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About 145 million American adults say that they own or have owned cryptocurrency. Statistically, that’s more than half of your co-workers, neighbors and friends.
It’s also about the number of Americans who own stocks.
Even though it’s not regulated by a government agency, cryptocurrency is becoming mainstream. However, President Biden recently signed an executive order to address cryptocurrency risks with a whole-of-government approach that could make cryptocurrency even more attractive to investors as well as traditional banks and credit unions.
For the near term though, cryptocurrency remains a volatile, speculative asset that will likely continue its gut-wrenching booms and busts. That’s not to say that cryptocurrency doesn’t belong in a well-diversified portfolio, but I recommend that my clients first educate themselves about cryptocurrency before deciding whether or not to invest.
As Warren Buffet said about investing in cryptocurrency: “I get into enough trouble with the things I think I know something about. Why in the world should I take a long or short position in something I don’t know about?”
Here are some important concepts to get comfortable with.
Say you order a new set of patio furniture online. A credit card company or payment processor like PayPal acts as a middleman between you and the seller.
However, if you want to buy that patio set with cryptocurrency, there’s no middleman. You conduct transactions directly with the merchant. The cryptocurrency network assigns a public and a private key that becomes your unique address. You then use your private key to digitally sign the transaction.
There’s no bank or third-party fees. You store your cryptocurrency in either a “hot” or a “cold” digital wallet. You can get a software-based hot wallet from an exchange like Coinbase or a provider like Electrum or Mycelium. A cold wallet is a small, encrypted portable device from providers such as Trezor and Ledger Nano.
It’s unclear which cryptocurrency names will survive, but the true value is likely in the underlying blockchain technology. Initially created to power Bitcoin, the granddaddy of cryptocurrencies, today there’s thousands of blockchains for digital currencies like Ethereum, Litecoin, Dogecoin, Tether and many others.
(As a side note, Dogecoin began as a joke referring to 2013 meme with a Shiba Innu dubbed Doge.)
The blockchain uses a digital ledger to duplicate and distribute your patio furniture transaction to computers across the blockchain. Peer-to-peer computer networks verify and time-stamp each transaction. Instead of a central authority like a bank with the associated costs and infrastructure, a network of users verifies the data.
The growing list of records, called blocks, are linked together using cryptography. Crypto mining verifies the next block on the blockchain. Miners are rewarded with cryptocurrency tokens plus any fees paid by the exchanging parties.
Because the transaction appears across the entire network of computers on the blockchain, it’s extremely difficult to change, hack or cheat the system. For countries with poor or corrupt financial institutions, cryptocurrencies based on blockchain protect against criminal activity. There’s also an element of integrity since users can rate each other, weeding out unscrupulous users.
That doesn’t mean that blockchain is totally hack-proof. Hypothetically, if a group of miners was able to take control of more than 51% of the blockchain’s mining hash rate or computing power, they could halt payments, reverse transactions, or double-spend coins.
Blockchain does have a few negatives. All those computers and the processes involved in mining cryptocurrency are energy hogs, making it environmentally unfriendly. Cambridge University found that Bitcoin mining takes more electricity annually than it takes to run Argentina.
And because blockchains require huge amounts of computing power over a distributed network, they are slower than centralized databases. The Bitcoin blockchain can only process 4.6 transactions per second, so it takes about 10 minutes to process a Bitcoin transaction. In contrast, the Visa network can process more than 1,700 transactions per second.
Blockchain is a transformative technology and has applications outside of cryptocurrency in healthcare, art, travel, legal, insurance and countless others. Think of any transaction that requires a central clearing authority, such as wire transfers or settling trades.
Here are just three possible uses of blockchain:
The IRS classifies crypto as a type of property rather than a currency. If you use digital currencies to buy or sell goods and services, you have to pay taxes. Using cryptocurrency can leave you with an unexpected tax bill.
For example, the patio furniture seller that receives your Bitcoin as payment has to pay taxes on its current value. You may owe capital gains taxes if the realized value of the sales transaction is greater than the price you paid for the cryptocurrency.
Buying crypto with cash and holding it isn’t a taxable event, but if you acquire digital currency from mining, you have to pay tax on the value immediately. Getting paid in crypto also triggers tax liability. Transferring crypto from one digital wallet to another isn’t taxable, but converting from one cryptocurrency to another is.
Investing in crypto also has tax implications. If you sell crypto at a profit, you have to pay tax on the difference between what you bought it for and the sale price.
