The Allure (and Danger) of Cryptocurrency

Interest in cryptocurrencies like Bitcoin, Ethereum, and Dogecoin has only continued to grow in recent years. (Read our post on Bitcoin and cryptocurrency basics here.) New and interesting stories appear in the media daily surrounding cryptocurrencies, such as Dogecoin’s value dropping 30% after Elon Musk’s SNL appearance, and Coinbase stock price dropping after its April IPO. All this attention has many investors wondering what, if any, place cryptocurrencies have in a diversified portfolio, or are they merely speculative investments?

Why Do People Invest in Bitcoin?

Although there are many different cryptocurrencies, Bitcoin is by far the most popular. Investors have varying motivations for investing in Bitcoin, but here are a few common reasons:

  • Decentralized Banking: Many proponents of Bitcoin support it because they see it as an improvement over our current centralized banking system. Traditional banking puts all the power in the hands of big banks, and they serve as intermediaries to all transactions. Bitcoin, along with blockchain technology, allows secure fund transfers without any middlemen or potential government intervention. (This is also why some use Bitcoin for nefarious purposes, like money laundering.)
  • Hedge Against Inflation: Some believe Bitcoin can serve as a hedge against inflation, similar to gold. With the current code, the amount of Bitcoin released decreases over time, until it reaches 21 million, at which time no more will be released. The idea here is that the limited supply will help Bitcoin hold its value against inflation better than, say, the US dollar, whose increased supply eats away at the value over time.
  • Speculation: Some investors have seen the price of Bitcoin continue to go up; they buy it because they believe it will continue to increase in the future.

Coinbase IPO

The Coinbase IPO in April 2021 was a signal of the growing popularity of cryptocurrencies and will likely lead to an increase in the number of cryptocurrency investors. Coinbase allows investors to buy, sell, and store cryptocurrencies on their platform, similar to a custodian like Schwab or Vanguard. This platform decreases the barrier to entry for many investors who are interested in buying cryptocurrency but don’t want to purchase it directly and hold it in their own digital wallet.

Risks Involved in Investing in Cryptocurrencies

Investing in anything involves risk, but a number of factors make putting money into cryptocurrency even riskier than more traditional investments.

  • Volatility: Unlike stocks and bonds, cryptocurrencies don’t have an underlying value on which to base their prices, which means the volatility we see is based on speculation. While Bitcoin has similar properties to other currencies, it can’t really be used like a traditional fiat currency, due to extreme volatility, among other reasons.
  • Regulatory Risk: While many Bitcoin investors like that it’s decentralized, the newness and lack of regulation make it inherently risky. We don’t know what sort of rules or restrictions governments may place on cryptocurrencies in the future, but they could decrease demand significantly. (Source: Vanguard)
  • Loss of Access: It’s estimated that about 20% of Bitcoin, or $140 billion, is inaccessible by buyers who have forgotten their key. (Source: The New York Times)

Environmental Concerns

How bad is the environmental impact? Here are some comparisons to put it in perspective:

  • Annual Bitcoin emissions are higher than American Airlines.
  • Bitcoin has roughly the same annual energy consumption as the Netherlands.
  • Over the past 2 years, Bitcoin’s energy usage has grown more than 200%.

Source: Entrepreneur

If You Want to Invest in Crypto

If you’re interested in investing in cryptocurrency despite the risks, it makes sense to treat it like an individual stock investment. Decide on a percentage of your portfolio to put in as “fun money” (no more than 5% of your investible assets) and keep everything else invested in a diversified portfolio based on your risk tolerance. It is possible that the cryptocurrency you purchase could become worthless, so never invest more than you’d be willing to lose. If your crypto investment spikes and your “fun money” becomes a higher allocation of your overall portfolio, rebalance back to your target allocation by selling a portion and investing the proceeds in your portfolio. Doing so will lock in your gains and reduce your risk.

Be aware that like other investments, you will owe taxes on any gains associated with cryptocurrency investments, and you must report them on your tax return.