Understanding the risks of Crypto

Does all of the hype around cryptocurrencies like Bitcoin have you wondering if you should get in on the action?

It’s easy to feel like you’re missing out when you look at Bitcoin’s price change over the last decade. At the start of January 2012, one bitcoin traded for around $5. By April 2021, it had risen to a peak price of $63,729. To put this into perspective, an investment of $100 in bitcoin back in 2012 would now be worth over $1.27 million.

While numbers like this can be very exciting, it's important to remember that this growth has been anything but smooth. There are definite risks involved in crypto that could result in significant loss.

What is Crypto?

The first thing to understand about crypto is that it wasn’t invented to be an investment. It was designed to be a decentralized form of digital currency using a relatively new type of technology called blockchain.

Naturally then, buying cryptocurrency is not the same as purchasing a share of stock. Cryptos do not produce any products that will generate revenue, nor is there a company full of talented employees making strategic decisions about future growth that’s fueling value.

Understanding the Risks

Fundamentally, crypto is all just computer code that gets sold for real money. Unfortunately, this can make it highly susceptible to threats of speculation, volatility, and government regulation.

1. Speculation

Bitcoin and other cryptos have made tremendous gains over the years, but it's not for the same reason that stocks and bonds traditionally increase in value. This can best be summed up by financial author Larry Swedroe:

“With stocks, we can look at valuation metrics, like earnings yield. With bonds, we can use the current yield-to-maturity. And with assets like reinsurance or lending, for which there are decades of data, we have historical evidence to make the appropriate estimates. With Bitcoin, none of the preceding analyses is possible. Bitcoin is purely speculation.”

To put it bluntly, the only true way to make money from crypto is to sell it for more than what you paid for it. This is a cycle that will eventually reach a breaking point. And as they say: When the music stops, you don’t want to be the one left holding the bag.

2. Volatility

Despite the overall rise in value, cryptos tend to be plagued with dramatic and often violent price fluctuations. Over the past decade, Bitcoin has crashed at least three times losing as much as 80 percent of its value in each cycle.

That’s not exactly the kind of asset you want your retirement savings to depend on. Investing always requires some risk to achieve growth, but there are better ways than others to optimize this risk.

When you compare this to present-day market conditions, stocks temporarily crashed by 50 percent at the start of the Great Recession in 2008. However, they were able to regain their previous value after approximately three years and continued to climb upwards until the events that unfolded at the start of the COVID-19 pandemic.

3. Government Intervention

Even though anonymity is perceived to be one of crypto’s best features, it’s also quickly becoming one of its greatest detriments.

New government regulation is constantly being introduced to restrict or ban the use of crypto altogether. When countries like Russia and China made it illegal to use, values plummeted.

While you can still own crypto in the U.S., the IRS now has very strict rules that both citizens and the platforms which deal in crypto must abide by. This includes verifying the identity of its users and keeping track of transactions so that profits can be taxed appropriately.

With increased intervention comes the risk that government may try to replace crypto with a new version. The U.S. has publicly announced that they are seriously considering making their own central bank of digital currency. If that happens, then there’s no telling what that would mean for Bitcoin and other cryptos.

If You Still Want to Invest ...

If you truly believe that cryptocurrencies are the way of the future and that prices may still go up, then limit your risks by only investing a small amount of capital. Use only your discretionary income and no more than you would consider to be “fun money.”

If you do happen to make some gains, sell them immediately and move the funds into more stable investments. Definitely don’t try to double down or spend more than you can afford to lose.

With Wall Street banks like Morgan Stanley starting to make cryptos available to clients, it’s possible that you might see this become an investment option in your retirement plan in the near future. If it does, we recommend keeping crypto capped to no more than 5 percent of your portfolio.

As was once said by the great investment guru Warren Buffett: Rule Number One is to never lose money. Rule Number Two is to never forget Rule Number One.

Keeping a diversified portfolio is of utmost importance, but there are plenty of options for diversification that carry far less risk than crypto and can be relied on more heavily.

_{About the Author}

_{Julianne F. Andrews, MBA, CFP®, AIF® began her career in financial planning in 1988 and co-founded Atlanta Financial Associates in 1992, merging into Mercer Advisors in 2020. She specializes in working with physicians and executives in the healthcare industry. Her passion for working with physicians comes from being a pediatrician’s spouse for more than three decades. Julie has been featured on Forbes’ list of America’s Top Women Wealth Advisors since 2017 as well as Forbes’ Best-in-State Wealth Advisors since 2018. Julie can be reached at jandrews@merceradvisors.com.}

_{Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. All expressions of opinion reflect the judgment of the author, are as of the date of publication, and are subject to change. The information discussed is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Due to various factors, including changing applicable laws, the content may no longer be reflective of current opinions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Mercer Advisors. Mercer Advisors is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice.}