This guide offers an introduction to what they are and how to invest in cryptocurrency:
- What Is Cryptocurrency?
- How To Invest in Cryptocurrency
- Benefits and Risks of Investing in Cryptocurrency
- Buying and Selling Crypto and the Effects on Your Taxes
- FAQ About Cryptocurrency
Cryptocurrencies are digital assets used to verify the transfer of funds and to secure information without a third-party intermediary. They function on a decentralized ledger called a blockchain — think of it as a digital transaction log — with special encryption techniques to protect privacy and expedite transactions.
The first cryptocurrency, Bitcoin, was invented by an unknown person or group of persons using the alias Satoshi Nakamoto in 2008. That year, Nakamoto wrote a white paper called “Bitcoin: A Peer-to-Peer Electronic Cash System.” The paper outlined Bitcoin’s capacity to act as a peer-to-peer public transaction ledger — a blockchain — without relying on central authorities.
Blockchain’s function as a decentralized ledger makes it unique. It doesn’t need an intermediary like a central bank clearing system or financial institution to ensure the exchange between two parties. Instead, you pay someone directly on the peer-to-peer network, and the individual who clears the transaction receives a small fee for their time. The payment is timestamped into a block of the digital transaction log — the ledger — which makes the transaction transparent and permanent.
The lack of centralization means that governments do not control cryptocurrencies. Instead, cryptocurrencies are hosted on networks and computers around the world, making them a popular alternative to fiat currencies like the U.S dollar and Japanese yen.
Some have argued that cryptocurrencies were created as a direct response to the financial crisis of 2008. But according to New York University finance professor David Yermack, Bitcoin is the result of decades of experimentation to eliminate the need for third-party clearance. “Bitcoin happened to be launched in 2009, but it was the culmination of decades of attempts to create a digital currency on a peer-to-peer basis,” Yermack told MarketWatch in 2018. “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments.”
In recent years, investors have speculated on the success of different cryptocurrencies. That speculation has led to rampant price swings and volatility. Yet these digital assets have become mainstream in recent years, leading more people to seek insight on how to invest in cryptocurrency.
Direct investing allows investors to buy the cryptocurrency and then decide when to hold and sell. This strategy offers the following benefits:
- It allows investors to maximize returns.
- It gives investors complete control over their crypto purchase.
- It provides investors with the opportunity to learn how to invest on the fly.
- Investors can choose how much they want to invest and grow confidence over time.
To make a direct investment in cryptocurrency — buying the actual currency — requires the following steps:
- Select a cryptocurrency from the broad universe of assets.
- Select the type of digital wallet you want to use.
- Select an exchange that allows the purchase of the specific cryptocurrency you chose.
Here are more details on how to buy cryptocurrency:
1. Select a Cryptocurrency From the Broad Universe of Assets
When deciding to buy a cryptocurrency, it’s essential to understand the blockchain project behind the currency.
Companies aiming to address a centralized problem with a blockchain solution will release a white paper on the functionality of their project and their social/business mission. For example, Aelf is a cryptocurrency project that aims to decentralize cloud computing and reduce the costs of storage for businesses. TRON, on the other hand, is a decentralized platform that aims to compete against Netflix and other video-sharing platforms by reducing the costs of content management through blockchain technology.
Many blockchain projects require that you purchase Bitcoin or Ethereum before you can sell or buy cryptocurrencies. Smaller blockchain projects operate on more extensive networks, and their tokens can be traded for Bitcoin or Ethereum during token sales or on exchanges. But many different blockchain projects have failed and cost individuals their total investment. Consider crypto projects that have been vetted by credible exchanges, investors and thought leaders.
Read More: What Is Blockchain Technology?
Choosing the right cryptocurrency requires time and research. For beginners, it’s best to consider several crypto projects that have generated widespread trust among investors around the world. The top cryptocurrencies to purchase include:
- Bitcoin: The first and largest cryptocurrency in 2019, Bitcoin has the largest user base and volume of transactions. More than 64% of the entire crypto market capitalization is composed of Bitcoin. In addition, more retailers allow customers to use Bitcoin to purchase products.
- Ethereum: Founded on the promise of “smart contracts,” Ethereum is a public, open-source, blockchain-based distributed computing platform. It is a critical project on which many other projects build their platforms.
- LiteCoin: Invented by Charlie Lee, LiteCoin is commonly referred to as the “silver” to Bitcoin’s “gold.” The company’s Lightning Network project places a priority on the speed of transactions. Whereas Bitcoin processes transactions in 10 minutes, Litecoin successfully processes in a little more than two minutes.
- Ripple: The cryptocurrency centers its project around cross-border transactions, low remittance fees and speed among counterparts. The project has received support from several governments and international financial organizations.
- Facebook Libra: This is the latest cryptocurrency to generate buzz across the global community, but the social media giant has not yet released it. The U.S. Congress is currently scrutinizing the security and safety of Facebook’s project, given the firm’s shaky history around consumer privacy. If launched, Facebook Libra would provide Facebook, WhatsApp and Instagram users with a global digital currency with significantly lower remittance costs.
