Disclaimer: Buying cryptocurrency comes with risks. This article is for informational and educational purposes only and does not constitute investment or financial advice.
Bitcoin was introduced in 2009 as a decentralized, peer-to-peer payment system that relied on digital coinage rather than central-bank-backed currency. The anonymity and transparency of the blockchain technology on which Bitcoin operated opened the door for other forms of digital currency — cryptocurrency — as an exchange medium.
As demand for digital monies increased, so did its potential value as an asset. This led speculators to acquire Bitcoin, Ether, and other forms of cryptocurrency for potentially large returns. And, despite its volatility and relative newness, cryptocurrency is quickly gaining acceptance among investors as a diversification mechanism for portfolios.
A glance at the glossary: Traditional and alternative investments
Traditional investments in a typical portfolio consist of stocks, bonds and cash. The values of these assets are pegged to markets and trading platforms, as well as economic fundamentals. Many of these holdings are also regulated by government agencies. For example, stocks traded on the New York Stock Exchange are regulated by the U.S. Securities and Exchange Commission.
On the other side of the (asset) coin, alternative investments consist of everything else that can increase or decrease in value. The coin or stamp collection gathering dust in your dresser’s top drawer could be considered an alternative investment as it could increase in value over time. Real estate, intellectual property, and artwork also fall into this category.
Unlike traditional investments, alternative investments are often (not always) “non-correlated,” meaning their appreciation or depreciation isn’t tied directly to the overall market. Rather, their value rises and falls, based on demand and perceived worth by other investors. Your coin collection will appreciate if other coin collectors and investors perceive value in that asset (and are willing to pay you for it). When used correctly and sanely, alternative investments provide great diversification to portfolios.
Currencies: Exchanges and investments
Now, back to cryptocurrency. Bitcoin and others are mediums of exchange, similar to fiat currencies such as yen, dollars and euros. And, investors buy fiat currency as alternative investments through the Foreign Exchange Market or FOREX. Cryptocurrency can also be considered an alternative investment, as it can increase (or decrease) in value. Furthermore, as it is not correlated to markets or the economy, it can offer portfolio diversity.
But, unlike government-backed bills and coins, cryptocurrencies have no FOREX-type exchanges. Cryptocurrency exchange-traded funds (ETFs) do exist in some countries, but the U.S. has yet to authorize this form of trading. The closest is Grayscale Investment Trust’s Bitcoin Investment Trust (GBTC), which allows investors to trade in shares of the trust, as opposed to actually buying and selling digital coinage.
Very high-risk hedge cryptocurrency funds are available for investment, but most of these require a large initial investment fee. What this means is that, if you are interested in adding cryptocurrency to your portfolio, you will need to find a cryptocurrency exchange, buy the coins or tokens directly, and secure them in a digital wallet.
Protecting yourself, diversifying your portfolio
Cryptocurrency is a viable alternative investment. To use it as such, you need to take steps to ensure that it brings positive value to your portfolio. Here’s how.
Educate yourself. Take time to thoroughly research and understand your targeted cryptocurrency. Know its track record, value, and potential returns, as well as longevity. You don’t want to find yourself with disappearing tokens or coins if the cryptocurrency you acquired and stored suddenly bites the dust.
Monitor consistently. Unlike traditional investments and certain alternative investments, your cryptocurrency holdings will require ongoing observation and scrutiny. It’s essential that you keep on top of cryptocurrency news and trends, to know when it’s time to buy or sell your holdings.
DYOR. If you hear something about a digital coinage that’s too good to be true, it probably is. Do your own research and look out for red flags like “Ghost” team members. The term refers to those who hide behind anonymous identities or fake profiles, versus live individuals, who are happy to share their experience and credibility in the space. Because crypto is unregulated, it’s on you, the investor, to take the time to carefully investigate the seller and its claims before making a purchase.
Restrain yourself. Keep the percentage of crypto in your portfolio to a level that you’re truly comfortable with; experts suggest that if you’re still feeling it out, dedicating 1% of your portfolio to cryptocurrency will provide enough exposure, without excessive downsides. Another study, released by the National Bureau of Economic Research, indicates that 4% to 6% of a portfolio should hold Bitcoin, with a minimal investment of 1% of assets in the space. Of course, it’s all about your risk tolerance and there’s no right answer, which is why the previous DYOR step is so essential.
A balancing act, with care
Even with their volatility and vulnerabilities, cryptocurrencies can be useful when it comes to adding variety, and potentially reducing risk to your traditional investment portfolio. But, investments in Bitcoin, Litecoin, Ether, or some of the newer digital coins are not for the faint of heart. If the goal is to add crypto to your holdings, do so carefully, and back your actions with plenty of research. Also it’s important to understand that if your intent is to use crypto investments to diversify your portfolio, be wary of letting yourself get too caught up in price speculation and making a fortune.
[i] Kajtazi, A., & Moro, A. (2018, October). The Role of Bitcoin in Well-Diversified Portfolios: A Comparative Global Study. International Review of Financial Analysis, 61, 143-157. doi:10.1016/j.irfa.2018.10.003
Saksonova, S., & Kuzmina-Merlino, I. (2019). Cryptocurrency as an Investment Instrument in a Modern Financial Market. St. Petersburg University Journal of Economic Studies, 35(2), 269-282. doi:10.21638/spbu05.2019.205