5 Questions to Ask Before Diving into Crypto

February 8, 2022

Did you know that more than 1 in 10 Americans traded cryptocurrency last year? Or that the global blockchain market will achieve $23.3 billion by 2023?

In short, cryptocurrency is booming. But the question is: is cryptocurrency the right choice for your portfolio?

If you’re not sure where to begin with cryptocurrency—or if you should begin with cryptocurrency at all—here are five essential questions to ask before diving into cryptocurrency.

Is It a Good Fit for My Strategy?

No investment is perfect for every investor, and no portfolio is a perfect fit for every investor. The right investment and the right asset allocation are both reliant on your risk tolerance and investment strategy. So the first question you need to ask is whether cryptocurrencies are the right fit for your investment strategy.

Some common investment strategies include:

  • Passive investing
  • Active investing
  • Growth investing
  • Value investing
  • Income investing
  • Indexing
  • Contrarian investing

There are also various investment theories that guide investment tactics, such as modern portfolio theory. Generally, investment strategies are either active (hands-on) or passive (hands-off, typically algorithmic). In addition, investment strategies often focus on three opportunities: growth, value, or income. In a growth strategy, for example, you focus on investments with strong growth characteristics, while an income strategy is focused on building income potential.

Either way, it’s a good idea to think about your risk tolerance and financial goals. Investing to build wealth, for example, is different from investing to send your child to college or investing to save up for a home.

Once you know what you’re trying to achieve and your typical tools for achieving it, you can assess whether cryptocurrency is the right fit.

Do I Understand Cryptocurrency?

As Warren Buffet once said, you should never invest in something you don’t understand. That’s especially true of cryptocurrency, which is an incredibly young asset in a market with rapidly evolving parameters.

Think of it this way: you wouldn’t invest in a company without understanding how it makes money. That’s different from knowing what products it makes. You have to understand the company’s business model, how it plans to earn money, and whether its current profit model is successful.

The same is true of cryptocurrency.

It helps to start with the basics. Cryptocurrency is a digital currency which is not issued by any national bank nor fixed on any national currency. It relies on technology called blockchain, which is a decentralized digital ledger that tracks all cryptocurrency transactions. There are thousands of cryptocurrencies, but the best known ones are big names like Bitcoin and Ethereum. In theory, you can use cryptocurrency like regular currency, but it doesn’t have a reliable exchange rate and isn’t widely accepted yet.

Once you get a firm grasp on the technology, you can delve into the details of how cryptocurrency companies make money. Remember, cryptocurrency isn’t based on national currencies, so the company’s business model is critical to how the currency retains value over time.

Am I in a Position to Buy Cryptocurrency?

Once you understand cryptocurrency, ask yourself whether you’re in a position to buy it.

Because cryptocurrency is a young and highly risky asset, investors should not try their hand at cryptocurrency until they meet other key markers of financial stability, including paying down debt and investing enough in your retirement plan to earn an employer contribution. Also, because cryptocurrency is risky, it should only make up about 5% to 10% of your total portfolio.

If you’re in a good position to invest in cryptocurrencies based on that information, investing doesn’t require a significant investment. Some exchanges allow users to purchase cryptocurrencies in increments starting at just a few dollars.

Have I Done My Homework?

If you can afford to invest in cryptocurrency, the next step is to ask whether you’ve done your homework.

While cryptocurrencies aim to be on par with fiat currency, they’re not traded on major financial exchanges, at least not yet. Cryptocurrency exchanges have made it much easier to buy and sell, but you’ll have to do some research on a good crypto wallet (unless you want to entrust your security to the exchange operators, anyway).

You should also pay careful attention to any possible red flags. Unfortunately, the cryptocurrency market is full of hype, and you have to learn how to look past all the noise so you don’t wind up with coins that have no use case.

For example, Bitcoin is designed to function as actual currency, but not all cryptocurrencies are. Ether, the second most valuable cryptocurrency, can be used as currency or as a means of compensating users who help run the network. You don’t need a coding background, but it’s a good idea to read some whitepapers outlining the technical details of how the network is designed to operate.

How Will I Diversify?

Last but not least, you have to ask the most essential investing question: how will I diversify?

While cryptocurrencies themselves are diverse, they all face one critical risk, which is that the technology is still quite new and evolving rapidly. Even if blockchain holds in the coming decades, cryptocurrency may or may not pan out, and individual currencies may or may not prove viable. And unfortunately, because the market is still so young, there aren’t many options like a mutual fund or ETF to give you wide exposure to the cryptocurrency market.

Your best bet for diversification is to look into the few cryptocurrency ETFs and mutual funds that are available, do your homework to assess the good ones, and invest in one of them rather than buying individual currency.

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