Key Takeaways

• What is cryptocurrency?

• Types of cryptocurrency

• How to invest in cryptocurrency

• Tips to know before investing in cryptocurrency

“Cryptocurrency” is such a cryptic concept, isn’t it? Lots of people have difficulty understanding the technology that powers cryptocurrency, let alone how it works as an investment.

This beginner’s guide will explain how cryptocurrency works, and will also teach you how to invest in cryptocurrency should you decide it’s the right type of investment for you.

What is Cryptocurrency?

In theory, cryptocurrency is a virtual currency that’s held and distributed online. In reality, it’s a digital asset that may gain or lose value in a similar fashion to stocks and bonds.

Whereas a cash currency incorporates paper bills and metal coins, a cryptocurrency uses a virtual “coin,” “token,” or “unit.” You can purchase a coin/token/unit from any company that facilitates cryptocurrency exchanges, and you can trade, buy, or sell with other people who own crypto—not unlike stock trading in corporate America.

What makes cryptocurrency distinct from standard currency (besides the fact there’s no physical cash) is that cryptocurrency is “decentralized.” There’s no central authority that governs the currency.

For example, the Federal Reserve manages the national currency of the United States, influencing prices, interest rates, and the overall supply of money being circulated in the economy. Cryptocurrency has no such oversight.

However, a cryptocurrency is generally maintained by a “system.” The system—which is managed by a cryptocurrency company—tracks all the units of cryptocurrency and their owners. The system will also determine when new crypto units can be created. All right, so that might sound a little bit like the Federal Reserve. But cryptocurrency systems have no central location or server where units are stored. There are no virtual banks.

Bitcoin is by far the largest and most popular cryptocurrency system in the world. In fact, some financial experts define any cryptocurrency that’s not Bitcoin as “altcoin.” That’s a testament to Bitcoin’s dominance.

How Does Cryptocurrency Work?

You might be wondering, “What gives a cryptocurrency unit its value?”

For most assets, the value is determined by market factors. Let’s take the real estate market, for example. What determines the value of a property? A property might be valuated higher if it’s in a desirable location, or if it’s more luxurious, or if it’s in a neighborhood that’s likely to see an increase in home prices.

What about stocks? Stock value is generally determined by the success of the company (or the impending success of the company). Higher profits mean higher dividends, which means higher stock prices.

Cryptocurrency values are also tied to the marketplace, but in a different way. There’s no physical asset that’s affected by the local economy. And the value isn’t tied to corporate profits. The value of a cryptocurrency unit is entirely dependent on whether or not people want to buy cryptocurrency units.

Wait… what??

You read that correctly. The value of cryptocurrency is based on nothing but consumer interest in buying cryptocurrency. If lots of people are buying crypto, then the value will rise. If people stop buying crypto, then the value will fall.

This is a head-scratching concept for both beginning and veteran investors. But it’s not such a crazy idea to high-risk investors who frequently trade in volatile assets. A “volatile asset” is an asset that may experience large and rapid changes in value. Penny stocks are a common (and more “socially acceptable”) type of volatile asset. They often pose too much risk for the average investor, but they can yield extremely high returns to those wolves of Wall Street who carefully study marketplace activity.

In the same vein, cryptocurrency can yield high returns if an investor takes advantage of marketplace surges.

What is Blockchain?

You might also be wondering, “What makes cryptocurrency an asset? How can something that has no physical existence be worth any money at all?”

American currency used to be backed by physical assets: first, gold, and then, silver. Every bill or coin would be linked to a unit of gold or silver so that it had a physical value, of sorts. Nowadays, the American currency is not backed up by anything, but every bill and coin has a value that’s assigned by the federal government. You can technically print your own dollars at home, but they’re not worth anything unless the government says they are. (Pro-tip: Don’t print your own dollars at home and try to use them—this is a crime called “counterfeiting.”)

Here’s the main problem that cryptocurrency aims to solve: how can something on the internet have individual value?
A $1 bill has value because it has been printed and assigned value by the federal government. Nobody can duplicate it. It’s yours.

