Cryptocurrency investing is similar to investing in other ETFs, but to understand the cryptocurrency space, you’ll need to have an appreciation for the subtleties that cryptocurrencies bring to the traditional asset model. If you’re interested in investing in cryptocurrency, this article will walk you through everything you need to know to get your portfolio started.
First, we’ll talk about the differences between cryptocurrencies, standard currencies (known as “fiat” currencies), and stocks. After you’re caught up on the basics, we’ll show you a few options for cryptocurrencies that are ripe for investment and dive into the guts of how you should go about investing in cryptocurrency.
Once the technical bits are out of the way, we’ll wrap up with an explanation of how cryptocurrency investments should report on your taxes. Without further ado, let’s learn about how cryptocurrencies are special relative to other assets.
Cryptocurrency vs. Stocks vs. Fiat
If you’re reading this article about starting to invest in cryptocurrencies, you probably already understand that cryptocurrencies are digital currencies which are created independent of any centralized authority and can trade as commodities using digital exchanges.
Likewise, if you’re an investor of any sort, you probably already understand stocks, though your understanding of their various “options” may be incomplete. For this article, you won’t need to understand stock options, just that stocks are a tradable share of a corporation’s capital which can sometimes offer proportional dividends of that corporation’s profits.
Stocks are commodities which are valuable because they back a portion of capital that investors can redeem directly with the corporation that issued the stock, should they choose to. You may hear some people refer to the concept of cryptocurrency stocks, but this is a bit of a misnomer because cryptocurrencies can’t be returned to their issuer, generally speaking. The concept of holding value in the context of the issuer is important, so keep it in mind as we continue.
Most investors will be unfamiliar with the concept of fiat currency. “Fiat” currency is a term that’s often thrown around in discussions of investing in cryptocurrency, typically by cryptocurrency idealists who think that cryptocurrencies are philosophically superior to the real-world currencies that we use every day. But why would someone think that cryptocurrencies are superior to the physical and digital dollars that we use every day?
Fiat currency is money without intrinsic value. Note that this doesn’t mean that fiat currency is worthless—in fact, most people would tell you that fiat currency is worth far more than any cryptocurrency or stock because fiat currency has a guarantee from a government that it is a valid media of exchange.
The core difference between fiat currencies and stocks or cryptocurrencies is that fiat currencies can’t redeem for the value they claim to represent, nor did any process cause the fiat currency to be value before it issued. Fiat currencies are simply worth whatever the government that issues them says they are worth.
To avoid sounding too tautological, consider an example: Alice wants to buy a piece of candy from Bob. Typically, Alice would hand Bob a one dollar note of US currency, which Bob would then put into the cash register and perhaps subsequently use to buy other goods. If Bob were to try to redeem his dollar to the government in exchange for a piece of candy, he would fail. In the past, Bob could redeem the dollar for a piece of gold or silver, but at that point, the dollar was not a fiat currency.
Cryptocurrencies aren’t redeemable for a physical object, but they do have a value which generates differently. Cryptocurrencies have value because effort is required to produce them, and that effort increases over time. We’ll talk more about mining later on, but for now, just recognize that cryptocurrencies have a value that fluctuates in response to how much work it takes to produce them.
List of Cryptocurrencies
In order of market capitalizations as of late 2016, the biggest cryptocurrencies are:
- Bitcoin – over $11 billion
- Ethereum – nearly $900 million
- Ripple – nearly $300 million
- Litecoin – nearly $200 million
- Monero – nearly $100 million
It’s also important to note that the market cap of over 700 less-prevalent cryptocurrencies amounts to just over $600 million, putting them in totality at roughly %75 as much market capitalization of Ethereum and as a tiny fraction of Bitcoin. This is critical knowledge for those interested in investing in cryptocurrency because market cap associates with liquidity.
Though different exchanges (which we’ll talk more about later) offer different levels of liquidity based off of their volume, novice cryptocurrency investors need to be aware that the biggest opportunities exist in those 700+ altcoins that don’t make the list of the biggest five. The smaller the coin, the less liquid trading in it will be, but the larger the chance of high volatility and thus high returns on your investment—or catastrophic losses.
