Over the past few years, cryptocurrency has taken the financial world by storm and challenged traditional investors’ views of what is considered an “investment”. While for many the mention of cryptocurrency induces a roll of the eyes, it is undeniable that its creation and proliferation has resulted in significant real-world impacts. It is still a far way off from becoming the currency of the future but given its recent volatility and mentions in the media, we have taken a high level look at what cryptocurrency is and if you should be investing in it. Cryptocurrency is a complex and extensive topic so we have included links throughout this article where you can find out more information.
What is Cryptocurrency?
Cryptocurrency is a digital currency which is encrypted so it is nearly impossible to counterfeit. There are many different types of cryptocurrencies, but a hallmark feature is that it is not issued by a government or any other central authority which means it can be spent across borders and without government or bank interference. This anonymity and lack of oversight is why the currency was created, and why it is so popular with the black market.
To get cryptocurrency, you can either purchase it or you can mine it. Mining is the way new bitcoins enter circulation, but it is also critical for the maintenance of the currency. Essentially very powerful computers solve complex mathematical problems which help to verify the cryptocurrency’s transactions. If this sounds confusing, that’s because it is. The key piece here is that the first one to solve a puzzle is rewarded with cryptocurrency and to be the first you must use tremendous computer power. This reward system adds to the appeal of cryptocurrency for many investors as they mine for it like prospectors mined for Otago gold in the 1800’s.
Bitcoin is by far the largest and most popular cryptocurrency and one of the few which can actually be spent in retailers such as Microsoft and Starbucks. It became a popular name in the news, not because of its use as a currency, but because of its volatility as an investment. The price of bitcoin one year ago was about $14k NZD and reached a high of over $88k NZD in May before losing almost half its value in a matter of weeks.
This volatility is a key part of the interest in cryptocurrencies and is the reason it is not suitable for most investors.
Should you invest in Cryptocurrency?
If you are considering investing in cryptocurrencies there are some (many) issues to keep in mind. The most immediate concern is how to keep them safe. To use bitcoin as an example, you have a digital wallet where your bitcoin is kept. To access that wallet, you need a secure key code. If you do not have that key, then there is nothing you can do to access your purchased bitcoin. Around the world investors are kicking themselves for losing this key and missing out on millions of dollars. While there are third party services you can use to help keep track of your bitcoin, given the anonymous nature of the currency it is at risk of being stolen while on these services. One such service in Christchurch had $250k stolen by a staffer who eventually fessed up and returned the currency.
On top of the safety issues there are also ethical considerations to investing in cryptocurrencies. Do you want your money to support the currency of the darknet? According to a University of Sydney study “approximately one-quarter of bitcoin users and one-half of bitcoin transactions are associated with illegal activity.” Additionally, there are significant environmental concerns with the mining of these currencies. To have the best chance of getting a bitcoin you need thousands of computers running constantly which of course uses power. Bitcoin consumes about half as much energy as the UK. While there have been efforts to make mining more sustainable, it is a lot of power usage for what is described by some as “a pointless use of energy”. This link is to a UN article which, despite its “pointless use of energy” quote provides a balanced approach to the sustainability pros and cons with cryptocurrency.
Finally, there are, of course, investment issues with putting money in bitcoin. It is a highly speculative instrument that is difficult to understand and has extreme volatility. Speculation is not the same as investment. “Know what you are investing in” is a key tenet of investing and when you buy a share of Contact Energy you know you are buying a piece of the company’s future profits. Dogecoin on the other hand is a cryptocurrency which has seen a recent gain in popularity and was initially created as a joke before its meteoric rise earlier this year. What are you investing in here? That in the future you will use Dogecoin to purchase your morning flat white? While many investments are volatile and have price moves that are difficult to understand, cryptocurrency takes it to another level while providing no store of value, inflation protection or cash flow.
If you have good understanding of what you will be putting your money in and you still want to invest, there are ways that you can have some fun without derailing your financial future. One option would be to have a core portfolio where you are investing for the future and a satellite portfolio for more risky investments. The core portfolio would follow key investment principles such as diversification and ensuring the right risk level for your goals. The satellite portfolio is for bets on more speculative assets such as cryptocurrencies where you invest money that you are willing to lose.
There have always been unconventional ways to earn a return such as putting money into art, whisky, or antique cars. The key message for people wanting to “invest” in cryptocurrency is to know what you are investing in before putting your hard-earned money into an unproven, illiquid, under regulated, highly volatile asset.