Cryptocurrency: What Is It and Should You Own It?

July 23, 2021
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Through my 26 years of experience, it seems that every several years something “new and trendy” is introduced into the investing world. Whether it was technology stocks and the dot-com bubble in the 1990s, Real estate (that can only go up) in the 2000’s up to the recent FANG stocks (Facebook, Apple, Amazon, Netflix, and Google). Over the past 18 months, cryptocurrency has been the hot topic. In this vlog, I will discuss: How does crypto work – specifically Bitcoin. What are the risks of investing in Bitcoin? And finally, should we own cryptocurrency?

How does Bitcoin work?

Bitcoin is a digital currency that has been invented without a central bank. Whereas the Federal Reserve is responsible for America’s monetary system, Bitcoin doesn’t have a single person or organization in charge.

To understand the reason for this, it’s worth looking at why Bitcoin was created. In 2008, a person using the pseudonym Satoshi Nakamoto wrote a white paper setting out their vision for the cryptocurrency. They imagined a world where people could make electronic payments to one another without using a bank or PayPal. Nakamoto imagined that one of the biggest advantages would be lower fees when payments are made. Running a bank is an expensive business – there’s security and office expenses to think about – and these costs often get passed on to consumers. His vision was to make everyone their own bank, and to contrast a system where middlemen would no longer be needed.

This brings us neatly to how Bitcoin was created. In the very beginning, it took 30,000 lines of code to get the cryptocurrency off the ground. Blockchain is the name of the technology that underpins Bitcoin. To cut a long story short, this is a public, fully digitized database of each and every transaction that takes place on the network. Bundles of transactions are placed into blocks and attached to the chain of blocks that came before it. A new block can only be added when a complex puzzle has been solved – and the first person to do so receives Bitcoins as a reward.

So… how many Bitcoins exist?

Well, ever since the cryptocurrency went live in January 2009, the total supply has been capped at 21 million. At the time of writing, more than 18.2 million of them have already been mined. Quick maths will tell you there are about 3 million yet to discover – and in the coming years it’s going to get harder and harder to find them. Estimates suggest the final Bitcoin will be mined in 2140, some 120 years from now.

Fans of Bitcoin (or BTC) argue that this is a refreshing change from what many central banks do: effectively print more money. This measure, known as quantitative easing, often results in inflation, meaning things just end up getting more expensive. By having a fixed supply, proponents claim that Bitcoin manages to achieve digital scarcity – and this makes every coin more valuable as a result.

Before we move on, just a quick word about that supply of 18.2 million Bitcoin that’s supposedly in circulation at the moment. Although it’s true that they have all been mined, the number of Bitcoins still active is likely to be a lot lower than this. A couple of years ago, one estimate suggested 4 million BTC has already been lost for ever – and on top of that, another 2 million had been stolen. This would mean that a third of the mined supply is gone. Scarce indeed. You might ask, well, how can it just vanish? Where is Bitcoin stored? Well, put simply, a private key grants you the ability to spend your coins. Losing this key can have catastrophic circumstances. Whereas you can ask for a reminder if you forget the password to your email, there’s no such feature with Bitcoin. My son found out the hard way, as his password was stored only on his phone and is now safely secured on the bottom of Candelwood Lake.

Where to spend Bitcoin

All of this brings us to the most consumer-friendly part of our feature on Bitcoin explained simply: where Bitcoin is accepted.

Although the likes of Visa and Mastercard and cash still dominate payment methods worldwide, many retailers are beginning to accept this cryptocurrency – and others – as a payment method. In the US, big brands that allow you to make purchases in BTC include Microsoft, which offers the coin as a payment method on its Xbox Store.

What are the Risks of Bitcoin?

Regulatory

In December 2020, the U.S. Financial Crimes Enforcement Network (FinCEN), a unit of the Treasury Dept., proposed rules affecting banks and money services companies as well as crypto exchanges. Exchanges would have to collect names and home addresses for the owners of private crypto wallets receiving more than $3,000 in cryptocurrencies in aggregate in a day. This would prevent the anonymity that some people prefer and could possibly drive the price down. For example, as China has recently discussed more regulation and disclosures, this news has driven the price down.

Environmental

There’s ample evidence pointing to Bitcoin mining as a bad deal for the environment. Users for mining are extremely important for Bitcoin, which requires computers and processors. According to a recent Bank of America report, rising Bitcoin prices have led to an “astronomical” surge in CO2 emissions. Over the past two years, the historic rise of Bitcoin has caused emissions to increase by over 40 million tons. Mining the currency emits more CO2 than the whole of Greece. And that could worsen. If the price of Bitcoin were to rise to $1 million, Bank of America calculates, the digital currency could turn into the fifth largest CO2 emitter in the world, surpassing Japan.

Bitcoin is still incredibly volatile.

The price of Bitcoin — and all cryptocurrency, for that matter — is incredibly volatile because it is such a young currency and market. It is not uncommon for the price of Bitcoin to experience wild swings within a day or even within minutes. This makes trading a dangerous venture. Typically, fundamentals would support currencies in general. But Bitcoin isn’t a fully functioning currency, and its “fundamentals” are still emerging.

Bitcoin isn’t money.

Another reason that Bitcoin is so risky is that it is a tradeable asset but it is not backed by anything. Bitcoin has value only because the people who are trading it say it has value. There are no governments or regulatory bodies helping Bitcoin retain its value. The value is all basically “made up," for lack of a better word. To put it another way, as uber-investor Warren Buffett did, “[Bitcoin] has no unique value at all." This makes it an incredibly risky investment if the market ever decides it’s no longer valuable.

Should we own it?

If you're hoping to make a quick profit (short term) on Bitcoin, or your investing objective is to become a crypto millionaire, adding it to your portfolio could be a decision you'll come to regret. That's because timing your investment perfectly to see short-term gains is really difficult when the price of the cryptocurrency fluctuates so much. And Bitcoin would likely need to see much more widespread adoption before it has a solid chance of becoming a millionaire maker for most people who invest reasonable sums in it.

But there is a good reason to add Bitcoin to your portfolio. In fact, the best and only reason why most investors should purchase some of the tokens is if doing so helps to build a diversified portfolio. In other words, if you've made a reasoned choice that you should have some exposure to cryptocurrencies along with your other assets, then Bitcoin could be a good buy.

Diversification is essential to successful investing. When you spread your money around a broad mix of different assets, you stand a better chance of some of them performing really well -- even if others don't. You also reduce your risk from any individual investment, since you are limiting the amount of cash you put into it.

Bitcoin is one of those assets that could outperform your expectations, potentially providing much higher returns than many other investments out there. That's because it's one of the safer crypto investments due to the solid team behind it, its established reputation, and the innovative blockchain technology it's built on.

But you could also lose most of your money if it falls out of favor due to its environmental effects or because other cryptocurrencies turn out to improve upon its payment capabilities. The crypto market is also largely unregulated, relatively new and untested, and is extremely volatile -- much more so than the stock market. And the cost of virtual currencies can often become divorced from their underlying value, driven instead by social media hype and celebrity tweets.

So if you're thinking about adding Bitcoin to your portfolio, make absolutely sure that it fits within your broader pool of investments in a way that's likely to help you accomplish your long-term objectives. If you do that, you should hopefully end up happy with your decision in the long run.