If this sounds like a lot of recordkeeping — it is. The IRS requires you to maintain records sufficient to establish the positions taken on tax returns. That means documenting receipts, sales, exchanges and the fair market value of your crypto assets. But unlike stocks, you don’t receive a Form 1099-B that shows you the cost basis of your transaction. If you use cryptocurrency for day trading, transactions could total in the thousands.
One bit of good news tax-wise is that it is possible to use tax loss harvesting to write off some losses. Like equity losses, you can deduct up to $3,000 of crypto losses against ordinary income per tax year and carry losses beyond $3,000 forward until death.
The value of cryptocurrency is largely driven by supply and demand. Unlike government-backed (fiat) currencies, in which governments have the option of printing more money to increase supply, the majority of cryptocurrencies have published supply limits according to their token minting and burning plan. There will only ever be 21 million Bitcoins. When demand outpaces supply, cryptocurrencies rise in value, sometimes dramatically.
Stablecoins aim to provide a less volatile type of cryptocurrency by pegging the coin’s value to another currency, commodity or financial instrument. For instance, the USDF Consortium, a membership-based association of FDIC-insured financial institutions, is trying to further the adoption of a bank-minted tokenized deposit (USDF™) that is pegged to the U.S. dollar and will be insured for up to $250,000 by the FDIC.
A stablecoin that turned out to not be stable at all rattled the markets. TerraUSD, which relies on algorithmic coin supply management, lost its peg to the U.S. dollar, and its Terra cryptocurrency lost 98% of its value in just 24 hours.
Unlike other assets that have built-in protections like FDIC-insurance, you are responsible for protecting your crypto assets. You’ll want to use two-factor authentication with a strong password and additional verification, such as fingerprint or facial recognition. Don’t buy crypto at the local coffee shop; use a secured internet connection.
Your digital key — a 256-bit long string of alphanumeric characters — is the only way to access your crypto assets. Hopefully, you won’t ever lose your private key. If you lose the key or throw away your cold wallet, the crypto is lost forever.
Seems unlikely? Tell that to James Howells, who accidentally threw an old hard drive into the trash, which was taken to the local landfill. He was never able to recover about $181 million in Bitcoin. Or Mark Frauenfelder, who wrote down his key for his hardware wallet on a piece of paper — which the cleaning people threw in the trash. Or Stefan Thomas who would have over $100 in cryptocurrency if he could remember his password.
James, Mark, and Stefan are not alone: One analysis found that of the 18.9 million Bitcoins in circulation, 3.7 million have been lost by owners.
If you die, your cryptocurrency is treated as a probatable asset. But because it’s decentralized, your beneficiaries may not be able to access it unless you include your cryptocurrency assets in your estate plan with instructions on how to access them.
In 2009, when Satoshi Nakamoto (a pseudonym for an individual or group of individuals) released a white paper detailing Bitcoin, the coin had no value. By February 2011, it hit $1. A decade later, it hit $68,000. A few months after that, it lost half its value.
Lots of investors panicked and sold. Historically, a bear market is the best time to invest since you are buying low with the hope of eventually selling the asset for more than you bought it for. Should you employ the same strategy with cryptocurrency?
Possibly. But first, think long and hard about your risk tolerance. Do bear markets give you angst? Do you feel compelled to sell equities and turn to the perceived safe haven of fixed income when economic news is bad? If yes, then investing in cryptocurrencies may not be right for you.
However, if you are willing to ride the highs and lows and already have a healthy emergency savings fund, have paid off all your high-interest debt, and are on track with your retirement savings and other financial goals, you can consider adding cryptocurrency as an alternative asset to a diversified portfolio.
If you are interested in investing in cryptocurrencies or even the underlying blockchain technology and don’t want to invest directly, companies are beginning to offer ETFs and mutual funds that offer exposure to companies involved in blockchain technology and cryptocurrency. This certainly makes investing much easier, but if the value skyrockets, you’ll have to share in the spoils.
Also understand that the SEC does not insure cryptocurrency against exchange failures or theft. Some exchanges offer insurance, but it doesn’t protect against breaches or someone stealing your private key.
It can be easy to get caught up in crypto excitement — especially when you hear about overnight millionaires and day traders making incredible profits — but the lows can be excruciating. Just as you would with any speculative asset, set a maximum threshold for cryptocurrency in your portfolio — and stick to it.
Senior Vice President, Financial Planning, Carson Group
Erin Wood is the Senior Vice President of Financial Planning at Carson Group, where she develops strategies to help families achieve their financial goals. She holds Certified Financial Planner, Chartered Retirement Planning Counselor and Certified Financial Behavior Specialist designations.
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