Investors, brands and businesses are realizing they cannot afford to ignore the new digital asset space. With a global market cap of roughly $2 trillion, the cryptocurrency industry rivals the world’s most valuable company, Apple Inc. (NASDAQ: AAPL), by market capitalization and has amassed more than 300 million users.
It is safe to say that cryptocurrency is going mainstream:
- In 2021, 5% of all venture capital investment in the U.S. went into crypto.
- 43% of Americans ages between 18 and 29 have traded or used cryptocurrency (Pew Research Center).
- More than 450 global cryptocurrency spot exchanges exist (CoinMarketCap).
- 52% of financial institutions already invest in cryptocurrencies (Fidelity).
However, despite the industry's rapid growth, critics of the space voice concern. The following discussion will examine the value behind cryptocurrency and discuss the risks and rewards associated with adding cryptocurrency to an investment portfolio.
What is Cryptocurrency?
Cryptocurrency is a type of digital asset that enables individuals to transmit digital value in a digital setting. The term cryptocurrency is a portmanteau of cryptography and currency because cryptocurrency makes use of cryptography, a complex encryption technique that secures transactions between users.
Bitcoin and most other cryptocurrencies are supported by a technology known as a blockchain
— a decentralized, distributed ledger that records the provenance of a digital asset. The blockchain secures cryptocurrency transactions by creating incentives to make tampering unprofitable for malicious users.
The implication is that ownership of crypto is held probabilistically through trustless enforcement. As a result, unlike traditional currencies, the circulation and operating rules of cryptocurrency do not rely on a central bank; instead, it is managed by programmed algorithms that no single entity controls.
Individual units of cryptocurrencies can be referred to as coins or tokens, depending on how they are used. Coins refer to the native asset on a blockchain network. They can be traded, used as a medium of exchange and act as a store of value. Conversely, tokens are not built into the blockchain itself; instead, their behavior comes about by the implementation of smart contracts.
They are more flexible and can be used for a variety of purposes. The common properties of all cryptocurrencies generally include:
- Borderless: You can send and receive crypto from anywhere in the world.
- Durable: Cryptocurrency can be used over and over again without degrading.
- Permissionless: You do not need to provide information or permission to own cryptocurrency and create a wallet.
- Irreversible: Transactions cannot be reversed, and units cannot be spent twice.
- Pseudonymous: No identifying information needs to be attached to the transactions.
What is Bitcoin?
Bitcoin is a form of digital currency and used by most as a store of value or speculative investment. It’s decentralized, meaning that no central bank controls it. Instead, Bitcoin is run by thousands of computers distributed around the world.
Despite not being legal tender in most of the world, Bitcoin is popular because it can’t be censored, has a finite supply of 21 million and allows transactions to be made at any time from anywhere.
Bitcoin is widely considered to be a flagship for other innovations in the crypto space. For this reason, all other cryptocurrencies are collectively referred to as altcoins.
What is Ethereum?
Ethereum is a decentralized computing platform and is the second biggest crypto by market capitalization. You can think of Ethereum as a public shared global computer network. It doesn’t run on a single device but instead runs simultaneously on thousands of devices around the world. People all over the world contribute their computer’s computing power to the network and are paid for doing so.
The main idea behind Ethereum is that developers can create and launch code that runs across a decentralized network instead of a centralized server (using smart contracts). This aspect means that these decentralized applications (dApps) cannot be censored or shut down.
Pros of Cryptocurrency:
- User protection and privacy
- Eases international trade
- Set inflation with a finite supply ever to be created
- No intermediary; more efficient, faster and cheaper transactions
Cons of Cryptocurrency:
- Increased illegal transactions
- Not widely accepted
- Some cryptocurrency mining processes aren’t eco-friendly
- No refund policy
Does Cryptocurrency Have Value?
The intrinsic value of cryptocurrency is reflected by its convenience of exchange and transaction advantages compared to other currencies, if it were to become widely adopted. This is known as a convenience yield — a concept that is empirically sound for cash-like assets.
For example, many individuals choose to have a bank account even though the rate paid by a bank is often below that of the treasury bill rate or AAA corporate bonds. The reason for this is convenience.
At its core, crypto is a natural hedging asset. On one hand, cryptocurrency is designed to be a hedge against inflation, seigniorage and failing monetary policy. Cryptocurrency does not rely on a central bank; instead, it is managed by programmed algorithms that are governed in a decentralized and democratic manner.
Additionally, cryptocurrencies are designed to outperform in times of great economic activity, as further technological innovation allows cryptocurrencies to scale, become more efficient and become more decentralized, ultimately, bolstering their transaction advantages compared to fiat currency.
