Bitcoin and Cryptocurrency and Your Financial Plan
As a CERTIFIED FINANCIAL PLANNER and financial coach, I'm often asked about Bitcoin and Cryptocurrency. Rarely are financial topics as popular as the subject of our discussion today. Bitcoin and cryptocurrencies, in general, have surged in popularity off and on since their creation, and every time that happens, I have curious clients request information about them. While I generally wouldn't suggest purchasing bitcoin to my clients, discussing what they are, what they do, and how they're created is an interesting one that's worth having.
With all of the information surrounding Bitcoin and Cryptocurrency, it's easy to lose track of what's legitimate information and what's "couch investor" talk. Today we'll attempt to cut through some of the noise and provide the most objective information possible. As a financial coach and financial advisor, I try to assess investments as a whole instead of as a piece. With the whole of the information, we can better understand what an asset is and why it may or may not be suitable for you individually.
Before we start, I'd also like to point out that the information provided here is general. It shouldn't be taken as advice on how or how not to invest your money. If you'd like advisement, my recommendation is and always will be to contact a financial professional like myself. With a financial coach or CERTIFIED FINANCIAL PLANNER™ by your side, you'll be able to create a financial plan that will help you learn to save money and invest it wisely.
What is Cryptocurrency?
To answer this question, let's start by defining what a currency is. One definition of currency provided by Webster is "something (such as coins, treasury notes, and banknotes) that is in circulation as a medium of exchange." Currencies come in many forms, like the US dollar, the Euro, the Peso, or the Pound. In the traditional sense, a currency is something provided by banks and backed by a country's government.
Fiat and Traditional Currency
While cryptocurrency is something new, it's not the first time currency has evolved. To understand cryptocurrency and bitcoin, we must know how it differs from more traditional currency forms in a historical context. Throughout history, currency could be anything that held value and was tradable. Some examples of items that could have been viewed as currency historically are fish, minerals, and heavy metals. As society moved forward and became more refined, people and governments eventually realized that this wasn't an effective way to trade. As a way to represent value, we began minting currency by creating coins and paper notes. These currencies were either directly valuable by being created out of gold, silver, or other precious metals or backed by governments and banks. Being "backed" essentially means that you could bring your issued note into a bank or a government institution and trade it for what it was worth in precious metal.
Fiat currency is another way that currency evolved over the years. Instead of being backed by gold or silver, it's instead backed by the government that issues it. In other words, fiat currency holds value because of a mutual agreement between the people and their government that it is valuable and tradable. A government's fiat currency is also dependent on the government's stability and the principles of supply and demand. Fiat currency is what most major countries use today, including the United States.
So, What is a Cryptocurrency? Investopedia defines cryptocurrencies as "a digital or virtual currency that is secured by cryptography". That may mean very little to most, but don't worry, we're about to explore and dissect.
First of all, the currency is virtual. This means that cryptocurrency is entirely digital. There's no physical "coin" you'll receive if you buy a cryptocurrency, like Bitcoin. This is often confused because retailers like Amazon sell physical coins that are more for display purposes than anything else. Physical coins are, in essence, toys that people may put in a case or hang on their wall. A real cryptocurrency is sold online and kept in a digital wallet that can be accessed using a key, a long and intricate password only known to the account's owner. Other than sounding really cool, the "crypto" in cryptocurrency comes from how the currency is secured. Cryptocurrencies use very sophisticated computer-based encryption that makes them nearly impossible to tamper with or counterfeit.
Being decentralized means that cryptocurrency isn't controlled, manipulated, inflated, or tampered with by a centralized governing body. This aspect of cryptocurrency is highly controversial. Some who lean towards a free-market philosophy love the fact that cryptocurrency is decentralized because it minimizes the amount of control that governments hold. Being decentralized also provides additional security to the transactions that are made using cryptocurrency. However, many of those in government are concerned by cryptocurrency's decentralization. These fears are sparked by those who use a decentralized cryptocurrency for illegal activities.
How Cryptocurrency is Made (Generally)
Because of the complexity of how cryptocurrency is made, and because some are made using different methods, we're going to have to speak in more general terms. Cryptocurrencies are software and are created by complex and intricate computer code. Cryptocurrency, similar to fiat currency, is valuable because of Supply and Demand. For those of us who are less economically-minded, the formula of supply and demand is simple. If supply goes up, demand goes down, and if supply goes down, demand goes up. Where supply and demand meet is what's called equilibrium, or price. At a cryptocurrency's inception, a limited and scarce amount is released into the world. If the cryptocurrency does well, people buy it hoping that the price of it will go up and sell it at a profit.
After a cryptocurrency's initial release, they are traded and sold. These transactions are sent to a network of third-party computers that compete to solve complex mathematical equations or algorithms. The first computer that succeeds in completing the algorithm adds the initial transaction to the blockchain (more on the blockchain below) and is awarded in the form of a coin or token. If that's too confusing, just remember - cryptocurrencies are software created and released by code or by computers verifying transactions, also known as mining.
The blockchain is the overarching ledger that stores a history of transactions of a cryptocurrency. Discussing the blockchain can become very complicated, but the theory behind it isn't overly difficult to understand. The blockchain essentially creates an unchangeable timeline that can be used as a ledger to record transactions.
What is Bitcoin?
Bitcoin is one of many forms of cryptocurrency. Everything described above applies to what bitcoin is. Bitcoin was created in 2008 and began circulating in 2009. It was created by an unknown person or group of people under the pseudonym Satoshi Nakamoto. In 2013 Bitcoin surged and grew from being traded at about $13 per Bitcoin to over $700. This surge created a lot of talk around Bitcoin and speculation about what would happen next. Later in 2013, Bitcoin dropped to about $300 but bounced back in 2016 to almost hit $1,000. In 2018 Bitcoin surged again to hit an all-time high of over $13,000. Many people who happened to buy into Bitcoin at the right time became very wealthy; however, many have lost fortunes attempting to play the Bitcoin market.
