Over the past year, there has been increasing interest in cryptocurrencies like Bitcoin, LiteCoin, Ethereum, and even the (joke) Dogecoin. This can be seen merely by the amount of volume sold over that time period, especially in the past six months. As much as it’s in the news, there are still a lot of unanswered questions about crypto and whether it’s a good idea to buy it.
The returns on Bitcoin in particular have been nothing short of shocking, with the price rising from approximately $6,800 per coin in mid-April 2020 to around $63,000 in mid-April 2021. (Of course, that number fluctuates pretty rapidly, so note the date of publication). Ethereum has also had tremendous gains in the past couple of years, especially from the end of 2020 into early 2021.
Seeing this, lots of people I know are starting to dabble in crypto. From classmates to clients to colleagues, digital currencies are all the rage today. But what are they, how do they work, and is it a good idea to buy them?
What is Bitcoin (and cryptocurrency, generally)?
Cryptocurrency is a fairly new concept in the world of money. But it has been around for well over a decade now. Satoshi Nakamoto (the real creator’s pseudonym) founded the currency in 2009. Bitcoin uses a technology called Blockchain to ensure the security of its transactions.
Blockchain technology stores information in separate “blocks” and then links them together to access the information in its entirety. Once a transaction takes place in Blockchain, the recording is irreversible. No single person or central bank controls the technology. Rather, it is highly decentralized, giving all users control over it.
Nakamoto created the program to have a total of 21 million Bitcoins. This means the currency cannot be inflated in the same way traditional government-issued currencies have been. Many of its users express concern about the Federal Reserve’s printing of the dollar and the decline in purchasing power that inevitably comes with such inflation. Bitcoin and other cryptocurrencies are seen as one way to protect against that erosion.
There are no physical Bitcoins. Everything is digital and held by users on exchanges like CoinBase or in digital currency wallets. These programs are highly security conscious to protect the user’s privacy and holdings. Wallets use unique codes to ensure that when the device is connected to the internet for transactions, only the one who has the authorization code can access the currency contained within it.
How does Bitcoin (and other cryptocurrencies) work?
This is a fairly complicated question. Given the fact that no central bank issues these currencies, it is the creators and users of the currencies that affect the price and value. For Bitcoin and similar currencies, users earn new coins by engaging in a process called mining, which involves computers solving increasingly complicated math equations.
At the start, the equations were fairly simple. But now they are so complicated and require so much computer processing power that annual Bitcoin mining uses about 120 TWh (tera-watt hours) of energy. That’s more than what some countries use.
Back in its early years, some users flippantly talked about how they had a few hundred Bitcoins. $100 of Bitcoin in October 2010 equaled about 1,000 Bitcoins. It wasn’t very energy-intensive to mine these coins, but over time the equations have become harder to solve and more processing power is required. It’s now a niche industry and the number of coins that are being mined have slowed down as a result.
Nakamoto wrote the software program to allow only 21 million Bitcoins to ever be “mined.” As of mid-April 2021, there are about 19 million Bitcoins mined and available for transactions. The supply will gradually dribble out new Bitcoins for the next few decades.
The basic idea is that there is a fixed supply of Bitcoins, Ethereum, (and other currencies) that can ever be created by fiat the same way that central bank currencies can. This is appealing to users who are skeptical of governments printing copious quantities of money, especially over the past year in response to the economic fallout of the COVID-19 pandemic.
Should you buy Bitcoin, Ethereum, and other cryptocurrencies?
Okay, you’re still with me. Take a breath. This is complicated stuff. Even how I presented it is a very simple version of the actual inner workings of cryptocurrencies. To dive more into those nitty-gritty details, check out the hyperlinks above.
So, all that said, the final question is whether it’s a good idea to buy it. My answer is a bit nuanced, so let’s walk through it.
Dave Ramsey believes that cryptocurrencies are not a good idea. He points to the volatility and the fact that they are a brand new concept, never before done in world history. And he has some fair points on that.
My perspective is not to dismiss it out of hand, though. While the currency is not issued by a central bank, that doesn’t mean it’s just a fad or fraud. Quite the contrary, actually.
We now have over 12 years of records on Bitcoin. Other cryptocurrencies have arisen as well as competing means of exchange, like LiteCoin, Ethereum, Cardano, Stellar Lumens, etc. What I also find fascinating is how Bitcoin miners in Venezuela were using those processes to have money for necessities as the country’s currency and economy were collapsing.
But it’s not just the most desperate making use of Bitcoin and other cryptocurrencies. Now, major investment firms are opening up access to crypto funds. Soon there will also be a Bitcoin ETF (exchange-traded fund) available in Canada. I expect an American fund to be available in the near future.
All that to say: cryptocurrency is not going anywhere. There is still a lot of volatility with it and only a few, albeit an increasing number of, merchants accept payments in cryptocurrencies. But all of that is changing each day as more people enter the crypto world and explore what its potential is.
My perspective on Bitcoin, Ethereum, and other cryptocurrencies is to treat it as an individual stock. Stocks tend to be volatile, and when the company has financial difficulties, the price of the stock can tumble quickly. This is why holding a mutual fund protects you, because there are hundreds of stocks in the fund that can help to absorb the impact of some that fall in value.
In treating things like an individual stock, Ramsey has suggested in the past owning no more than 10% of your retirement savings in individual stocks. This is probably a good rule of thumb, but I would put it even lower around 5%. For cryptocurrency, at this point, I would not want to own more than 3% of my net worth in it.
The way I plan to treat it is as gravy. It’s extra, a bonus. But if there isn’t any gravy, there’s still the main course of the meal: your other investments and paid-off home. If a highly volatile type of savings/investment is your main meal and it crashes overnight (sometimes literally with crypto), that’s called being up a creek.
My perspective on this may shift a bit over time. Especially if I pursue the Certified Financial Planner designation (stay tuned), I will have a more thorough understanding of the investing process and will add cryptocurrency considerations to my advice.
For now, my suggestion is to not buy anything you would not be okay with losing completely. Think of it as fun money with a potentially great return. But fun money is just that: fun money. Continue investing a good amount into your Roth IRA and 401k each year and choose funds that meet or beat the S&P 500 index. But a bit of Bitcoin, Ethereum, and other cryptocurrencies in your overall portfolio couldn’t hurt.
