What Is Cryptocurrency?

An investment with a lot of hype

Visual illustration of what Bitcoin and cryptocurrency could look like
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If you’ve heard of cryptocurrency or Bitcoin, you might be wondering what all the hype is about. Cryptocurrency is a digital, or virtual currency. In theory, it could be used in place of government-issued currencies like the U.S. dollar. However, it isn’t yet widely accepted by merchants. Instead, most of the interest has been from investors in Bitcoin, the oldest and most well-known cryptocurrency.

Here’s what you need to know about how cryptocurrency works and how it might fit into your investment portfolio.

The History of Cryptocurrency 

In a basic sense, cryptocurrency is simply electronic money, a concept that has been around since the 1990s. Various versions of cryptocurrencies came and went over the years without garnering much attention until Bitcoin came along in 2009.

The precise history of Bitcoin has been shrouded in some mystery, but its invention has been traced back to a white paper written by Satoshi Nakamoto (now also known as Craig Steven Wright).  The vision of Bitcoin was to create a decentralized currency system that did not require the involvement of banks or any other intermediaries. The currency would operate using a distributed ledger with underlying technology known as a blockchain.

The idea of Bitcoin was to allow money to change hands without a bank’s involvement. Instead, all transactions would have a unique cryptographic signature, allowing for the creation of an indisputable record.

Since Bitcoin’s arrival, many other cryptocurrencies, such as Ethereum and Ripple, have arrived on the scene.

Who Should Invest in Cryptocurrency?

Cryptocurrency may not be a sensible investment for the average person. While it may be possible to make money quickly from it, values are also highly volatile, so you can lose money as quickly as you can earn it. 

That said, some experts consider cryptocurrency to be an “alternative” investment lumped in with precious metals, private equity, collectibles, and any other investments not easily available on major exchanges.

If you have a sizable amount of money and a diverse set of investments already, adding a small investment of alternative purchases such as cryptocurrency may help diversify your portfolio even more.

Pros and Cons of Investing in Cryptocurrency

Pros

  • Potential for high returns

  • Offers diversification

Cons

  • Enormous volatility

  • May be hard to understand

  • May be difficult to purchase

  • No known benchmark for valuation

Potential for High Returns

No investment return can be guaranteed. But the value of Bitcoin, in particular, has seen remarkable growth—and volatility—in recent years. Someone who invested $10,000 in Bitcoin at the end of 2016 would have seen their investment rise to more than $75,000 in December 2019.

Offers Diversification

As mentioned above, cryptocurrency can potentially enhance a portfolio simply by being different than what you may already be invested in. The returns on cryptocurrency appear to be relatively uncorrelated to other asset classes, such as equities. Thus, using a modest amount as a diversifier could add to overall returns, or stave off bigger losses.

Enormous Volatility

If you invest in cryptocurrency, settle in for a wild ride. Its value has gone up and down dramatically in recent years. For example, at one point in December 2017, one bitcoin was valued at more than $14,000. It then fell to less than $3,600 at the start of 2019 and was back above $12,000 by July of that year.

It May Be Hard to Understand

In general, it’s a good idea to invest in things you are familiar with. If you are investing in a company, for example, it is important to understand what it does and how it makes money.

Understanding the ins and outs of cryptocurrency, however, may be a challenge since it’s a digital and virtual currency, unlike a physical product or service. Investors may need (and want) to understand blockchain and other terms associated with crypto before investing.

It’s May Be More Difficult to Purchase

Crypto investments don’t trade on major stock exchanges, so you can’t just buy them through any brokerage like a stock. In general, you’ll need to buy them through an online exchange, using a digital wallet.

There’s No Benchmark for Valuation

Unlike traditional assets like stocks or real estate, there’s no uniform understanding of how to value cryptocurrency properly. That makes it very difficult to know whether you’re paying more than the investment is really worth.

Cryptocurrency has often been criticized for the one key thing that makes it unique to traditional currencies—its anonymity. Bitcoin and other cryptocurrencies have been used to purchase things on the “dark web,” including weapons, drugs, and other illegal items. These actions have led to concern over cryptocurrency as a possible tool for organized crime. 

Alternatives to Consider

If you believe in the potential of cryptocurrency but do not wish to invest directly in it, there are some options to consider. You can consider investing in companies that are leveraging cryptocurrency and its underlying technology to improve business results. For example, banks and other financial services companies have incorporated blockchain technology into their transactions. Blockchain also has applications for companies involved in cloud computing.

The Bottom Line

When it comes to investing in crypto, consider all of your options first. Determine if it’s the right fit for your portfolio and if you have room in your budget for the risk that comes with it. Also, consider your long-term financial goals. With the right strategy in place, you may see valuable returns on your investments.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. 

Article Sources

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  9. Wells Fargo. "Wells Fargo to Pilot Internal Settlement Service Using Distributed Ledger Technology," Accessed Dec. 4, 2019.

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