Following the selection of the cryptocurrency, investors need to obtain a wallet in which they can store their currency. Digital wallets are the platforms on which investors can buy, sell and trade their cryptocurrencies. These wallets have a unique address, and you’ll use a private key to access your cryptocurrencies.
Digital wallets comprise six different categories. Before purchasing Bitcoin or other digital assets, it’s important to know the different fees, benefits, risks and restrictions of these wallets.
- Hardware wallet: These can include USB data devices or other hardware storage devices that allow users to store cryptocurrencies offline. To access the cryptocurrency, you’ll need to connect the hardware wallet to a computer.
- Benefits: No-cost, secure offline use that makes it difficult for cybercriminals to access. Hardware wallets are considered to be the most secure among the options, particularly for large volumes of crypto.
- Risks: Storage devices can be lost or stolen. One person accidentally threw away a hard drive with 7,500 Bitcoins — then valued at more than $127 million USD — on it in Australia in 2013.
- Desktop/Software wallet: The most common form of cryptocurrency storage, these programs let users download cryptocurrency for storage on a computer.
- Benefits: Ease of use makes this a preferred cold storage method for investors with large quantities of cryptocurrencies.
- Risks: Desktops connected to the internet are susceptible to viruses, malware and online threats. Privacy issues also arise when compared with the web.
- Mobile wallet: Downloaded and managed on your phone, the mobile wallet allows users to scan QR codes, which are vital for storage, transfer and even use in payments.
- Benefits: Mobile wallets offer ease of use and practicality.
- Risks: Malware is perhaps the largest threat to a mobile wallet, and mobile wallets are prone to hacking attacks and viruses.
- Online Wallet: Stores your cryptocurrency on the web through one of the online cryptocurrency exchanges.
- Benefits: Easy to use and access, most online wallets are protected by dual-authentication processes that require a second key or authenticator code — the best option for small amounts of cryptocurrency.
- Risks: Online wallets are susceptible to hacks at the exchange or individual attacks by hackers who access user databases. Online purchases and sales can take longer to process due to security protocols, possibly exposing you to sharp price downturns.
- Paper wallet: These wallets are slips of paper with private keys and cryptocurrency addresses on the paper. The paper lets you transfer Bitcoins to a different wallet.
- Benefits: Paper wallets are easy to carry in an emergency and easy to store securely, and they’re virtually immune to hackers.
- Risks: Paper wallets are easy to lose or destroy by accident, and transferring or trading the currency requires some technical skill.
Finally, you’ll need to set up an account on a cryptocurrency exchange so you can purchase the tokens you want to buy. The most reliable cryptocurrency exchanges have large numbers of buyers and sellers, trusted verification and security programs and a significant level of liquidity. Several options include:
- Coinbase: The largest and perhaps easiest to use, Coinbase is computer- and mobile-supported. Investors can link a bank account directly to the exchange and operate on a premium platform called Coinbase Pro. After a verification process, Coinbase offers access to 15 cryptocurrencies. Users can buy Bitcoin, Ethereum, XRP, Litecoin, EOS, Bitcoin Cash and Augur.
- Kraken: The largest cryptocurrency exchange in Europe has expanded into North America. Kraken has a low fee structure that focuses on the amount of trading by participants. The exchange is a bit more advanced and allows margin, over-the-counter and futures trading.
- Cash App: The money app backed by Twitter and Square CEO Jack Dorsey allows users to buy Bitcoin from their Cash App balance. The app allows users to spend their proceeds from a sale on a Visa debit card.
- Bittrex: A global exchange based in Seattle, Bittrex is not regulated by any U.S. Securities laws. Although it has a very robust selection of cryptocurrencies, the exchange recently barred U.S. buyers from trading 32 cryptocurrencies.
Take a Look: Inside the Life of a Real Cryptocurrency Miner
Cryptocurrency provides investors with some benefits they can’t receive from buying equities on the stock market.
- Should Blockchain projects overtake centralized portions of the economy — such as traditional banking, mortgage and title processing and e-commerce payments — their value will increase over time.
- Crypto investments are still very young on a timeline horizon. Owning cryptocurrencies ahead of mass adoption could see a small investment turn into a very significant gain.
- Cryptocurrency is convenient to own and transfer between parties.
- Transactions are anonymous and highly transparent.
But several risks exist that investors must tolerate when dealing with cryptocurrencies like Bitcoin.
- Cryptocurrencies have experienced volatility and wild price swings in recent years. For example, the price of Bitcoin swung up and down thousands of dollars during June 2019.
- The currency is 100% virtual — there’s no physical option — and is not backed by any centralized government or central bank. It is susceptible to cyber theft, and accounts are not guaranteed by the FDIC like the U.S. dollar is by banks.
- Many cryptocurrency projects have been fraudulent or failed in recent years. Certain projects are subject to failure due to a lack of investor confidence.
When buying and selling a cryptocurrency, it’s essential to be transparent with the IRS about your transactions. Large volumes of capital exiting and entering bank accounts tend to attract attention from regulators. Also, Coinbase uses IRS Form 1099-K to report payments to cryptocurrency traders if the traders made over 200 transactions with a total value of over $20,000.