Remember, altcoins are unpredictable, but a good place to gamble. The biggest coins are far more stable and tend to have large and relatively well-controlled trends except for black swan style crashes.
How To Invest In Cryptocurrency
To get started trading cryptocurrency, you’ll need to get set up with a few trading exchanges and a few different wallets for each of the currencies that you’re interested in investing.
Investing in cryptocurrency will require some technical aptitude if you’re planning on investing in the smaller currencies, but for the big few—Bitcoin, especially—you can easily get by via the exchanges doing most of the technical work for you. The burden of trading profitably is on you.
Especially if you are new to trading commodities, read up on options, investing, and the role of exchanges. There are many seasoned traders and powerful algorithms trading on the cryptocurrency exchanges across the world, and they love nothing more than to take a newcomer’s money.
Exchanges are markets where you can offer cryptocurrencies for sale or purchase cryptocurrencies for your use. Many exchanges traffic in multiple currencies, but some specialize in Bitcoin alone, so be sure to check out the exchange beforehand. If you plan on trading your USD for cryptocurrencies to start, the largest and most reputable exchanges are the best place to begin because they’ll give you the best rate.
Keep in mind; not all exchanges are willing to accept USD or cash out in USD. Many Western exchanges will operate only in Euros, whereas the Japanese and Chinese exchanges will operate only in yen and yuan respectively—there’s no way to get around this other than to exchange your USD for these other fiat currencies if you want to trade on these exchanges, which isn’t usually worth the trouble.
You’ll want to have accounts on at least a couple of exchanges. Sometimes there can be small variations in pricing from exchange to exchange, and you can take advantage of these arbitrage opportunities only if you have multiple accounts and multiple wallets which can accommodate the transactions.
For you to use exchanges, you’ll need to understand how to use a cryptocurrency wallet. Most exchanges have a wallet associated with your account where your coins remain, but they’ll also prompt you for a private wallet address on your hard drive or elsewhere in the cloud.
Think of a wallet as a locked bucket to keep your cryptocurrencies. You can only store cryptocurrencies of the same kind in a given wallet, so no mixing Bitcoins and Litecoins into the same spot. You can make as many wallets as you want. All transactions interact with your wallet, whether it’s the wallet associated with your account on the exchange or your wallet sitting on your hard drive.
Wallets are also features that can be publicly accessible for various purposes. If you decide to invest in one of the less traded coins, you’ll probably encounter concepts like trading fees, which will deposit in certain wallets owned by the exchange after each trade.
If you decide to dabble in the illegal uses of cryptocurrency, you’ll probably also encounter currency laundry wallets. Laundry wallets accept many different users’ currency and redistribute them through a variety of other wallets before finally depositing them into a brand new wallet, thus obfuscating the trail of coin ownership to anyone trying to analyze from the outside.
The Best Time To Invest
The question of when to invest is one that has haunted investors of stocks for a long time before cryptocurrencies. For investing in cryptocurrency, some of the traditional caveats apply, but there are also a few exceptions.
To summarize the traditional wisdom on timing the market:
- The best time to invest is right now
- The best way to invest is consistently, regardless of market circumstances
- If you try to time the market by waiting for a period of low valuation, you’ll likely miss at least some of the period of high valuation
- If you try to time the market by implementing an options trading strategy at the right time, you’ll likely miss at least some of the period you are targeting
- If you lack the grit to ride out bear markets, your efforts to time the market will likely result in large loss of funds
- If you lack the grit to ride out bull markets, your efforts to time the market will likely result in large loss of potential value
These teachings are broadly true in the cryptocurrency space for the major cryptocurrencies like Bitcoin, Litecoin, and Ethereum. Don’t try to time the market, just keep investing steadily regardless of conditions, and you’ll benefit from the historical rising price of these cryptocurrencies over time. The historical price of Bitcoin bears this strategy out. When you start to invest, declare a set point of value at which you’ll exit the market and take your money home—then keep investing, and wait.