As a result, a richer view of valuation of crypto is based on transaction advantages and convenience as opposed to simply seeing crypto as an asset that doesn’t produce cash flow. If enough people believe that crypto will function as a medium of exchange, then in the interim, crypto will function as a speculative store of value.
Who Should Have Crypto in an Investment Portfolio?
Cryptocurrency is considered a high-risk investment because it's inherently volatile, often fluctuating by large amounts within a short period of time. The extreme volatility results from prices that heavily rely on shared beliefs and market sentiment. High risk isn’t inherently bad or good for an investor.
Risk works both ways, meaning that each investment into crypto carries the risk of significant failure and benefit of significant success. As an investor, you must evaluate your own risk tolerance before venturing into a cryptocurrency investment and decide between a short-term strategy, long-term strategy or a combination of both.
A short-term strategy is suited for those with high risk appetites who are willing to leverage the volatility of short-term price movements. Some traders can make money this way, but most people are better off just buying and holding their cryptocurrency for the long term.
In fact, even from a mathematical standpoint, long-term investment is generally more favorable than short-term investment. According to the Wharton School of Business, the median return for most altcoins is less than the mean return. In other words, most days you lose money or make very little money; however, such days are heavily compensated by a few big outliers.
Hence, the fundamental strategy of a crypto portfolio is to hold long enough to experience an outlier move in the market.
How Much Crypto Should be in an Investment Portfolio?
In modern portfolio theory, risk and reward is the focal point when considering investment choices. As such, it is best practice to take into account the trade-off between the risk and the reward of an investment before making a decision.
Generally speaking, the Sharpe ratio is the gold standard for maximizing the trade-off between the risk and reward of a portfolio. Using it, you compare how much excess return you receive for the extra volatility you endure for holding riskier assets. Typically, a higher Sharpe ratio indicates better investment performance, given the risk.
Historically, Bitcoin has a higher Sharpe than the S&P 500; appreciating over 31,000% over the past decade. However, when taking into account survivor bias (the tendency to ignore coins that have died out) and transaction costs associated with crypto, the Sharpe Ratio alone suggests that crypto should not be added.
However, the Sharpe ratio cannot be used in isolation; instead, another metric called alpha should be considered. Alpha measures the performance of an investment as compared to a benchmark index such as the S&P 500. More specifically, it measures covariance (the directional relationship between the returns on two assets) and takes into account the effect of outliers whereas Sharpe Ratio doesn't do either.
As a result, it is important to consider alpha when dealing with a portfolio with different types of assets and taking into account the abnormal returns of crypto.
When taking into account both metrics, the following can be concluded:
To increase the total risk-to-reward trade-off of an investment portfolio, you should start with the highest Sharpe ratio portfolio you can find — a diversified equities portfolio — and add an asset with positive alpha. This process will increase the Sharpe ratio of the total portfolio and improve the given opportunity set. In other words, by cleverly combining risky assets with conservative assets, you can maximize the risk-adjusted performance of your aggregate portfolio.
Despite this, it is important to note that crypto returns are inflated by survivor bias, as coins that have died out — lost all their value — are not considered. Additionally, certain risks such as regulation are ignored.
Where to Buy Cryptocurrencies
ETH, BTC, DOT and other cryptocurrencies can be traded on major exchanges such as Coinbase Global Inc. (NASDAQ: COIN), Gemini, Crypto.com, KuCoin and Kraken. If you already have digital assets, it's a good idea to put them to work and earn interest on your cryptocurrency.
Cryptocurrency is offered by eToro USA LLC (“the MSB”) (NMLS: 1769299) and is not FDIC or SIPC insured. Investing involves risk.
eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk.
How to Store Cryptocurrencies Safely
Cryptocurrencies can be stored using a hardware wallet or a software wallet. A hardware wallet is widely regarded as the most secure way to store crypto. It keeps your private keys offline so that your crypto is inaccessible to anyone but the holder of the private keys.
Ledger wallet is a great choice for a hardware wallet –– Ledger claims to provide the highest level of security for crypto assets.
Software wallets enable crypto holders to securely store their digital currencies and tokens in one place.
These types of wallets allow users to buy, swap, lend and earn cryptocurrency in an efficient manner. The Coinbase Wallet is an example of a software wallet.
Current Market Outlook
Overall, the cryptocurrency space offers a lot of growth potential, particularly for the promising coins mentioned above. The number of cryptocurrency investors around the world has steadily increased, with recent growth being explosive.
However, because of the high risk of cryptocurrencies and uncertainty regarding government regulation, investing in cryptocurrencies isn’t for the faint of heart. For the most up-to-date cryptocurrency prices, check out Benzinga’s table below.
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