Over the last year, Bitcoin has increased over 1395%, even after a $2000 drop on December 21, 2017, and everyone seems to want a piece of its breakthrough success. Bitcoin is arguably the hottest topic in finance, yet few people understand it.
What is Bitcoin?
Bitcoin is the gold standard of cryptocurrencies. At its root, crypto means “hidden, concealed, secret” and currency is simply a medium of exchange. When the founder of Bitcoin, Satoshi Nakamoto, created Bitcoin in 2009 he/she/they [identity is still unknown] wanted transactions to only share just enough information for the transaction to go through. As a result, the only thing known about a sender or receiver is the address where they receive Bitcoin. Every transaction involving that address is stored in the blockchain. Many call Bitcoin transactions anonymous, but that’s incorrect. Bitcoin is only pseudonymous, meaning if the address were linked to a person, all of their transactions would be known.
Contrary to popular belief, Bitcoin was not the first cryptocurrency. Digicash was the first cryptocurrency created in the 1980s. The difference between Bitcoin and its predecessors, specifically Digicash, is its decentralized database through blockchain. Cryptocurrency is internet cash— it is used to exchange value over a secure transaction without an intermediary or a “trusted third party.”
The blockchain is a decentralized and distributed ledger that records all of the transactions of the currency. Blockchain removes the third party (bank, credit card) as the intermediary. The fact that the records are decentralized is the biggest breakthrough because it removes the security risks- hacking which causes theft, record validation— that come with a centralized database.
To understand blockchain technology, we should examine the way we transact business online. When we make an online purchase, we use a third party we trust, such as a credit card processor or PayPal. When the third party sends our funds to the seller, we feel comfortable knowing that in the event we don’t receive what we paid for, although it will take some time, the third party will return our money.
The blockchain addresses the questions, who had it first, who was it transferred to, when was it transferred, and how many were transferred. Actually, these are the questions that the current system addresses that are so hard-wired into our system that we don’t think about them anymore. Once a transaction is verified, it cannot be changed, and as a result, it provides a level of certainty that has not existed before. When Bitcoin was created in 2009, it was poised to change the way we do business online.
Bitcoin is one of approximately 1,324 cryptocurrencies currently available. Unfortunately, Bitcoin has become the name for all cryptocurrencies, but technically any “coin” that’s not Bitcoin is called an “altcoin” or alternative coin. Currently, the top two altcoins are Litecoin and Ethereum. You can follow all of the coins at Worldcoin Index. When looking at altcoins, ensure you have a methodology for valuing and picking coins.
How to Invest in Cryptocurrencies
Not only can cryptocurrency be used to pay for goods and services, it can also be held or traded for investment in a cryptocurrency portfolio. There are three ways to invest in cryptocurrencies directly, through exchange-traded funds, or through companies that work with cryptocurrency.
Directly Buy Coins
You can create a cryptocurrency portfolio through websites such as Coinbase and Kraken. Setting up the accounts with these programs is similar to setting up a bank account. Once you are verified, which can take anywhere from a few hours to a few days, you can purchase cryptocurrencies. My suggestion is that you research, just like stock, any currency that you are interested in. Some of the questions you will want to answer:
- how long has the currency been in circulation
- how much is in circulation
- what’s the purpose of the currency
For example, the purpose of Ethereum is not a peer-to-peer electronic cash system, like Bitcoin or Litecoin, but a system to run distributed applications such as smart contracts. Additionally, not every cryptocurrency runs on blockchain technology. For example, IOTA runs on a program called Tangle, another type of distributed ledger.
The downside of investing directly in cryptocurrencies is that there is not much guidance concerning them. It is unclear how they transfer for estate purposes and planning. Given the structure, it is extremely cumbersome to purchase cryptocurrency directly in tax-advantaged accounts such as individual retirement accounts (IRAs). Additionally, as an owner of cryptocurrencies, it is important for the owner to secure their coins from theft or hacks, which often requires a bit of work. There is no FDIC or SPIC insurance or a lot of regulation on the cryptocurrency markets.
