Cryptocurrency Investment: Wise Or Risky Move?

Investing in cryptocurrency is a hotly debated topic. On the one hand, cryptocurrencies like Bitcoin and Ethereum have experienced tremendous growth and popularity in recent years, with Bitcoin reaching an all-time high of over $70,000 in March 2024. On the other hand, the crypto market is incredibly volatile, with frequent and significant price swings. This volatility is driven by various factors, including market speculation, regulatory news, technological advancements, and macroeconomic trends.

Another factor to consider is the level of risk involved. Cryptocurrency is a speculative investment, and its value is based purely on speculation and market demand. As such, it is subject to extreme price volatility and is not suitable for all investors. Additionally, the crypto market is largely unregulated, and consumer protections are minimal or non-existent, making it vulnerable to fraud and cybercrime.

Despite the risks, some people argue that adding crypto to a diversified portfolio can be beneficial. Crypto is still a very young market, and there is potential for significant returns if the right investments are made. However, it is crucial to understand the risks involved and only invest what you can afford to lose.

Volatility

As a relatively new asset class, crypto is widely considered to be highly volatile. In fact, crypto market volatility is considered to be in a different league from traditional markets. For example, Bitcoin (BTC) has witnessed over eight 50% corrections in its 15 years of existence. However, it has also managed to recover from each correction and reach new all-time highs.

The crypto market's unique characteristics, such as its immaturity, lack of regulation, and 24/7 trading, also contribute to its volatility. For instance, the effects of news events and speculation are often exaggerated in crypto due to the market's small size and lack of liquidity. Positive or negative news coverage, earnings reports, and the actions of large holders (often called "whales") can all impact the price of crypto assets.

Additionally, the crypto market's heavy retail investor base, who are typically less informed and more impressionable than traditional investors, can also lead to contagion-like sentiment shifts that drive volatility. A great example of this is when Tesla bought Bitcoin in January 2021, causing a price rally to an all-time high.

While crypto's volatility can be a deterrent for some investors, others view it as an opportunity for high returns. Strategies such as dollar-cost averaging and investing in stablecoins can help limit the downside impact of volatility for less risk-tolerant investors.

Security

Cryptocurrency is a digital payment system that doesn't rely on banks to verify transactions. It is a peer-to-peer system that enables anyone, anywhere, to send and receive payments. Cryptocurrency is stored in digital wallets, and the first cryptocurrency was Bitcoin, which was founded in 2009 and remains the most well-known today.

The security of cryptocurrency is a complex issue. On the one hand, cryptocurrencies are built on blockchain technology, which is highly secure and makes it difficult for hackers to tamper with transaction records. Additionally, transactions typically require two-factor authentication, providing an extra layer of security.

However, there are several risks associated with cryptocurrency that investors should be aware of:

• User risk: Cryptocurrency transactions cannot be reversed or cancelled once they have been sent. It is estimated that about one-fifth of all bitcoins are now inaccessible due to lost passwords or incorrect sending addresses.
• Regulatory risks: The regulatory status of cryptocurrencies is still evolving, and sudden changes could make it challenging to sell or cause a market-wide price drop.
• Counterparty risks: Many individuals and businesses rely on exchanges or custodians to store their cryptocurrency. Theft or loss by these third parties could result in the loss of one's entire investment.
• Management risks: Due to the lack of consistent regulations, there are limited protections against deceptive or unethical management practices.
• Programming risks: Many investment platforms use automated smart contracts, and investors assume the risk of bugs or exploits that could lead to the loss of their investment.
• Market manipulation: This remains a substantial problem in the cryptocurrency market, with influential people, organizations, and exchanges acting unethically.
• Volatility: The cryptocurrency market is highly volatile, and investments require careful price monitoring.
• Criminal activities: Cryptocurrencies have become popular for illicit activities such as money laundering, illicit purchases, and ransomware.

To protect their investments, individuals should consider taking a multi-pronged approach. This includes using reputable exchanges, enabling two-factor authentication, and storing cryptocurrency in external wallets, preferably cold wallets that are not connected to the internet. Additionally, strong passwords, backup seed words, and avoiding public Wi-Fi can enhance security.

Overall, while there are risks associated with investing in cryptocurrency, taking proactive security measures can help mitigate these risks and protect digital assets.

Taxation

The taxation of cryptocurrency gains and income varies by jurisdiction. Here is an overview of the taxation treatment of cryptocurrencies in the US and the UK.

