Investing in Cryptocurrency: The Most Important Things To Know
June 4, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial
In the world of financial planning, we consistently hear about the importance of diversification. By investing in many different types of assets, you can reduce your asset-specific exposure to risk, which will likely improve your risk-reward ratio.
A well-diversified portfolio will have much more than just stocks; it will also have cash, bonds, and, in many cases, physical assets such as real estate or commodities. The systematic need for diversification has been well-known for centuries. In 2009, however, a new asset class was introduced into the investment world: the development of Bitcoin, and the many other ‘alt-coins’ which followed, helped give risk-tolerant investors an opportunity to diversify even further.
Using cryptography and published on a public ledger, cryptocurrencies, like cash, function as a medium of exchange that is necessarily finite. As demand for Bitcoin increased, most notably between 2009 and 2017, the value of the coin increased from less than one cent per coin to nearly $20,000. After the coin’s fall from its peak in December 2017, more than 75 percent its value was lost. But since then, Bitcoin (and many other cryptocurrencies) has enjoyed a relative price increase and, as of May 28, is trading for more than $9,000 per coin.
Cryptocurrency Trading: Pros and Cons
As is the case with all possible investment options, trading cryptocurrencies is something that has both benefits and drawbacks. In addition to Bitcoin (the original and most popular cryptocurrency), some of the most frequently traded cryptocurrencies includes Ethereum, Ripple, Tether, Bitcoin Cash, and Litecoin. The most obvious benefit of investing in cryptocurrencies is that, if you can time the market correctly, you can earn incredible returns over time. Investing just $1 in Bitcoin in 2009 would have yielded more than $2 million by 2017.
Of course, when it was first introduced, very few people were willing to invest in cryptocurrencies and even fewer had the patience to wait eight years. But even still, it is clear that investing in cryptocurrency can produce strong returns.
At the same time, whenever an asset—of any class—has a strong potential for returns, there will also be some risks attached. Individuals investing at peak of the crypto market in 2017 would have lost about half of their wealth to date. There are also countless cryptocurrencies that have made their way onto the market, only to flop a few months later. Because of this, investing in cryptocurrency is considered a uniquely risky endeavor—you should only consider investing if you are willing to assume some risk and are also able to thoroughly understand the market.
Between the “breakout” of coronavirus and the status quo, Bitcoin has nearly doubled in value, rising from about $4,800 on March 12 to about $9,500 on May 28. Most other major cryptocurrencies have enjoyed a similar rise during this time, despite the fact the stock market has declined. There are likely quite a few factors that have helped fuel this trend. The increasing digitalization of our economy, along with the increased acceptance of cryptocurrencies by major corporations (even including Subway), has helped increase the utility of these coins, which results in a natural price increase. But additionally, and perhaps more importantly, the recent rise of the crypto market has also been fueled by the fact many traders have wanted to take their wealth out of the stock market and direct it elsewhere. Because of this, cryptocurrency is frequently recognized as a “contra asset.”
How Can I Buy Cryptocurrency?
Typically, if you would like to own cryptocurrency directly, you will need to use a specific exchange, where you will then be able to create a crypto “wallet.” Coinbase is the most popular exchange designed for holding crypto. However, other common trading platforms—including TD Ameritrade, E*Trade, and even Robinhood and PayPal—also make it possible for users to buy to cryptocurrency.
Though cryptocurrency is sold in specific units, you do not need to buy an entire coin at once. Even if Bitcoin costs $10,000, crypto exchanges will still allow you to spend as much (or as little) as you want. For example, you could spend $10 on Bitcoin which, at this price, would mean you simply own 0.001 Bitcoins. Essentially all other cryptocurrencies function the same way, allowing your trading strategy to be a bit more flexible. Additionally, if you don’t want to invest in crypto directly, you could also invest indirectly with crypto-connected ETFs. These ETFs, which are traded similarly to stocks, make it easy to develop a diversified crypto position without the need for creating a crypto wallet.
How will Cryptocurrency be Taxed? What Records Do I Need to Keep?
In the eyes of the IRS, cryptocurrency is considered taxable property, making it very similar to stocks. While there is no federal property tax applied to cryptocurrencies, capital gains taxes do apply. This means that if you sell cryptocurrency and make a net profit, you will be taxed a percentage of your total gains. Currently, the capital gains tax rate in the United States is (usually) 15 percent.
As is the case with all commodities, it is a good idea to keep careful track of the coins you own and also keep track of how much money each position has yielded (or lost). Most platforms will keep track of this for you, but you might also want to create your own records. Because crypto is somewhat volatile, many traders will enter into and exit out of their positions on a regular basis. If you do trade frequently (such as regular day trading), your financial situation will become more complex, though still manageable.
Overall, investing in cryptocurrency have many distinct risks and benefits. Whether crypto trading is right for you will depend on your long-term financial goals. If you decide that crypto trading makes sense, be sure to clear reliable financial records and pay all associated taxes.