Investment Versus Speculation
One thing you'll notice right away when looking at the brief history of Bitcoin above is that it's highly volatile. While the overall value of Bitcoin depends largely on supply and demand, many worry that the interest in it and cryptocurrency, in general, creates a bubble. Bubbles, concerning economics, are when something is overvalued. Throughout Bitcoin's history, you can see several bubbles that eventually "pop" and cause investors to lose a lot of money. This is one reason that I generally wouldn't recommend cryptocurrency to my clients.
We also have to view cryptocurrency for what it is. Unless you're "mining" the cryptocurrency it doesn't really "pay out" regularly. If you purchase cryptocurrency, you're doing so in hopes that its price will continue to rise so you can sell it at a profit. However, if the price of Bitcoin is already in a bubble, the likelihood that you'll make very much off of your investment is very slim. In purchasing something in a bubble, you're also taking a considerable risk that the bubble might pop, which would cause you to lose a lot of money.
A better option may be to meet with a financial coach or CERTIFIED FINANCIAL PLANNER™ and create a financial plan based on sound financial principles. In doing so, you'll be able to work your personal principles into your financial plan and rely on time-tested techniques, like saving and Dollar Cost Averaging. With cryptocurrencies, like Bitcoin, investors are playing the market, which comes with a ton of risk. When you attempt to play the market, you're relying on past information, so you never really know when's a good time to invest. Instead, you could use methods like Dollar Cost Averaging, which spreads risk over time so that you're never trying to invest oodles of money in a lump sum.
Cryptocurrency's Uses, Risks, and Rewards.
Outside of speculating, purchasing, and selling - there isn't much to be done with cryptocurrency. You can use it to purchase things online, but most vendors don't accept it as a form of currency. Cryptocurrencies generally don't pay dividends or anything like that, so your options to use them are very limited. When discussing the possibility of purchasing a cryptocurrency, its use for many people can also be overlooked. In my recent article about incorporating your personal principles into your financial plan, I discuss how it's essential to make sure that your investments align with your personal beliefs and values. This can be an issue when you consider what many cryptocurrencies are used for.
While the majority of people purchase cryptocurrency solely in hopes that its value will go up so they can sell for a profit, it's also important to note that some holders use it as an attempt to get around the law. Bitcoin and cryptocurrencies are frequently used on the Dark or Deep Web to facilitate illegal transactions more anonymously. Many people who just want to make money don't condone these criminals' illicit actions and take issue in supporting a system that facilitates them.
Cryptocurrency VS. NFTs
You may have also heard of NFTs or Non-Fungible Tokens. NFTs are cryptographic tokens that are bought and sold for their worth but are mostly collectible items. These are similar to cryptocurrencies in many ways, and I recently wrote an article outlining what they are and how they work. In short, an NFT is a piece of digital art that you can purchase. Often, these NFTs come with a physical form, but sometimes they're entirely digital. Typically, NFTs use a blockchain ledger, similar to cryptocurrency, that keeps track of who bought the original NFT. Unlike cryptocurrencies, NFTs aren't fungible. This means that they can't be mutually exchanged like a dollar bill. Instead, think of an NFT like a piece of artwork - it's one of a kind and can't really be traded.
Having an NFT is essentially a way of digitally stamping your NFT as authentic and or original. An NFT can be a piece of digital art, like a song, picture, or GIF. To break it down and put it very simply - you can think of a cryptocurrency, like bitcoin, like a dollar bill. These can be mutually exchanged for other bitcoins, and at the end of the day, you don't really care if you have the same bitcoin or a different one as long as you have the same amount you started with. Think of an NFT like a painting. While you could trade one painting for another, they aren't identical enough to be exchangeable.
What are the Most Popular Cryptocurrencies?
I've mentioned throughout this post that Bitcoin is a type of cryptocurrency. This may leave many people wondering what other cryptocurrencies there are. While Bitcoin is the most popular and most well-known cryptocurrency, it's far from the only one. Ethereum, Litecoin, and Dogecoin are also three reputable and popular cryptocurrencies. Ethereum is the second most valuable behind Bitcoin. Litecoin was created in response to issues that Bitcoin's platform initially had but have since been fixed. Dogecoin was originally created ironically but has since cultivated a cult following.
Numerous other cryptocurrencies are created and sold every day; however, listing many of them would be a post in and of itself. If one was interested in purchasing a cryptocurrency, they'd probably be best served to buy one of the better-known ones with a more extended reputation.
Investing in Cryptocurrency
Like I said at the beginning of this post - I find it challenging to recommend investing in any cryptocurrency. They're relatively new, which leaves many difficult unanswered questions like how they're going to be regulated in the future. They fluctuate in value frequently, which means you're never sure if you're purchasing on the crest of a bubble or right before it pops. And the ethics behind their use are sketchy at best.
A CERTIFIED FINANCIAL PLANNER™ Can Help you Decide if Cryptocurrency is a Good Fit in Your Financial Plan
Instead, I find it best to focus your financial planning efforts on more tried and true methods. If you're interested in investing or creating a financial plan that's designed to grow your wealth in a much safer way, I'd recommend working with a financial planner or financial coach. If that's something you're interested in, please give me a call. As a Certified Financial Planner, I work with clients all the time to come up with evidence-backed ways to invest their money. Visit our Client Service Experience Page to see how we can help!
Until next time, this is Melissa Making Cents.
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and a Financial Coach in Dallas, Texas.