United States

The US Internal Revenue Service (IRS) treats cryptocurrencies as property, not a currency. As such, cryptocurrency transactions are taxable events, and capital gains tax rules apply. If you hold a cryptocurrency for a year or less before selling or exchanging it, any gain will be subject to short-term capital gains tax rates, which correspond to ordinary income tax rates. On the other hand, gains on cryptocurrencies held for over a year are generally subject to lower long-term capital gains tax rates.

It is important to note that if you sell a cryptocurrency at a loss, you can use that loss to offset other capital gains. Additionally, if your losses exceed your gains, you may be able to use the remaining loss to offset a portion of your ordinary income.

When it comes to cryptocurrency-related investment products, such as exchange-traded funds (ETFs), the tax treatment can become more complex. While the IRS has not provided specific guidance on the taxation of cryptocurrency ETFs, these products are generally treated as securities for tax purposes, similar to stocks or bonds. This can lead to complications with "wash sale" rules, which involve selling a security at a loss and then buying a similar security shortly before or after. As cryptocurrency is considered property and not subject to wash sale rules, the question arises as to whether selling a cryptocurrency ETF and then buying a similar product would trigger the wash sale rule.

United Kingdom

In the UK, crypto assets are also not considered money or currency by key financial institutions, including HM Revenue and Customs (HMRC). Instead, they are treated similarly to shares for tax purposes. This means that individuals buying, holding, and selling cryptocurrencies are typically subject to capital gains tax (CGT) on any gains made from the disposal of crypto assets. The annual tax-free allowance for CGT is £3,000, and gains above this threshold are taxed at 10% up to the basic rate and 20% for higher and additional tax rates.

Income tax may apply in certain circumstances, such as when income is derived from mining activities or specific types of airdrops. In these cases, the income is generally taxable as miscellaneous income. If you are considered to be carrying out trading activities with cryptocurrencies, income tax and National Insurance contributions may also apply.

It is important to note that the UK does not have a specific crypto assets taxation regime, and the usual tax laws are applied. The tax treatment depends on the nature and use of the tokens rather than their definition. HMRC provides guidance on the different types of crypto assets, including exchange tokens (cryptocurrency), utility tokens, security tokens, and stablecoins.

Timing

The timing of your investment in cryptocurrency is crucial. The crypto market is extremely volatile, and the value of even the most popular cryptocurrencies like Bitcoin can fluctuate wildly.

If you are looking for long-term growth and stability, a "time in the market" strategy may be more suitable. This involves buying and holding assets like Bitcoin or Ethereum for several years, riding out the ups and downs of the market. For example, if you had bought 1 Bitcoin in 2015 when the price was around $300 and held onto it, you would have seen your investment reach an all-time high of over $75,000 in March 2024, despite periods of significant volatility.

On the other hand, if you are seeking short-term gains and are willing to take on more risk, you may prefer "timing the market." This strategy involves attempting to predict and capitalise on market movements by buying low and selling high within shorter time frames. For instance, if you had bought Bitcoin at $10,000 in early 2020 and sold it when it reached $30,000 by the end of the year, you would have tripled your investment. However, if you had then bought back in at $40,000, hoping for continued growth, and the price dropped to $25,000 shortly after, you would be facing losses.

It's important to note that timing the market requires more frequent trading and a keen eye on market trends and news. Additionally, the crypto market is subject to various factors that can impact its volatility, such as market speculation, regulatory news, technological advancements, and macroeconomic trends. As such, predicting the ideal time to buy or sell can be extremely challenging.

Another strategy to consider is Dollar Cost Averaging (DCA). This approach aims to strike a balance between timing the market and time in the market. With DCA, you invest a fixed amount of money in crypto at regular intervals, regardless of the price. This reduces the impact of short-term volatility by spreading out your purchases over time. While you may see smaller returns compared to investing a large sum at the right moment, DCA can help you avoid the risk of buying a large amount of crypto when prices are high, only for the value to drop soon after.

In conclusion, the timing of your crypto investment depends on your risk tolerance, investment goals, and time horizon. "Time in the market" is generally more suitable for long-term investors seeking stability, while "timing the market" appeals to those seeking short-term gains and willing to take on more risk. Dollar Cost Averaging offers a middle ground between the two, helping to mitigate the impact of volatility.

Blockchain technology

However, there are also some drawbacks to blockchain technology. It requires significant computational power and energy consumption, which can be costly and create a large carbon footprint. Blockchain is also limited in the number of transactions it can process per second, and its decentralized nature can make it appealing to criminals for illegal activities.

Despite these challenges, blockchain technology has the potential to revolutionize various industries, including finance, media and entertainment, retail, energy, and voting systems. By enabling secure and transparent data sharing, blockchain can help to streamline processes, improve accuracy, and reduce the need for intermediaries.

Frequently asked questions