In the first three parts of this Diversifying Wealth series, we discussed several traditional alternative investments to stocks: Real Estate, Bonds, & Precious Metals. Each of these asset classes have existed as an important “value creator” for centuries.
However, a new asset class has emerged within the past 15 years: cryptocurrencies. These digital currencies are as intriguing as they are polarizing, having quickly transformed from an obscure hobby for tech enthusiasts into a global phenomenon that has captured the imagination of investors, businesses, and governments alike.
This blog post will delve into the world of cryptocurrencies, exploring the technological breakthroughs and economic theories behind them, their potential to reshape the concept of money, and the opportunities and challenges they present to investors. Whether you’re a seasoned crypto investor or new to the blockchain, join us as we navigate the complex, thrilling, and often unpredictable world of cryptocurrencies!
A Brief History of Cryptocurrencies
Bitcoin, the first and most well-known cryptocurrency, was introduced in a 2008 white paper published under the pseudonym Satoshi Nakamoto. Nakamoto’s vision was to create a decentralized digital currency that could operate independently of central banks and governments, using a peer-to-peer network to verify transactions. The cryptocurrency was hardcoded to have a deflationary finite supply of 21,000,000 coins, with the amount of new bitcoin supply being cut in half every ~4 years until the year 2140.
In January 2009, Nakamoto mined the first block of the Bitcoin blockchain, marking the birth of Bitcoin. Its early years were dominated by enthusiasts and speculators, with the first notable transaction being the purchase of two pizzas for 10,000 bitcoins in 2010 (now worth $711,971,806).
Since then, Bitcoin has seen explosive growth, reaching unprecedented heights in market value, and becoming a household name. Its success has sparked widespread interest in the blockchain technology powering the Bitcoin network, inspiring the creation of thousands of other cryptocurrencies commonly referred to as “Altcoins”.
One such cryptocurrency is Ethereum, proposed in late 2013 by programmer Vitalik Buterin. He sought to build upon Bitcoin’s foundation by introducing a platform that could execute smart contracts, which are self-executing contracts with the terms of the agreement directly written into code. Launched in 2015, Ethereum expanded the potential applications of blockchain technology far beyond the scope of simple financial transactions.
Ethereum’s native currency, Ether, facilitates operations on the Ethereum network but is also traded as a cryptocurrency. Ethereum’s introduction of smart contracts has enabled the development of decentralized applications (dApps) and decentralized finance (DeFi) platforms, making it a backbone of the modern crypto ecosystem.
Other cryptocurrencies have emerged, each aiming to address perceived limitations of earlier cryptocurrencies, introduce entirely new functionalities, or exist entirely as a meme. Some notable examples include:
Ripple (XRP) - Designed for fast, inexpensive international money transfers, targeting the traditional banking system’s inefficiencies.
Solana (SOL) - Ethereum competitor utilizing two separate consensus mechanisms for scalability and faster transaction processing.
Cardano (ADA) - Another Etheruem competitor focusing on security and scalability through a research-driven approach to design and development.
Polkadot (DOT) - Aimed at connecting all different blockchains and allowing data transfers.
Chainlink (LINK) - Network designed to be the bridge that links real-world data with smart contracts.
Tether (USDT) - Stablecoin that is pegged to the price of the US dollar, frequently used by traders to move in and out of positions without converting to traditional currency.
Dogecoin (DOGE) - Meme coin that started as a joke, but has garnered significant mainstream attention.
📖 Bonus read: Meme Coin Explained
How to Invest
The most common way to invest in cryptocurrencies is by purchasing directly through a crypto exchange (such as Coinbase) and holding them in a digital wallet. This approach allows investors to have full control over their assets, benefitting from potential price appreciation over time, as well as allowing the use of cryptocurrency for purposes like spending, staking, or yield farming.
📖 Bonus read: Staking Explained
📖 Bonus read: Yield Farming Explained
As an alternative, the SEC recently approved spot ETFs for Bitcoin in January, which allows for investment in the asset, without dealing with the technical aspects of purchasing and storing the cryptocurrency. The spot ETF investment vehicle does not currently exist in the United States for other cryptocurrencies, although the SEC has a late May deadline to decide on approval for Ethereum spot ETFs.
New creation of cryptocurrency tokens commonly occurs through the process of either mining or staking. Cryptocurrency mining involves using computer power to solve complex mathematical problems that validate transactions on the blockchain. Successful miners are rewarded with new coins. However, mining can be resource-intensive and may not be profitable for individual investors due to competition and energy costs. Meanwhile, some cryptocurrencies allow you to earn additional coins in the form of transaction fees by staking your existing holdings to support network operations.
Lastly, there are certain stocks that grant companies exposure to the cryptocurrencies, without the need for them to invest directly in purchasing cryptocurrencies themselves. These include:
Coinbase (COIN) - One of the largest crypto exchanges, with an IPO in 2021. Coinbase derives the majority of its revenue from cryptocurrency trading fees, so its share price moves heavily in sync with crypto asset prices.