Digital assets are more complicated. Take a digital photo, for instance. A digital photo is made from computer code. Let’s say that you emailed a digital photo to your friend. Your computer copies the code and transfers it to your friend over the internet. Now a single piece of code exists on both your computer and your friend’s computer. You’ve duplicated the code so it can’t have any individual worth. And who owns the digital photo—you or your friend? It’s unclear.
Cryptocurrency uses a type of coding called “blockchain” to give a crypto unit an individual value and to assign ownership to a single person or entity.

Blockchain splits a single code into multiple codes that are stored across many different computers.

For example, let’s say that the code for a crypto unit was 13BD22.

• “13” is stored on Computer A.

• “BD” is stored on Computer B.

• “22” is stored on Computer C.

If a hacker wanted to duplicate the code, he or she would need to hack all three computers to gain access to the entire code. Of course, in a real blockchain, the code would be much longer and would be spread across thousands of different computers.

Every computer that holds a piece of the code is called a “node,” and together these computers comprise the “public ledger.” The purpose of the public ledger is to ensure that all cryptocurrency data is accurate. Whenever there’s a change in data, every computer checks its records against one another. It’s an effective way to detect hacking.

But if you wanted to make legitimate changes to the data (like if you sold your crypto unit to someone else) then you’d just use a cryptographic key, like a password. The smart thing about blockchain is that you can only add data to code. You can’t erase any data. That’s to ensure that the ownership history will always remain intact.

How to Invest in Blockchain

Blockchain is often associated with cryptocurrency, but it’s a technology that stands on its own two legs. It might be a good investment option in its own right.

Several large technology companies run blockchain operations, such as IBM, Oracle Corp., and Visa. You might consider purchasing individual stocks in these companies, or you could purchase exchange-traded funds (ETFs) that deal exclusively with blockchain-related companies. Some viable ETFs include:

• Reality Shares Nasdaq NexGen Economy ETF (BLCN)

• Amplify Transformational Data Sharing ETF (BLOK)

• Innovation Shares NextGen Protocol ETF (KOIN)

These ETFs have performed very well over the past year and have generated good returns. The blockchain sector, as a whole, has outperformed the market.

Many investors are wary about investing in blockchain because they’re afraid of the volatility that’s associated with cryptocurrency. But it’s important to know that investing in companies that run blockchain is not the same thing as investing in cryptocurrency. Investing in the stock market is less risky than investing in crypto.

Is it Worth it to Invest in Cryptocurrency?

Hopefully, you now have a pretty good understanding of cryptocurrency. Now you might be asking yourself, “Is it worth it to invest in cryptocurrency?”

Cryptocurrency is a high-risk investment because, as mentioned earlier, it’s a volatile asset.

Here’s a scenario that’s likely to happen in cryptocurrency. Let’s say you buy a few units of Bitcoin. Something happens that drives a large number of people to purchase Bitcoin:

• Endorsements: Public figures or business leaders promote Bitcoin, which entices a larger number of people to buy.

• Press: Bitcoin enters the public consciousness due to a movie, article, or journalistic piece, and it leads to an increase in purchases.

• Manipulation: Stock manipulators purchase a large number of Bitcoin units. They contact hundreds or thousands of amateur investors and convince (or coerce) them to purchase units, as well.

When everyone starts buying the cryptocurrency, the value of each crypto unit increases sharply. But remember: crypto is a volatile asset, and the value may fall as quickly as it rises.

If you sold your units early, you could possibly make a huge return on investment. That’s what the stock manipulators do. They’d sell their units when the demand is highest and reap a large profit.

But it’s difficult to determine the right time to sell your holdings. Timing the stock market is hard enough, but it’s even harder to time a volatile market. The cryptocurrency could fall dramatically in value in just a couple of days or even a couple of hours. If you didn’t sell your units before the demand cools, they could nosedive in value and generate a substantial loss.

However, savvy investors who don’t mind the risk could potentially earn huge profits, so long as they pay close attention to the cryptocurrency market and act quickly when there’s a surge in demand.

