We covered a lot of ground in part 1 and part 2 on what cryptocurrency is and how to spend or use it. But what about trading in it, directly or in fund form? If you are curious about trading cryptocurrency, know that, at this point:
Cryptocurrency is a highly risky holding: For every cryptocurrency success story you read, there are plenty of other tales of woes.
Cryptocurrency is not an investment; it is a speculative venture: Bottom line, cryptocurrency does not fit into our principles of evidence-based investing … at least not yet.
Consider the Risks
The transactional risks we covered in part 2 can also impact cryptocurrency traders. To recap, these include:
- Potential loss or theft of an underlying cryptocurrency you are holding
- Loss of equilibrium between a cryptocurrency’s supply and demand
- Governmental regulation hobbling a cryptocurrency’s growth potential
- The massive energy consumption required to mine cryptocurrency
These and other risks have translated into an extremely volatile ride for cryptocurrency traders. Then again, every investment carries some risk, or there would be no expected return. This drives an important difference between evidence-based investing vs. speculative ventures, and how we evaluate future expected returns.
What is a bitcoin worth? A dollar? $100? $1 million? The value of bitcoin has been one of the most volatile the market has seen since tulip mania in the 1600s. Bitcoin was trading for around $7,000 per coin in early 2020; as of February 20, 2021, the price topped $55,000. In the coming months, there is not much stopping it from being worth far more than that … or far less.
As such, there is no way to establish meaningful expectations. In his ETF.com column, “Bitcoin & Its Risks,” financial author Larry Swedroe summarized how market valuations typically occur:
“With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With bitcoin, none of the preceding analysis is possible. Bitcoin is purely speculation.”
Investing vs. Speculating
In other words: It is not impossible to profit from trading in cryptocurrencies, but the attempt is more speculating than investing.
In contrast, evidence-based investing creates a unified portfolio that can be managed according to YOUR individual goals and risk tolerances. It requires the ability to:
- Estimate an asset's expected return, based on relatively well-established fundamentals
- Factor in how different asset classes interact with one another within your total portfolio
- Provide a sensible structure for embracing a long-term, buy, hold, and rebalance strategy
Cryptocurrency simply does not yet work within these parameters. It does have a price, but it cannot be effectively valued for planning purposes.
Knowing the risks, if you are still interested in trading in cryptocurrency - for fun or potential profit - here is our advice:
- Treat it like an entertaining trip to the casino. Do not venture more than you can readily afford to lose!
- Use only “fun money,” outside the investments you need to fund your essential lifestyle.
- If you do strike it rich, regularly remove a good chunk of the gains off the table to invest in your managed portfolio. If a bubble bursts, you avoid losing everything you've "won". (And... do not forget to set aside enough to pay any taxes you may have incurred.)
Making Sense of Cryptocurrency
This wraps our three-part series on cryptocurrency. We hope we have successfully put the headlines into context. Whether or not cryptocurrencies mature into mainstream transactional tools, we are here to help you manage your wealth and preserve your legacy.