Microstrategy (MSTR) - Founder Michael Saylor is one of the most prominent Bitcoin advocates. The company is the largest corporate holder of bitcoin, holding 174,530 as of February 2024, valued at an estimated $9.1B.
Crypto Mining Companies - There are several Bitcoin mining companies that investors have the ability to invest in. However, their share price is exposed to both the price of Bitcoin, as well as electricity prices impacting the ability to mine profitably.
Pros and Cons of Cryptocurrency Investing
Potential benefits of cryptocurrency investing include:
High Return Potential - Cryptocurrencies have shown the ability to generate substantial returns in relatively short periods. Bitcoin and Ethereum have been two of the most successful assets of the past decade, outpacing traditional investment vehicles in many cases.
Diversification - Adding cryptocurrencies to an investment portfolio can provide diversification benefits. Their price movements often do not directly correlate with traditional financial markets, potentially reducing overall portfolio risk.
Liquidity - The cryptocurrency market operates 24/7, offering higher liquidity compared to some other assets. This means you can buy and sell cryptocurrencies at any time without waiting for markets to open.
Accessibility - The digital nature of cryptocurrencies allows for easy entry into the market, lowering barriers compared to traditional investment avenues.
Innovation and Growth Potential - Investing in cryptocurrencies offers exposure to blockchain technology, which is at the forefront of financial and technological innovation. The sector is expected to grow and expand into various industries, presenting new opportunities for investors.
Cryptocurrencies also come with some serious potential downside risks that any investor interested in the space should be aware of:
Volatility - Cryptocurrencies are known for their extreme price volatility. Prices can skyrocket, but can also plummet just as quickly, posing a significant risk to investors looking for stability in their investments.
Regulatory Uncertainty - The regulatory environment for cryptocurrencies is still evolving. Potential future regulations or bans in various countries can impact market prices and the legality of holding or trading cryptocurrencies.
Security Risks - While blockchain technology is secure, exchanges and digital wallets can be vulnerable to hacking and phishing. Investors need to be vigilant about security measures, including the use of hardware wallets and enabling two-factor authentication
Lack of Consumer Protection - Unlike traditional financial systems, cryptocurrency transactions are generally irreversible, and there is little recourse if funds are lost due to scams, fraud, or technical errors
Market Manipulation - The cryptocurrency market is less regulated than traditional financial markets, making it more susceptible to manipulation and speculative bubbles.
Personally, you would probably be hard pressed to find a financial advisor who is more bullish long-term on the cryptocurrency space than I am. But, this comes with some very important caveats.
First and foremost, I don’t think there is a space that exists where investors need to be more careful when it comes to security. While I don’t believe cryptocurrency itself to be a scam in any way, there are many bad actors in the space that have preyed on investors, and it is always important to be knowledgeable on how to best protect your assets. Instances like the FTX bankruptcy (and resulting crashes of businesses like BlockFi, Celsius, and Gemini) in 2022 have shown the potential downsides of centralization within the space, seriously hurting investors, and injuring the reputation of the industry as a whole.
Furthermore, investors need to be prepared for intense volatility with their investments. While this advice is also applicable to other asset classes such as stocks, I caution anybody in the cryptocurrency space to not make investments with any funds that they believe they might need to access at any point within the next 3-5+ year timeframe. Bear markets in cryptocurrency can last several years and have more downside potential than most other asset classes.
The below charts illustrate this volatility, showing both the downside risk, as well as the vast potential upside for investors that are willing to be patient and have a good sense of market timing.
There are multiple roles that experts believe cryptocurrency will take, including:
As a global electronic medium of exchange, eliminating the need for multiple currencies, and reducing transaction costs.
As digital gold, with finite supply, serving as a store of wealth and equity/inflation hedge.
As an “Internet 2.0”, decentralizing web applications for greater security and privacy of its users.
If cryptocurrency is able to fulfill any of these roles, the asset class has the potential to skyrocket in value. Currently, cryptocurrencies holistically have a global market cap of $2.53 trillion, with some prominent investors speculating that this could explode to rapid new heights by the end of the decade.
Of the thousands and thousands of cryptocurrencies that exist today, most are worthless, and my belief is that only a small percentage will offer any real value in the near-term. My advice is that both beginning and experienced investors should concentrate their positions on the biggest and most secure assets, and that anything beyond that is reckless speculation.
In light of these considerations, I advocate for a balanced approach to investing in cryptocurrencies. Educating yourself about the technology, the market dynamics, and the specific projects you invest in is crucial.
And perhaps most importantly, investors should only invest what they can afford to lose, given the highly speculative and volatile nature of many cryptocurrencies.
Wile I remain bullish on the long-term prospects of cryptocurrencies and the innovation they bring to the financial world, caution and informed decision-making are paramount. The journey of investing in cryptocurrencies is fraught with risks and opportunities, making it essential for investors to navigate this exciting space with care and diligence.