In a September 2021 survey, 16% of U.S. adults said they had invested in, traded, or used cryptocurrency. This compares with just 1% in a 2015 survey that focused on Bitcoin, the oldest broadly available cryptocurrency. Today, there are more than 19,000 crypto assets, including cryptocurrencies, stablecoins, and digital tokens. Cryptocurrency — often simply called crypto — has become so entrenched that the Internal Revenue Service added a question about cryptocurrency to the 2021 Form 1040, and Super Bowl ads featured pitches for crypto platforms. Popularity does not mean an investment is a good idea, but you may wonder what role, if any, cryptocurrency might play in your portfolio.
High risk and volatility
First and foremost, it's important to keep in mind that cryptocurrency is a high-risk, highly volatile asset. Over the period from Bitcoin's inception in 2009 to early 2022, it was about 15 times more volatile than the S&P 500 and 60 times more volatile than bonds. Bitcoin and other cryptocurrencies have become more established, but they are still significantly more volatile than the broader market. If the prospect of a wild investment roller coaster makes you uncomfortable, crypto may not be for you.
This extreme volatility reflects the fact that cryptocurrency is still a relatively new type of asset, and values are pushed and pulled even more than established investments by media hype, investor sentiment, potential regulations, and short-term profit taking. Put simply, investors are uncertain how to value crypto. And the reason for this uncertainty is that most cryptocurrencies, including the two most common forms, Bitcoin and Ether, are not pegged to any government-issued currency and have no intrinsic value other than what investors might pay for it.
Stablecoins, which are pegged directly to the value of the U.S. dollar or other reserve assets, are intended to remove the volatility from cryptocurrency while preserving some appealing features such as ease of digital transfer. However, stablecoins still carry significant risk.
Value and speculation
When you buy stock, you are purchasing a share of a business and are entitled to a share of the business's earnings. When you buy a bond, you are purchasing the right to the interest and return of principal (assuming the issuer does not default). You are likely also hoping that the price will rise should you choose to sell, but there is underlying value to the investment regardless of price movement.
By contrast, when you buy cryptocurrency, you are engaging in something close to pure speculation — the possibility that another investor might consider the digital asset more valuable in the future even if there is no underlying value.
Cryptocurrency can be used to purchase some products, and the government of El Salvador has made cryptocurrency legal tender. It's likely that a wider range of opportunities to use crypto will develop, but dollars or other government-sponsored currency will generally remain easier and more appealing for most transactions because the buyer and seller can have confidence that the value of the currency will not change dramatically before or after the transaction.
Some proponents see cryptocurrency as a hedge against inflation, but there is no evidence that this is true — though any investment that consistently returns more than the rate of inflation might be considered a hedge. Most proponents see crypto as a store of value, similar to gold.
The key factor that may give crypto long-term value is limited production. The two most common forms of cryptocurrency, Bitcoin and Ether, have built-in safeguards that limit the number of bitcoins and ether than can exist. Once those limits are reached, value may grow, assuming that investors continue to want cryptocurrency.
Ups and downs without a historical baseline
Some investors may look at the extreme volatility of cryptocurrency as an opportunity to make quick profits by buying low and selling high, but this requires timing a market sector that is very difficult to predict, and the risks are extremely high. In May 2021, when China banned financial institutions and payment companies from offering services related to cryptocurrency, Bitcoin dropped almost 30% in a day and the capitalization (total value) of all cryptocurrencies dropped 35%. Two other common cryptocurrencies, Ether and Dogecoin, dropped 43% and 53% respectively.
On the upside, Bitcoin has earned an average annual return of about 220% since it was created in 2009. Obviously, this is an astonishing return, and those who invested early received remarkable rewards. But this kind of growth is likely to be unsustainable, based on speculation in a new asset with unknown value.
The question for investors today is where does cryptocurrency go from here? It is never possible to accurately predict market direction, but stocks and bonds have a long history that can provide investors with a general sense of long-term trends. This record does not exist for cryptocurrency. Bitcoin, which was released in 2009, has the longest record, followed by Ether, which was released in 2015. Neither offers enough history to establish a trend, especially with the extreme volatility of a brand-new type of asset. Other cryptocurrencies have even shorter records.
Balancing risk and potential
Considering all these factors, it should be clear that adding cryptocurrency to your portfolio involves adding volatility and risk in return for an unknown potential for gain. This kind of trade-off is not appropriate for all investors.
Like most investment decisions, the role of cypto in your portfolio depends on your time frame, personal goals, and risk tolerance. It also may depend on your personal opinion of the future of cryptocurrency and the role it might play in the global financial system. If you want to include crypto in your portfolio, more well-established forms of cryptocurrency might be a wiser choice than less-established crypto assets that may carry even higher risk.
It may be appropriate to look at cryptocurrency as a high-risk, potentially high-reward asset, similar to a start-up or small tech stock. You should not invest in crypto in lieu of other investments that are necessary to pursue your long-term goals. To look at it another way, you should not invest more than you are comfortable losing.
To determine whether cryptocurrency is appropriate for you, it would be wise to consult a financial professional. Although there is no assurance that working with a financial professional will improve investment results, a professional can evaluate your objectives and available resources and help you consider appropriate long-term financial strategies.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
Cryptocurrencies are not traditional investments; they are highly speculative instruments, carry a significant amount of risk, and are not suitable for all investors. Cryptocurrencies are not typically subject to the same reporting and data integrity requirements that apply to more traditional investment products. The IRS is treating cryptocurrency as an asset subject to capital gains taxation rather than as a currency.
The reserves of stablecoins may not be subject to rigorous audits, and the quality and quantity of collateral may not, in some cases, correspond to the issuer's claims. Stablecoins that maintain their value through algorithmic mechanisms are potentially subject to failure due to market pressures, operational failures, and other risks.
