July 2021 E-Newsletter: Cryptocurrency 101: The Good, The Bad, and the Ugly Unknown

Jonathan M. Gardey, MBA, CFA®, CFP®

President and Chief Executive Officer

Do you feel like every other headline in your news feed these days has something to do with cryptocurrency?

Bitcoin is up 6000% percent.

Dogecoin investor loses millions in matter of days.

Ethereum plummets as China cracks down on crypto mining.

Bitcoin extends losses, erasing all gains for 2021—again!

The ups and downs and ins and outs are enough to give anyone whiplash. At first, the buzz may have been easy to ignore. But, every day it seems as if crypto is doggedly pressing on. Thanks in part to celebrity endorsements from Elon Musk and other online influencers. But, what is cryptocurrency anyway? And should it be a part of your investment portfolio?

In this newsletter, we crack open the mysterious world of crypto to forearm you with the knowledge you’ll need to understand this non-currency-currency’s place in today’s world.

What is Crypto?

Cryptocurrency was a term coined in 2009 by Satoshi Nakamoto, when he described a new kind of money, or currency, which would exist in limited supply in the electronic sphere created by and protected by encryption.

Encryption + Currency  = Cryptocurrency

You see, unlike the dollar bill, cryptocurrency only exists as code. There are no hard coins to stash in your piggy bank or dollar bills to fold up and tuck into the gold money clip you inherited from your grandfather. But, cryptocurrency holders are buying, selling, trading, and using cryptocurrency in ways that emulate the way we spend regulated ‘fiat” money, or legal tender.

Of course, the natural next question is whether or not (or to what degree) cryptocurrency could potentially replace government regulated fiat money. If this is a possibility, is it more advantageous to hop on the crypto bandwagon now rather than later?

How does Crypto Differ from Regular Money?

Like fiat money, crypto is limited in supply. Bitcoin supply, for example, is limited to a maximum of 21 million coins. With fiat money around the world, a nation’s central bank is the only one who can add or subtract from its supply of legal tender, which allows them to keep spending power relatively stable.

For cryptocurrency, though, there is no central bank or regulating authority stabilizing its value through the addition or subtraction of dollars or coins in circulation. For most cryptocurrencies including Bitcoin and Ethereum, stability is backed by the blockchain technology that allows cryptocurrency to exist.

In the simplest terms, a blockchain is a decentralized, record-keeping database, or ledger, of all transactions in a crypto’s network. The blockchain is made up of a chronological series of blocks, or transactions waiting to be settled.  These blocks are then chained together in chronological order, creating a time-stamped history of all crypto transactions (see below).

Source: PWC.com

The data entered in blockchains is immutable and cannot be reversed. This means that transaction histories are permanent and viewable to anyone. What this also means is that no single person or regulative authority has control. All users retain collective control.

So, who completes the transactions if there are no banks involved? Crypto miners. Crypto “miners” compete against one another to solve and unlock the complex mathematical equation that secures the block in question. The miner who solves the equation first gets to add the new block to the blockchain and is rewarded handsomely with the crypto they are mining.

Risks and Benefits of this (Non) Currency

Now that we’ve covered what cryptocurrency is, let’s explore the challenges and opportunities that exist for those hoping to earn, store, and spend their crypto assets.

Cryptocurrency tends to appeal to those who are not huge fans of government regulation, or who live in a country that lacks a dependable currency of its own. Just take the tiny Pacific coast town of El Zonte in El Salvador as a prime example. This town without a single bank runs entirely on Bitcoin. Salaries are paid in Bitcoin, tourists buy goods in Bitcoin, and the one lone ATM buys and sells Bitcoin.

Cryptocurrency and the blockchains behind them could also offer a faster and cheaper way to conduct both domestic and international commerce.

But, adopting this technology is not without significant risks.

Security Risks

When you purchase currency on an exchange platform, you may be exposed to risk of loss by hackers, malware, or other security breaches.  You see, your private encryption key can be stolen just like a credit card number or bank password. But, when you lose your encryption key, there isn’t any bank you can call up to cancel your key and request a new one, the way you can with a credit card. Losing the key could mean forfeiting all your crypto assets, and all the value associated with it (that cannot be recovered).

Market Risk

The value of crypto can fluctuate wildly, and as little as a celebrity tweet could cause values to balloon or bust. Beware of the estimated values you see right now, because it’s not unlikely they could change in the time it takes you to toast your morning bagel.

Regulatory Risk

Because cryptos are not government currency, they can be used for many illicit activities such as money laundering, illegal activities, or even tax evasion. As governments begin to further restrict crypto, questions are arising about its liquidity and longevity. Will government regulation cripple crypto’s growth potential?

Energy Consumption

Cryptocurrency mining centers around the globe are using enormous amounts of electricity. In just this past month, China shut down 90% of major mining, citing power concerns and financial risk as the chief concerns.

Great Expectations? Perhaps not quite yet.

Given the challenges that crypto presents, and the wild mood swings we see in its value, many investors are still wary of this new means of exchange. And rightfully so!

But given its place in the limelight right now, it’s hard not to question whether crypto will become a more permanent fixture in our economy and if it should hold a place in your investment portfolio.

At this point in time, we’re not putting our earned money on any particular outcome. Most notably, because there is no way to establish meaningful expectations of crypto’s performance in the future like we can with other investments. As financial author Larry Swedroe summarizes in his ETF.com column, “Bitcoin & Its Risks:”

“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 analysis is possible. Bitcoin is purely speculation.”

Of course, it’s not impossible to turn a profit trading cryptocurrencies; but, the act of trying to do so is a complete gamble compared to actual investing simply because of the amount of risk undertaken when you put your money into such a new and highly volatile sphere.

The key difference between investing and speculating is simply risk. Investors take on calculated risk in an attempt to turn a profit based on reasonable judgement, investigation, and a high probability of success. Speculators place their money in positions with a high probability of failure and rely on chance for the cards to fall in their favor.

So, personal feelings about the future of crypto aside, the most present concern should be how much you are willing to risk to participate in crypto. At this time, we don’t recommend allocating more than a miniscule amount of your discretionary investment income toward any crypto assets. That is, only use extra money you have outside your primary investments (the investments you need to fund your lifestyle) if you want to get in on the action.  

Whether cryptocurrency is here to stay or a passing craze, we remain available to assist you in managing your wealth, whatever form that takes.  

Important Disclosure Information

Gardey Financial Advisors Disclosures Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gardey Financial Advisors (“Gardey”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Gardey. Please remember to contact Gardey if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  To better understand the nature and scope of the advisory services and business practices of Gardey, please review our SEC Form ADV Part 2A, available via the SEC's website @ www.adviserinfo.sec.gov.  (Click on the link, select “Investment Advisor Firm,” and type in the firm name. Results will provide you both Part 1 and 2 of the Gardey Financial Advisors Form ADV.  Statistics from third-party sources are deemed to be accurate but have not been confirmed by Gardey.