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Investing in Cryptocurrency – Part II

By Jane Young, CFP, EA 

Many view cryptocurrencies as the currency of the future.  A major benefit is they are not controlled by central banks and their ability to manage the supply of money.  The possibility of corruption is reduced because the power to control the currency is decentralized - eliminating the danger of extreme money printing which can lead to hyperinflation.   As an investment, this can provide diversification and serve as a hedge against inflation and geo-political uncertainty.  The currency also provides anonymity and is not subject to freeze or seizure by government authorities.  

To be widely used, currency needs stability and even the most well-established cryptocurrency, the Bitcoin, exhibits extreme volatility.  Cryptocurrency and blockchain technology are still on the cutting edge and undergoing tremendous change.    However, the infrastructure is growing and becoming stronger everyday.

Thousands of blockchain projects have been introduced or are in development – the competition is fierce.   Investing in most cryptocurrencies carries great risk, like investing in a start-up company or venture capital – where most of them will fail.   Cryptocurrency risk is accentuated by the fact that there is not a company in the background producing a cash flow.  For you to profit, someone else must be willing to pay more than you did, a concept referred to as the “greater fool theory”.

 A few cryptocurrencies, such as Bitcoin, Ethereum, Litecoin and Tether are starting to gain legitimacy.  Good long-term investments depend on widespread adoption to succeed.  Many investors are starting to use Bitcoin as a store of value and hedge against inflation, similar to the way people invest in gold.  However, Bitcoin is virtual and not backed by a hard asset.  Bitcoin has a limited supply and, as a scarce resource, could gain widespread use as a digital form of cash.  Some believe the value will rise if the demand continues to exceed the limited supply.

Bitcoin has gained additional legitimacy as many large companies such as AT&T, PayPal, Microsoft and Overstock.com have started accepting Bitcoin as payment.  As it becomes more widely accepted, investors will start to recognize it as a legitimate asset class in their portfolio or as a vehicle for low-cost money transfers.

If you decide to invest in cryptocurrency, treat it as an extremely volatile speculative investment.   Start with a small amount that you can afford to lose.  You should probably stick with the most well-known currencies and thoroughly research them before you buy.  As with any investment, never invest in something that you do not fully understand.   Cryptocurrencies are created for different uses, educate yourself to develop a full understanding of the currency you are considering.

Cryptocurrencies have a short history of about 12 years, and they are exceedingly difficult to value.   The value is largely dependent on supply and demand and is prone to wild swings.  The currencies can be subject to bubbles created by enthusiastic investors acting on emotion.  If you decide to move forward, do so with great caution.