Cryptocurrency can provide astronomically high returns overnight; however, there is also a considerable downside
Written byCFI Team
Published June 10, 2022
Updated January 8, 2023
With trillions of dollars invested and all the hype in cryptocurrencies and new crypto projects being rolled out daily, the question that many investors are asking themselves is whether cryptocurrencies are a good investment.
Despite investors losing most, if not all, of their investment in scams like the Squid Game token, TerraUSD stablecoin, and other altcoins, is it still wise to invest in cryptocurrencies? Even with the incredible volatility experienced so far and stories about crypto millions made or lost overnight, would a prudent investor still look at putting their money into the market?
Summary
- Cryptocurrency can be a great investment with astronomically high returns overnight; however, there is also a considerable downside.
- Investors should analyze whether their time horizon, risk tolerance, and liquidity requirements fit their investor profile.
- Investors need to do their homework, allocate an appropriate amount of their investment, and learn how to actually invest.
What to Consider First?
Before you decide on any investment, you should look at asset allocation. Simply put, asset allocation means spreading your investments across various instruments to provide diversified returns over the long run. The same applies to cryptocurrencies – you should decide on your risk tolerance, financial goals, and timeframe to decide how much of your investment portfolio can be allocated to cryptocurrencies.
You should research and conduct due diligence on the cryptocurrency or digital asset you are considering. Simply listening to a friend’s hot tip or buying digital assets out of the Fear-of-Missing-Out (FOMO) is not recommended. For any crypto-asset investment, it would be wise to read the whitepaper in order to understand better the cryptocurrency’s purpose, technology, and use case.
Understanding the team also gives you a sense of the track record of the people responsible. Ultimately, given the lack of regulation and oversight in digital assets, you want to avoid the risk of trading a crypto asset that collapses due to fraud.
Once you find a crypto asset you are comfortable investing in, you need to decide how to invest in it. Do you buy the crypto asset directly? If so, will you use your account at the crypto exchange or broker to hold your investment, or will you hold it yourself? If so, do you have a digital wallet set up? Or will you choose to invest via Exchange Traded Funds or an asset manager, like a hedge fund or mutual fund?
Do you decide that you want to invest by proxy and buy the stocks of crypto exchanges? Or buy stocks in other publicly listed companies that are involved in blockchain technology or supply the sector, like GPU manufacturers? Each one of these investments comes with its own pros and cons, and the prudent investor would weigh all of the given options.
Is Cryptocurrency a Good Investment for You?
Firstly, we need to make the distinction between investing and trading – the biggest difference being the time horizon. With trading in any asset, the time horizon tends to be short-term and often more speculative in nature. It is not rare for traders to execute dozens of trades a day to take advantage of intra-day price fluctuations.
Trading vs Investing
Trading is approached with discipline as those who are most successful carefully manage their exposures. On the other hand, investing is also a disciplined plan but meets specific financial goals over a longer period, usually five years or more. Investors may build a strategy in order to save for college, purchase a house, or plan for retirement.
Next, you need to examine your risk tolerance. As cryptocurrencies experience volatility, whether cryptos is a good investment depends on how much risk you can bear. If even small swings in prices keep you up at night, higher volatility investments may not be the suitable investment for you.
With crypto assets experiencing levels of price volatility that aren’t too different from those experienced by other asset classes, such as growth stocks or high-yield bonds, they are risky assets. You need to be prepared to face fairly significant price swings or potential loss.
Liquidity constraints
One further consideration is the liquidity constraints that face certain crypto assets. Liquidity is simply the relative ease or difficulty that which one can buy or sell a certain asset when they want to without moving the price significantly.
As an example, if you are looking to buy a rare automobile, there are that many of those around and if you can find one, the price you will pay is effectively the seller commands. If you buy it, the next seller will certainly command a higher price for the next buyer – making the market very illiquid.
However, if you are looking to buy something more generic, say some Japanese yen in exchange for your U.S. dollars, there is ample liquidity so the price you pay for the yen will be wherever the market lies. The next buyer of the yen will also likely purchase the yen at or near the same price you transacted as there is abundant liquidity in sellers of JPY who will accept UD in return.
Certain cryptocurrencies are more liquid than others, which means that to invest in such cryptos, you must be prepared to deal with the illiquidity when you buy and potentially when you sell. A worst-case scenario would be the inability to sell your crypto investment when you need to, due to a lack of liquidity in that particular cryptocurrency.
Benefits of Investing in Cryptocurrency
So far, we’ve discussed some of the main considerations that investors need to be cautious about but there are certainly positive arguments about whether cryptocurrencies are a good investment as well.
1. New asset class
As cryptocurrencies mature and develop, such as we’ve seen with Bitcoin and Ethereum, we also see the emergence of such assets as a new asset class. To be sure, we’ve seen large professional fund managers, such as Cathy Wood from Ark Investment Management, creating dedicated investment funds solely investing in Bitcoin and other cryptos.
2. Diversification
The said institutional investors also look to diversify their risks by keeping different investments that behave differently under the same economic conditions. Some argue that cryptocurrencies provide positive diversification effects, specifically against rising inflation.
Moreover, we’ve seen the development of more investment instruments that capture the upside of not only specific cryptocurrencies, such as options and futures on Bitcoin and Ethereum, but also specific investment funds that professionally manage cryptocurrencies on behalf of investors.
3. Upside potential
Lastly, one more positive is the fact that the sector is quite new, and as such there are potentially much more changes that may come down the line to make investing in cryptocurrencies even more attractive. Examples are stablecoins, which are cryptocurrencies that are linked to the value of a fiat currency and assets to back the digital currency.
For those who worry about fraud, there can be more stringent regulations, say to deal with the Initial Coin Offerings, to help protect investors. We mentioned futures on cryptocurrencies and as the market develops, there can be futures on other cryptocurrencies that are traded on a reputable exchange. Futures also allow for cryptocurrency bears to sell the asset short, thereby improving the liquidity overall.
Related Resources
To keep learning and advance your career, the following resources will be helpful:
- Free Introduction to Cryptocurrency Course
- Cryptocurrency Intermediates: Bitcoin Explained
- Investment Horizon
- Risk Tolerance
- See all cryptocurrency resources
