some shape or form over the last few years. Smaller Latin countries like El Salvador are pushing forward and making sweeping adoption laws. What is clear is governments who have been largely hands-off are now becoming active and paying greater attention, which is a healthy sign for digital assets. We should welcome regulation that allows for innovation to thrive while protecting investors from scammers and fraudulent activity.
Questionable Advice from Social Media
There are many great financial resources on social media platforms like YouTube, Facebook, and Instagram. However, for every great resource, there are two not-so-great resources. Be wary of offers showing exponential returns without discussing the risks or their process. Seek prudent, thoughtful sources of financial information, without the hype and attention-grabbing graphics.
Fertile Ground for Scammers
Security is paramount in this space due to it being prime real estate for scammers who prey on individuals who don’t fully understand its complexity. Be wary of involvement with companies or individuals whose strategies or promises seem too good to be true. With such a complex asset, bad actors may have the upper hand in defrauding well-intentioned investors. While digital assets provide new ways to provide security, that means there are new ways for malicious actors to take advantage of individuals who don’t understand how to elevate their computer, identity, and network security. So, know you may be wondering…
“How do I invest in coin technology?”
Savvy investing in any type of asset requires educating yourself and being intentional about the moves you make. If you’re viewing digital assets as a get-rich-quick scheme, take a step back and apply fundamental investment principles before moving forward. Digital assets are in the very early stages of adoption and are rapidly evolving. Know your risk, don’t invest more than you can afford to lose, understand the pros and cons discussed here, and make your own determination about whether you should participate in the digital assets market.