The caveats are unique to the cryptocurrencies with lower market caps. Remember:
- Cryptocurrencies where one mining pool commands the majority of mining power can easily have their price manipulated in ways which hurt regular investors
- Cryptocurrencies which are recent victims of major hacks or identified flaws in their protocols can easily suffer permanent price drops or protocol abandonment
- Less popular cryptocurrencies can suffer from “rats leaving a sinking ship” phenomenon, where liquidity drops to near-zero and results in a total loss of all stored value as a result
Do your research before making any investments. Learn what insiders are saying about the cryptocurrency, and learn what their misgivings are.
Aside from the above, you should also be very wary of participating in any initial coin offerings (ICOs). ICOs advertise as the ultimate way to time the market—you buy into a new cryptocurrency on the ground level, before it’s public. Once it goes public, the value of the coin shoots up as a result of the coin’s superior technical virtues, and you’re rich because you were farsighted enough to invest early on.
ICOs rarely work as intended, however. Most of the people who buy into ICOs are left holding worthless cryptocurrency after the coin’s public debut simply because the coin itself has nothing to offer other than being new. While it’s debatable whether ICOs are a scam or not, you should be extremely wary of any advertised cryptocurrency that has yet to hit the exchanges.
If it isn’t already on the exchanges, it’s equivalent to a shipwreck underwater that may contain treasure. Funding the ICO is like funding the expedition to explore the shipwreck and find the treasure—except that it’s entirely possible that the shipwreck has no treasure whatsoever, and you’ve merely paid off the expedition crew, who were in on the entire scheme all along.
Then, of course, there are the ICOs which make the initial investors into millionaires overnight. Tread with caution, and remain very skeptical.
The Best Way To Store Cryptocurrency
It’s important to keep your wallet files safe. Wallets are encrypted by default—meaning that you can’t simply change them so that you have an infinite amount of cryptocurrency—but they’re also very frequently targeted by hackers. It’s best to keep your wallet files passworded and zipped into a hidden folder on your computer until you need to use it.
Remember, if someone can steal your wallet file, they can steal your cryptocurrency. For the casual user interested in investing in cryptocurrency, we suggest that you use only your exchange’s online wallet and one single wallet stored on your computer.
This will keep as much of your wallet’s security risk exposure in your control as possible.
Offline wallets prevent anyone from stealing your wallet unless either the exchange fails—which, while unlikely, would be a huge problem for many people—or unless you’re a target for hacking, which is extremely unlikely unless you are hoarding huge amounts of cryptocurrency in your wallet.
As you gain trading acumen, it may be appropriate to spread your cryptocurrency over several wallets, stored in several places. This will hedge your fortune against a single vulnerability wiping out everything that you’ve earned.
Dealing With Taxes
Now that you have a basic investment strategy worked out, it’s time to figure out how much you owe the tax man at the end of the year.
Cryptocurrencies aren’t considered currencies whatsoever by government regulators. Instead, cryptocurrencies are commodities. This means that their gain or loss of value is subject to the steep capital gains tax. This can easily wipe out modest gains in value, so you should be advised not to cash out your coins into US dollars unless your profits will far exceed the difference between the buy and the sell value plus taxes.
There are a few online calculators which might be helpful when it comes to calculating your taxes, but it’s unknown whether the people that use these devices end up getting a visit from the IRS or not. As long as you make a good faith effort to pay what you owe, you should be okay—just remember to account for all of your wallets across all of the exchanges that you participate in, and don’t be afraid to report a loss on an altcoin investment if you had one.
It’s unclear whether the many minor cryptocurrencies will prompt the wrath of the IRS in the same fashion as shirking Bitcoin taxes will, but you shouldn’t push your luck. Keeping clean records is much easier with the help of exchanges which promise to give you your tax paperwork at the end of the year, so try to seek one of those out when you are getting started with your investments.
Good luck, and remember to stay frosty if people on the cryptocurrency boards start to talk about “going to the moon.”