What are the risks of investing in cryptocurrency? This is a big question to tackle, but some of the most important areas to consider have much to do with the basic architecture and business practices of investing in Bitcoin, Ether, etc.
There are two basic types of risk involved in many cases. The potential for loss of your investment funds is extremely high with crypto but much depends on the type of currency you are investing in or the types of investments in the space that you make.
What does this mean?
What follows IS NOT financial advice in the sense that you will be told what to invest in and what not to invest in. What follows is a reminder that with any type of investment there are risks–do not assume that you can find a risk-free opportunity in the cryptocurrency space in particular or as an investor in general. There are basically two kinds of risks when you invest–the risks you know and understand, and those waiting to surprise you.
Buying Bitcoin, Margin Trading
The week of October 18, 2021 included financial headlines discussing Bitcoin’s valuation reaching $60K and what that could mean for the future of crypto.
Lots of people are jumping on the bandwagon, have jumped, or will do so as a result of such headlines. But the risks associated with Bitcoin are essentially the risks you get with all digital currencies not backed by real-world assets. The enthusiasm of the investors in this area are what adds value.
There is zero inherent value in Bitcoin, and that’s the basic risk. You start with the Emperor’s new clothes and end up the same way if the valuation tanks along the way.
There are people with a great deal of disposable income who have no problem losing some of their investment funds to a risky, but potentially lucrative opportunity. But the danger is that some give into FOMO, or Fear of Missing Out…and drop more money than they can actually afford to lose into such investments.
Some crypto exchanges may offer you the ability to try investing that uses margin trading practices with crypto. Margin trading involves the ability to borrow money to invest with.
But margin investing is risky even when you are borrowing to purchase more traditional stocks–if you don’t understand the basic vocabulary of this type of investment you are NOT READY to try it–there is a substantial risk of loss and some people experience very large financial setbacks because they don’t fully understand the rules of margin trading (let alone the ins and outs of investing in general in terms of risk).
Yes, you can get burned on a margin trade and lose your money just because you didn’t fully understand the rules of when a margin trade must be repaid. Investor beware.
The investment advice website Motley Fool describes “exposure” to cryptocurrency as a factor to consider. You can get “direct exposure” to the “demand for virtual currency” by investing directly in Bitcoin, Dogecoin, Ethereum, Binance, etc.
This, as you can guess from the warnings above, is a high-risk investment option. Less risky but not risk-free. It’s probably wise not to bother looking for “risk-free crypto” opportunities unless you are considering a stablecoin or other currency backed by real money.
Any cryptocurrency not backed by “fiat currency” or real-world dollars, Euros, etc. is essentially being given value due to investor enthusiasm and nothing more.
That means that they are just as risky to invest in as commodities, as margin trading, etc. And if you need to have the phrase “margin call” explained to you, you are likely in need of more information about investing before you start trying to spend your actual money on Bitcoin, etc.
The OTHER type of investing related to the “exposure” to crypto is putting your investment funds into a company that “has exposure” to crypto.
So your money in this case would be invested in stocks for a company that deals in crypto rather than purchasing virtual currency directly. There is a reduced amount of risk associated with buying stock in such a company rather than the currencies themselves.
That does NOT mean the company is safe from the rise and fall of Bitcoin or others…but there is a firewall of sorts in buying such stock.
That said, if the bottom falls out of the crypto market at some stage, such companies are likely to themselves experience severe losses…the difference being that the stocks you purchased could still regain a portion of their value over time.
It’s not that cryptocurrencies themselves could not do that, but your losses when investing in the digital money itself would definitely be more direct.
Investment Strategy Counts
“I like Starbucks as an investment. Everybody needs coffee.” Ever hear that one before? It’s a statement that makes investment professionals internally roll their eyes. There is much more required to be a successful investor than looking at the number of Fortune 500 companies out there and deciding which ones to put your cash into.
The reason there are investment professionals such as retirement planners, stock advisors, and others is precisely because a one-size-fits-all approach to investments is a TERRIBLE idea. Some people’s idea of investing is to buy a stock and then forget all about it–they think that the “main” approach to investing is “buy and hold”.
But if you try to buy and hold with Bitcoin, you could be very disappointed. Commodities in general are not buy-and-hold strategies. Neither is crypto.
Why? Their nature includes volatility. Buy and hold stocks are an approach for those who want lower risk–if you cannot afford to lose your investment funds, you’ll need to take more fiscally conservative approaches to the market.
In general (and omitting a GREAT deal of nuance in some cases) there are more stable and “safe haven” investments such as bonds and Treasuries, all the way to the riskiest investments including Bitcoin and other virtual currency.
You can protect yourself with an investment by setting an exit strategy. This will NOT protect you against all possible losses. It WILL protect you from going into complete free-fall, financially speaking, should your investment begin to lose a certain amount of value. And that is the gist of the exit strategy–you set a limit on how far in value an investment will go before you divest yourself.
Ideally you would be able to set up a stop-loss measure for yourself to kick in automatically when an investment falls below a certain value. With crypto that may or may not be possible depending on how you buy and sell–if you use an exchange that has a platform designed to facilitate such a strategy, you should take full advantage. But if you do not use such services, it may be up to you to personally monitor the value of your coins and act accordingly.
Not having an exit strategy is a recipe for losing all your investment funds. Don’t approach any investment without knowing what you’ll do if it begins to lose an unacceptable-to-you amount of money.
Joe Wallace has covered real estate and financial topics, including crypto and NFTs since 1995. His work has appeared on Veteran.com, The Pentagon Channel, ABC and many print and online publications. Joe is a 13-year veteran of the United States Air Force and a former reporter for Air Force Television News.