By: Joseph Goldy, AAMS®
With the news this week of Elon Musk investing $1.5 billion into bitcoin, along with Mastercard and Bank of New York announcing they will be supporting cryptocurrency on their networks, digital currencies have been getting a lot of attention. For those new to the altcoin world, it helps to understand the basics.
It begins with the blockchain
The blockchain is the decentralized, global ledger of every transaction for a particular cryptocurrency going back to when the currency was first created. Blockchains provide the backbone of most cryptocurrencies and act as the “network” over which two parties can securely transfer their digital money between each other.
The network’s security comes by way of its openness since anyone can review the transactions at any time (while not seeing the people behind the transactions). In contrast to a closed third-party intermediary, such as Venmo or PayPal, cryptocurrencies rely on blockchain technology, which is opensource, providing continuous transparency to the transactions while simultaneously ensuring accuracy.
To better understand the blockchain, picture the list of transactions you see when you log into your checking account online. If you go back in time to when you first opened the account and looked at every transaction to the present day, it should add to your current balance to the penny. However, if the Starbucks Latte you bought two years ago for $3.65 changed to $36.50 by mistake, your balance would no longer be accurate.
How would you ever catch this? You likely wouldn’t, but if everyone in the world had access to your checking account transactions and analyzed them to locate the mistake, someone would probably see the error quickly. Similarly, a cryptocurrency’s blockchain contains every transaction dating back to its creation, continuously verified for accuracy on a global scale.
Bitcoin
The concept of bitcoin was born from a white paper written in 2009 by a person, or people, going by the name Satoshi Nakamoto. Interestingly, Nakamoto’s identity is still a mystery to this day. And while many people often view bitcoin as the first real cryptocurrency, several unsuccessful predecessors came earlier, many of which influenced the coin’s current features. This interesting Investopedia article chronicles some of those early versions of digital currency.
Since Satoshi conceived of bitcoin to exist purely in digital form, there are no physical coins. This aspect allows bitcoin to be stored, used, and transferred with ease. The value of bitcoin fluctuates considerably, with one bitcoin currently around $47,000, up from $7,300 toward the end of 2019. However, you can buy or sell any fraction of that amount, allowing you to invest smaller amounts.
An appealing feature of bitcoin is the theoretical limit on its supply. The most bitcoin that will ever be produced is 21 million, and with 18 million bitcoins currently in circulation, the cap is estimated to be reached by the year 2140.
Mining Bitcoin
The process of creating new bitcoin is called “mining” and accomplished by people around the world using powerful computers who are tasked with continually verifying the transactions on the blockchain.
About every 10 minutes, their computers are solving math problems, which unlock roughly 12 new bitcoins (approx. $560,000) and then allocated in a lottery-style fashion.
How to Purchase Cryptocurrency
One of the most common methods of investing in cryptocurrencies is to buy directly through an online platform such as Coinbase, Kraken, or others. Opening an account is straightforward, and it can be linked to your bank account for fund transfers into and out of the platform.
With direct investing, you decide which currencies you want to purchase, and there is a small transaction fee each time you buy or sell. (Tip: If you choose to use Coinbase, utilizing their Coinbase Pro platform will reduce the transaction fees considerably.)
One benefit of buying altcoins directly through an online platform is that you can choose from a wide variety of currencies. Bitcoin is by far the most widely recognized. However, there are competing technologies offered in coins, such as litecoin, etherium, and chainlink, to name a few.
Including Crypto in a Investment Portfolio
Although building a crypto portfolio can seem daunting, using time-tested portfolio management techniques such as diversification and dollar-cost averaging are two ways to minimize risk. For example, if you’ve decided to allocate a certain amount to a crypto portfolio, it can be averaged in over 12 months of investing every quarter. This strategy could help when investing in something with a volatile market price, such as stocks or cryptocurrencies, since investing at regular intervals takes the timing out of the equation.
You can also diversify your crypto portfolio by investing in various crypto sizes, uses, and technologies. The idea is to diversify your portfolio across these different metrics to mitigate the risk of investing in one technology that doesn’t pan out.
If direct investing seems like too much of an endeavor, you can simply buy a fund that invests in a particular digital currency. Fund company Grayscale offers funds that invest in a variety of the more popular altcoins. There are also additional funds currently looking for SEC approval and working their way to market. Although your choice of currencies will be more limited with a fund, the benefits include being able to purchase through your brokerage account as quickly as a stock and the ability to purchase in tax-advantaged accounts, such as an IRA.
This convenience comes with a fee, of course, and in Grayscale’s Bitcoin Trust, that fee is 2% annually as of this writing. The management fee may not sound like much, but it acts as a drag on returns over time, as shown in the chart below. The green line is bitcoin’s actual value over three years compared to Grayscale’s fund price in blue.
While the possibilities of cryptocurrencies are intriguing, they may not be right for everyone. Digital currency is still a mostly unregulated, new technology with many unknowns about its future viability. Despite the recent favorable press and backing by some financial industry heavyweights, it is always prudent for those thinking of investing to do thorough research and have a clear strategy in mind before putting actual money to work.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.