The IRS classifies crypto investments as a capital asset, like property. This means that sales and profits follow the same rules on capital gains. A person who sold Bitcoin at a profit within the last 12 months would report short-term capital gains on their tax form. These profits would count as ordinary income.
You can report cryptocurrencies bought and sold for profit after a year as long-term capital gains, which classifies the proceeds as investment income. Losses accrued on trading can be counted toward the $3,000 in capital losses allowed as deductions. Anything over that level must be counted in future years, according to the IRS.
Buying and selling cryptocurrency is subject to volatility. Even if you sold your cryptocurrency for a profit last year and lost it all this year, you will still owe money for your capital gains during the previous year. It’s essential to stash a portion of your earnings away for the taxman.
Cryptocurrency investing isn’t for the faint of heart because of its volatility and the technological knowledge required to trade it. Before investing in a cryptocurrency project, consider the following:
- The business proposition and social mission: Is the use of blockchain and crypto solving a practical issue? Is there a viable problem, and does this project offer a solid business case for resolution?
- The supply of crypto: Most coins go through a process known as mining, which impacts the total supply of available currencies and their price now and in the future. Bitcoin, for example, has a fixed number of coins (just 21 million), which will affect supply and demand in the future.
- Price history: Cryptocurrencies are historically volatile. But it’s important to weigh price history with these other elements to determine why prices are rising and falling. Some cryptocurrencies have been affected by pump-and-dump schemes, for example.
- Community activity: A larger community around a cryptocurrency is a good sign of its health and interest in the project. A strong, active community will put pressure on developers to fix bugs, advance the project to new stages and find new test cases and value for the projects.
Another option is to invest indirectly by putting your money in investments that might benefit from cryptocurrency and/or blockchain taking off. You can choose this option if you want to be in the cryptocurrency space and:
- Worry about the short-term volatility in the price of Bitcoin or other cryptocurrencies
- Want to invest a very large amount while mitigating risk
- Lack the time to consistently monitor the price of cryptocurrencies on a day-to-day basis
- Believe in cryptocurrency but wish to capitalize more from the infrastructure and community instead of the currencies
Indirect investors might consider any of the following options:
- Publicly traded companies like Overstock, which is building blockchain projects
- Crowdfunding projects dedicated to new blockchain programs or ancillary projects
- IRA investments that take a long-term outlook on blockchain disruption and benefits to the global economy
If you’re still unsure about investing in cryptocurrency, check out the answers to some common questions about it:
Why is it a good idea to invest in cryptocurrencies instead of other investments?
Cryptocurrencies have netted some investors significant sums of money in a small amount of time, although many others have lost large sums in just months. Bitcoin and other cryptocurrencies are better long-term investments tied to the adoption of blockchain across the global economy.
Should I invest in multiple currencies or just one?
Investors are encouraged to diversify across many different assets. Owning more than one cryptocurrency ensures protection that all of your investment won’t be lost to one failed blockchain project.
But investors merely looking to put a small amount into cryptocurrency should consider Bitcoin and Ethereum. They are the largest cryptocurrencies by volume. Bitcoin is seen by many as a store of value, whereas Ethereum is seen as an investment in the backbone of future blockchain functionality.
Is it wise to use multiple wallets and cryptocurrency exchanges?
Using multiple wallets and exchanges is a popular way to reduce exposure to cybercriminals and hackers. But risks exist in this process: For example, passwords to wallets and exchanges are typically very complex. Failure to recall a key to a wallet can result in the permanent loss of cryptocurrencies stored on these wallets.
Is cryptocurrency safe? Can I get hacked?
Like all investments, risks exist. Several high-profile investors have lost their key phrases, passwords and wallets containing hundreds of thousands, if not millions, of Bitcoins.
Cryptocurrency exchanges have also faced large-scale attacks that led to the complete collapse of these networks and the loss of investors’ capital.
The most famous hack occurred in 2014 when Japanese exchange Mt. Gox was hacked. Cybercriminals made off with $460 million, and users are still trying to recover pennies on the dollar.
Are there crypto investment strategies?
A variety of cryptocurrency investment strategies exist for beginners and advanced traders. One of the more popular ways to invest in cryptocurrencies is to use a process known as “dollar-cost averaging.” In this situation, investors would purchase a set amount of a cryptocurrency every week, month, or quarter to reduce exposure to volatility.
Other strategies include traditional long-term investment options like “buy and hold” and “buying on the dip.” But nothing is quite as reliable as reading white papers and forums, getting to know the projects and buying the cryptocurrencies that you believe will change the world.
More on Investing in Cryptocurrency
- Everything You Need To Know About Crypto This Week
- Inside the Life of a Real Cryptocurrency Miner
- How Bitcoin and Other Cryptocurrencies Are Changing the Future
Garrett Baldwin has covered the cryptocurrency space since 2013 and is a former consultant for cryptocurrency hedge fund Scow Capital and the blockchain project Databloc.io. He has written extensively on cryptocurrencies and Blockchain for Modern Trader, Finalternatives and Money Morning and interviewed industry leaders including Tyler Winklevoss, Alex Mashinsky and Omid Malekan.