Cryptocurrency has taken the investment world by storm. With hundreds of new “coins” bubbling to the surface, many people are wondering if they should buy into this new type of currency or if it’s another investment trend that will pass.
Should crypto have a place in your portfolio?
A Brief History of Cryptocurrency
In a nutshell, cryptocurrency is a digital currency for purchasing goods and services. It’s also a burgeoning investing avenue.
The first successful version of crypto is Bitcoin (though several early versions of digital currency cropped up by the 1980s), which operates on blockchain technology.
Blockchain is a sophisticated database that stores data in blocks that are “chained” together. While the technology can become complex quickly, it’s essential to know that it’s a method for recording and storing information. Bitcoin, for example, uses blockchain technology to record and legitimize transactions.
Imagine, instead of buying your new area rug from Overstock with a credit card, you could pay with Bitcoin. Given Bitcoin’s growing prominence in the finance space, more and more retailers are beginning to accept it as a form of payment.
Investors are also hanging onto their cryptocurrency in hopes of an enormous future payout.
In fact, many institutional investors are swapping their gold and precious metal holdings for Bitcoin, presumably for a hedge against inflation and diversification efforts. This larger financial move to embrace Bitcoin begins to suggest that this type of crypto, at least, could stick around for the long haul.
Bitcoin is simply one example of cryptocurrency. How does this digital money work?
Cryptocurrency functions on a completely different playing field than other financial instruments, namely because of where it originates. It’s a decentralized investment vehicle, meaning it operates without banks, governments, or other institutions.
This freedom is a double-edged sword, as most crypto is unregulated, making it incredibly volatile and challenging to secure. As it’s still relatively new, it’s unclear how cryptocurrency behaves long-term—another significant financial risk.
Is Crypto Investing The New Lottery?
Bitcoin, specifically, has been in the news a lot this year. The volatile cryptocurrency keeps reaching new record highs, losing value, and spiking again. And there are a handful of cryptocurrency investors who have gotten really wealthy really fast.
Presently, one Bitcoin is worth about $32,000. The rise in Bitcoin and blockchain technology has inspired other digital currencies like Ethereum, Litecoin, NEO, among dozens of others.
But for most people, the get-rich-quick method isn’t how wealth works. Getting rich slowly isn’t as exciting as winning the lottery or making a really lucky investment— but it has worked, over time, for a lot more people.
While Bitcoin is slowly gaining merit in the finance world, other coins and crypto remain on the outskirts. It’s important to approach investing in cryptocurrency with a heavy dose of caution. All of the unknowns make it no more secure than trying your hand at a slot machine—and remember, the house almost always wins.
Investing In Crypto Is Risky—Can You Do It Safely?
If you’re interested in investing in crypto, brace yourself for a rollercoaster ride without a seatbelt. As the technology is still relatively young, there isn’t enough data to truly determine how crypto reacts long-term.
Take Bitcoin as an example. It reached big highs in 2018 ($20k per coin) then subsequently lost 90% of its value the following year. It was up to $62k earlier this year and now, it’s around $32k. That’s quite an intense few years for investors.
In general, you should be on track with your other financial milestones before investing in crypto. Given the potential fluctuations, your financial house should be in order before introducing something new into the mix.
Cryptocurrency is risky and volatile—right now, there is no way around that. But you can include cryptocurrency in your portfolio thoughtfully and intentionally.
For example, instead of buying Bitcoin (or part of one) directly, you could invest in an ETF, mutual fund, or stock that owns a lot of Bitcoin or invests in blockchain technology.
You can also hold the investments in current retirement accounts instead of opening a new account on Coinbase or a similar crypto exchange platform. Approaching crypto from this lens might be more palatable and offer slightly less risk. Even so, this should amount to a small section of your portfolio (about 1-5%) that you’re willing to lose.
How Is Cryptocurrency Taxed?
Cryptocurrency is still an investment. Even though it’s decentralized, investors aren’t immune from the tax consequences.
The IRS classifies Bitcoin as a property asset, and as such, whether you mine it, sell it, or use it to pay for a good or service, you’ll be on the hook for capital gains tax.
For example, when you sell or exchange your crypto, you’re subject to capital gains tax. Like stocks or real estate, the capital gains tax depends on the difference between the price that you bought it and the price that you sold or exchanged it.
You’ll pay either short-term or long-term capital gains depending on how long you held the asset. Assets held for less than a year are taxed as short-term capital gains or your ordinary-income rate, which can be as high as 37%.
Long-term capital gains rates are much more favorable (0%, 15%, or 20%, respectively) and apply to assets held for more than a year. Most people are in the 15% capital gains tax bracket.
It’s often best for investors to hang onto assets for over a year to qualify for long-term capital gains treatment.
Before Crypto, Go Back To The Basics
Of course, the prospect of making a lot of money overnight is tempting. But financial security starts with the basics. Without good financial habits, financial management becomes infinitely more challenging, even if you do get a lucky break.
Cultivating healthy financial habits puts you on track to accomplish your goals.
How can you do that?
Step 1: Know How You Spend Money
The first step toward financial security is understanding how you spend money.
- Are you earning enough to cover your expenses?
- Do you know how much you’re spending month to month?
- Do you have room in the budget to save for retirement and other long-term goals?
If not, cut back on the things you don’t need and redirect that savings towards other financial goals (i.e. paying down debt, building up savings, or boosting your retirement accounts).
Step 2: Build an Emergency Fund
Next, start setting cash aside in an emergency fund and build up enough to cover three months of net pay. It may take a while to reach this goal, but you’ll be glad you did when you need to put down a security deposit or make a big car repair.
Step 3: Kick Debt To The Curb
Third, pay down your debt as aggressively as you can. Start with the highest-interest debt like credit cards and work your way down. The sooner you can pay these off, the less you’ll owe in interest over time.
Step 4: Invest for Retirement
Finally, start saving for retirement with a 401(k) or Roth IRA. Putting a certain percentage of your paycheck into your 401(k) might not be as exciting as buying Bitcoin, but that’s kind of the point— you’re putting money aside into investments that, based on historical trends, should grow steadily enough that you don’t really have to think about them.
Once you’ve nailed all the basics, it’s OK to start making more complicated investments. But if you still have credit card debt or aren’t yet saving for retirement, check those boxes first.
Invest For The Right Reasons
We’re just going to say it: FOMO isn’t a good reason to invest.
Before you buy Bitcoin, ask yourself why you want it in your portfolio.
- Is it to diversify your investments or learn about a new asset class?
- Or is it FOMO?
When we experience the “fear of missing out,” we’re worrying that the risk of not doing something is greater than the risk of doing it. This rhetoric constantly circles Bitcoin conversations. “If you buy in now, you could end up a millionaire. Won’t you regret it if you don’t?”
We all want to be free from the fear of not having enough money to do the things we want.
It’s possible that Bitcoin could get you there, just like it’s possible that buying a lottery ticket could get you there.
But the tried-and-true strategies— building up savings and sticking to a long-term investment plan— have gotten millions of people there over the last few decades.
If you’ve already mastered the basic building blocks of personal finance, you’re well on your way to financial security. You’re not missing out on anything by sticking to your strategy. Until we know a lot more about Bitcoin, it’s best to stick with the Gen Y motto: Simple first, sexy later.