Exchange Traded Funds (ETFs)
The stock market provides options if you want to invest in the technology but are uncomfortable, unable, or simply unwilling to purchase cryptocurrency on your own. Grayscale is the first company to offer securities that “provide exposure to the digital currency asset class.” The Bitcoin Investment Trust (symbol: GBTC) is an ETF (exchange-traded fund) currently available for the cryptocurrency. There are several ETFs seeking approval from the SEC (Securities and Exchange Commission) to provide more options. Grayscale is seeking approval for a second ETF which would focus on Ethereum, the second largest cryptocurrency.
However, the downside to buying cryptocurrency ETFs, or any ETF generally, is that the price per share can easily go above the value of the underlying assets. In its prospectus, the document that gives all of the necessary details about a fund, Grayscale indicated that the premium over investing in Bitcoin directly was 42%, but in August of 2017 the premium had doubled. Even with that premium, the ETF space provides exposure to cryptocurrency in a way that’s easy to manage for estate purposes. Additionally, ETFs are available for purchase in retirement accounts. Finally, there’s no need for individuals to secure cryptocurrencies because the company managing the ETF is responsible for that aspect.
Companies working with Cryptocurrency
If you are looking for a more traditional approach to get involved in the cryptocurrency rush, there are multiple publicly traded technology companies working with cryptocurrency. As with any investment, you have to do some research, but here are some examples. Nvidia (symbol: NVDA) and Advanced Microdevices (symbol: AMD) design processing units specifically for cryptocurrency transactions. In December 2016, Overstock (symbol: OSTK) became the first publicly traded company to issue stock over the internet, through blockchain technology.
Additionally, the Ethereum Enterprise Alliance connects Fortune 500 companies, “startups, academics, and technology vendors with Ethereum subject matter experts.” The Alliance focuses on working with Ethereum “to create software capable of handling the most complex, highly demanding applications at the speed of business.” A few of the well-known companies in the Alliance include BP (symbol: BP), Intel (symbol: INTC), and JPMorgan (symbol: JPM).
Do Cryptocurrencies and Bitcoin make sense for your portfolio?
Unlike the stock market, the cryptocurrency market never closes. The market for Bitcoin and other cryptocurrencies is extremely volatile and largely unregulated, including your cryptocurrency portfolio. Its volatility means it is subject to large swings in price, and there’s a saying, “Up like a rocket, down like a rock.” The lack of regulation leaves the market open for manipulation and exploitation, two situations where the average investor is most vulnerable. Additionally, Bitcoin is not the easiest concept to understand, as we’ve heard before.
The general rule for investing is not to invest in anything you don’t understand. Bitcoin and other currencies are speculative. To find out if you have room for speculation in your portfolio, examine your portfolio to ensure that you have the appropriate allocation of stocks and bonds for your risk capacity (age and goals). Generally, a good place to start to determine proper allocation is to use your age and subtract it from 100 for how much you should have in stock. For example, if you are 29, a conservative allocation would be 71% invested in stock and 29% in bonds.
Once you have an established portfolio, you can look to more risky or speculative investments, such as cryptocurrency, to add a bit of “kick” (alpha) to your portfolio. If you are speculating, never invest more than you can afford to lose. Because these currencies are speculative, there’s little to no regulation, and it’s not the easiest to understand. Cryptocurrencies should be no more than 5% of your portfolio, subtracted from your stock allocation.
If you are ready to buy some bitcoin or other cryptocurrencies, Coinbase is the exchange we recommend starting on. Their selection is much smaller and only holds the strongest coins, but their holding are insured and they are one of the most trusted exchanges. Sign up for Coinbase using this link to get $10 in free bitcoins.
Have experience with Bitcoin and other coins you want to share? Have a question for the community to discuss? Leave us a comment and let’s talk.
Courtney is a former Financial and Investment Advisor for one of the top brokerage houses on Wall Street. In 2014, she started The Ivy Investor, a blog focused on explaining investing, retirement, and wealth concepts in simple terms. Courtney is the epitome of a buy and hold investor. But she, like many others, has caught the cryptocurrency bug. Courtney holds a J.D. from West Virginia University College of Law and an LL.M. (Master of Laws) in Taxation from Temple University Beasley School of Law with a certificate in Estate Planning.