Again, cryptocurrency is a high-risk investment and it shouldn’t be the foundation of your investment strategy. Know that cryptocurrency has generally been decreasing in value year to year.

First, you should prioritize low-risk investments, like bonds and rental properties. Then you should plan some medium-risk investments, like stocks or fix-and-flip properties. A high-risk investment, like cryptocurrency, should only be the tip of your investment pyramid.

Like all high-risk investments, you should try and generate a passive income that can adequately absorb any losses you might take on crypto.

What are the Types of Cryptocurrency?

There are many different types of cryptocurrency systems that you can invest in. Bitcoin is arguably the grandfather of all crypto. It has been around for over 10 years and it’s the largest cryptocurrency system in the world, with a market capitalization of about $128 billion.

But here are some of the other cryptocurrency you can buy:

• Litecoin: Created by a former Google employee, Litecoin is very similar to Bitcoin, but has shorter transaction times and lower fees.

• Ethereum: It’s a cryptocurrency, but the main focus is on purchasing applications without having to pay a middleman (in other words, bypassing the Apple Store).

• Ripple: This is a cryptocurrency that doesn’t use blockchain technology. It’s mostly used by corporations to move large sums of money.

• Cardano: This is a blockchain-based cryptocurrency that’s used primarily to store private data.

How to Invest in Cryptocurrency?

If you’ve decided that you’re willing to take a risk on crypto, you might be asking yourself, “How do I invest in cryptocurrency?”

Every cryptocurrency is a little bit different, but, assuming you want to purchase for-profit, let’s cover how to buy crypto for currencies like Bitcoin and Litecoin.

First, you need to pick an exchange to buy from—like choosing a broker for stocks. The most popular crypto exchanges are:

• Coinbase

• GDAx

• Bitfinex

These exchanges enable you to purchase crypto with your debit card. Typically you’re able to choose between different cryptocurrencies, like Bitcoin and Ethereum. A single coin might be valued at thousands of dollars. However, most exchanges allow you to buy a fraction of a coin, which is far more affordable for first-time investors. Just like a stockbroker, an exchange will charge fees for every transaction you make.

Once you’ve purchased a unit of crypto, it’ll be added to your “wallet.” Not your actual wallet, of course, but a virtual wallet that you’ll receive when you open your account with an exchange. The wallet will hold the codes for all your cryptocurrency.

There are software wallets and hardware wallets. A software wallet is just a software program that holds your crypto. You need it for active trading, and you’ll typically get one when you open an account with an exchange.
A hardware wallet is a physical device that holds your crypto. It looks like a USB drive and it’s more secure than a software wallet, but it’s not necessary unless you’re buying a huge portion of crypto.

Tips to Know Before Investing in Cryptocurrency

Here are a couple of important things you should know before investing in cryptocurrency.

• Capital Gains Tax: For tax purposes, cryptocurrency is considered an asset, like a stock or property. When you sell crypto and make a profit, you’ll have to pay capital gains tax on what you earned. Keep this in mind when you’re budgeting for the year and planning for taxes.

• Short-Term Investing: Because cryptocurrency is a volatile asset, many investors would consider it to be a short-term investment rather than a long-term one. It’s possible that in the future, cryptocurrency may become a stable investment and that long-term holdings will yield significant profit. But that’s a big “if.” Since cryptocurrency values have been decreasing, you might have a better chance of making a profit by timing the market. That’s incredibly risky, but crypto is high-risk. If you want your money to appreciate over a long period, you’re better off investing in long-term bonds, index funds, or IRAs.

Summary

Cryptocurrency is a digital asset that uses blockchain technology to assign ownership to each unit. The value of cryptocurrency is entirely dependent on the demand in the crypto market—cryptocurrency units have no intrinsic value. Cryptocurrency is a high-risk investment because it’s a volatile asset and investors should buy with caution. It’s easy to learn how to invest in cryptocurrency. Just open an account at a cryptocurrency exchange, which acts as a broker.

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