Cryptocurrency has been getting a lot of headlines in the financial press the last few years, and I am often asked about investing in it. Many investment advisors expected the glory days of digital currency to be long over by now, yet it continues to get stronger, increase in price, and find a broader following. What’s up with crypto, and should it be in your portfolio?
First, what is cryptocurrency? It is one form of digital currency, money that exists only in electronic form which may or may not be controlled by any country’s central bank. There are three types of digital currencies:
- Cryptocurrency, such as Bitcoin and Ethereum. A unit of currency is an encrypted data string, created or “mined” by computers solving complex digital problems. A computer network called a blockchain maintains the currency, securely records transactions, and limits the creation of new currency.
- A virtual currency is always unregulated, and it is controlled by its developers.
- A Central Bank Digital Currency (CBDC) is created and regulated by a country and is legal tender in that country. According to a July 22, 2021, article at Axios, 16 countries, including China, are in the pilot phase or have launched a CBDC, and 15 others have CBDCs in development.
With interest from this many countries, it certainly doesn’t look like as if electronic money is going away anytime soon. What are the advantages of using digital currency to buy and sell goods and services?
- Transactions are fast. There are no clearing houses or banks involved. Payment is instantaneous, rather than taking days or weeks to work through the system. International transactions are also cheaper, with no costs of converting one currency into another, which often add 3% or more to any foreign transaction.
- Unlike physical currencies, digital units cannot be physically destroyed, misplaced, or lost.
- Transactions are private since they do not pass through the banking system.
There are disadvantages to crypto and virtual currencies as well.
- The biggest drawback, in my opinion, is the extreme volatility of their price. While the daily value of the US dollar fluctuates by 0.10% to 0.50%, the average daily volatility of Bitcoin is 3.0% to 6.0%, around 6 to 60 times higher. A currency needs to be stable to have value as a medium of exchange, so the volatility and unpredictability of digital currencies make them a poor transactional currency.
- If you don’t have an internet connection, you can’t use your currency.
- If you forget or lose the password to your digital wallet, your money is forever lost with no hope of recovery. Your digital wallet is also susceptible to theft, just like any physical currency.
The same high volatility that makes crypto and virtual currencies a poor choice for currency is what makes them an enticing vehicle for speculating. Had you purchased $100 of Bitcoin for $1.00 in 2011, it would have a value of $6,200,000 today. Had you purchased $100 US Dollars (DXY) in 2011, you would have $119.
It’s obvious the allure of digital currencies is not transactional. Nor are they viewed as a traditional investment with intrinsic long-term value, like real estate, stocks, or bonds. They are viewed as a speculation, a high-risk vehicle by which to get rich quickly, just like investing in options or future contracts.
Digital currencies typically have no place in any conservative investment portfolio. Instead, they need to be approached in the same manner as any risky speculation. Never borrow to speculate in virtual or crypto currencies, and never commit more money to speculating in them than you are absolutely comfortable in losing.
Related: Getting a Handle on Valuing Bitcoin