Cryptocurrency came into existence in 2009 when Satoshi Nakamoto, an anonymous person or group of people, mined the first block in the chain for Bitcoin. Since then, more than 1,600 alternative cryptocurrencies have been created to allow people to take advantage of their security and anonymity.
In 2017, the price of a Bitcoin surged from $900 to $20,000, turning it into an object of interest for both beginner and experienced investors alike. Volatility and a lack of regulations, however, make investing in it and other cryptocurrencies a risky venture.
Cryptocurrency is considered by some as “one of the most important asset classes of a lifetime,” says Hamza Amir, a partner at the cryptoasset management firm Oxala Capital.
If you’re thinking about investing in cryptocurrency, it’s important to understand how it works and how to invest responsibly.
What are cryptocurrencies?
Cryptocurrency is a digital asset that uses cryptography technology to provide users with a more secure and anonymous payment method.
In contrast to fiat currencies like the U.S. Dollar, cryptocurrencies are decentralized. This means that no single organization or government regulates its circulation or backs its value.
As of September 2018, there are more than 1,600 cryptocurrencies that you can buy and sell. The most popular, however, include:
- Bitcoin Cash
There are several options to buy cryptocurrencies. You can even buy Bitcoin with a credit card.
How does cryptocurrency work?
Cryptocurrencies are typically based on blockchain technology. A blockchain is a record of transactions—say, of money, goods, or data—designed to prevent people from adding, removing, or changing data without other users detecting the attempt.
Blockchain has no centralized database. This essentially cuts out the middleman that you’d have to deal with when sending money through a bank or buying stocks via a brokerage firm.
As a result, you get faster transaction times and lower fees. Also, because the data is stored across a network rather than in a centralized place, it’s less vulnerable to hackers and other exploitation.
What is blockchain technology?
To give you an idea of how blockchain technology works, picture it as you would Wikipedia or Google Docs. Many people can access and write entries into the same ledger at the same time.
The difference is that there’s no single owner or administrator. Instead, the community controls the information. Blockchain gathers and stores data into blocks.
Every 10 minutes, the network reconciles all of the transactions that occurred since the last “block,” or group of transactions using cryptography. As a result, the data remains transparent, secure, and incorruptible.
For example, let’s say you buy a car and use blockchain to process the payment. The transaction data is recorded and shared with other users in the blockchain network. In addition, the transaction is timestamped and added to a block, which also gets a timestamp when it’s completed.
So, if you decide to go back and change the transaction, everyone in the network will know because the code has been altered.
Instead of a standard username and password, blockchain technology provides advanced methods of encryption using public and private “keys.”
A public key is essentially your address on the blockchain and consists of a long string of randomly-generated numbers. Your private key acts like a password that gives you access to your digital assets.
Is cryptocurrency legal?
Only a handful of countries have an implicit or outright ban on cryptocurrencies. The list includes countries like Algeria, Bangladesh, Bolivia, and China where there is a ban on trading with cryptocurrencies like Bitcoin. It also includes countries like India, Canada, and Vietnam where owning them is okay but where there is a banking ban that limits their trade via financial institutions.
Cryptocurrency is legal in the U.S., and many online and even physical retailers have started accepting it as a payment method. You can also treat them as an investment opportunity, although it’s possible that the government will begin regulating their use.
For tax purposes, the U.S. government considers cryptocurrencies as property. That means they’re subject to both capital gains and income taxes.
As a result, if you plan to invest in Bitcoin or other cryptocurrencies, it’s essential to find a tax professional who has experience working with digital assets. Doing so will ensure you don’t run into any problems with the IRS.
A quick guide to cryptocurrency trading
“Cryptocurrencies have been the best performing investment in the history of mankind, and they’re just getting started,” says Amir. “Investing intelligently now can provide the greatest return on investment better than any other asset class.”
But buying and selling cryptocurrencies as an investment is not a simple or easy process. Therefore, it’s important that you have a strategy before you begin. Here are five tips to help you along the way.
Only invest what you’re willing to lose
“The prices of cryptocurrencies are far more volatile than any other market in the world,” says Amir. “Be prepared to hold on if you choose to invest.”
The rise and fall of Bitcoin prices in 2017 are just one example. At the beginning of the year, the price hovered close to $900 and surged to nearly $20,000 in December. As of September 2018, prices are around $6,200.
So, investors who bought at $900 and held through the rise and fall still came out with a great return. But if you bought in when prices were at their highest point, you would have lost almost 70% of your investment.
Keep your investments safe
Because cryptocurrencies are digital assets, it’s crucial that you implement security measures to keep them away from hackers. “[It’s] still a very new industry filled with scam and hacks,” says Amir.
“Store [your] investment in cold storage or a hardware wallet, and keep the keys and wallet access secure and private.”
There are plenty of hardware wallets available that allow you to encrypt your investment. It is, however, connected to a network, which still makes it susceptible to hacks and computer malfunctions.
Cold storage, on the other hand, is the act of storing your cryptocurrencies offline. You can do this with a USB drive, a physical representation of the currency, or an offline hardware wallet.
Do your research into all of your options to make sure your investment is safe. And if you plan to store them in an online hardware wallet, make a backup just in case.
Purchase only from trusted exchanges
Due to the complexity of cryptocurrencies, it’s easy for newbie investors to fall for a scam. As a result, it’s important to only purchase your chosen cryptocurrency on established, legitimate exchanges.
Amir recommends Gemini, Coinbase, and Robinhood to people who are just getting started.
If you’re thinking about trading on another exchange, do your research before you create an account. Learn more about the exchange and look for reviews of other traders to make sure it’s a good option.
Buy and hold
Cryptocurrencies are still relatively new and institutional investors aren’t yet fully on board. They can, therefore, be a risky investment. However, according to Amir, you generally don’t need to deal with that if you hold onto your investment for at least two years.
“The riskiness comes from partaking in an investment that is driven heavily by speculators in an unregulated, uninsured market that actively trades 24/7 and 365 days a year,” he says.
So, if you’re considering cryptocurrency as an investment, make sure you don’t need that money for at least a couple of years, and maybe longer.
When it comes to investing, it’s never a good idea to put all of your eggs in one basket. That’s especially the case when you’re dealing with a volatile investment like cryptocurrency.
In other words, don’t make cryptocurrencies your only investment choice. It’s important to also invest in other assets, such as stocks, bonds, and mutual funds.
More importantly, ensure that your retirement savings are on track before you begin investing in any risky investment. That way, losing money on something like stocks or cryptocurrencies won’t jeopardize your future.
The bottom line
As cryptocurrencies mature, they’re becoming more and more viable as an investment opportunity. But like Warren Buffett once said, “Never invest in a business you don’t understand.”
Continue digging deeper into how cryptocurrencies and blockchain technology work, and how to invest in them like a pro.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.