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In 1630s Holland, the tulip rapidly became the luxury item of choice. As prices rose steadily, traders began to speculate, driving up prices. By February 1637, not only were merchants and nobility trading tulips, but commoners saw an opportunity to get rich quick. Due to the influx of demand, prices rose, and no one was willing to pay the exorbitant price of a tulip bulb future, the market collapsed. This collapse was most felt by speculators who had sold land and other possessions to enter tulip trading. Once the market collapsed, they lost significant amounts of their net worth. The Dutch Tulip Mania is not the only economic bubble to burst but is the first documented in a long line of get rich quick opportunities.
Cryptocurrency has similarly risen in popularity and you’ve likely heard stories of people buying early what was once an obscure “coin”, only to watch the value increase a hundred-fold. After hearing the success stories, others began trading crypto and some lost substantial amounts of money. [1][2] Here are four reasons to be wary when it comes to crypto.
Complexity
Cryptocurrencies are decentralized digital assets used as mediums of exchange stored on computerized ledger databases. [3] Most of us can figure out what that means, but few can explain how it works. Understanding how something works is not a prerequisite for using it. For example, I am confident I cannot explain how a combustion engine works, but that does not stop me from driving my car. However, using a product is different than investing in it. Cryptocurrency is an investment. Investing is owning an asset with the goal of generating income or appreciation in value. How does cryptocurrency accomplish that? There is a lot of new exciting technology surrounding crypto, but how does it produce value? The blockchain technology that many cryptocurrencies trade on is valuable technology, but cryptocurrencies themselves operate more similarly to a precious metal, and don’t produce anything. When looking to invest, I want to understand how an asset produces value. Cryptocurrency doesn’t give me that answer.
Fear of Missing out
In the fall of 2017 Bitcoin began its rapid rise in price and popularity. Although Bitcoin has since demolished its record high during this period, its price quadrupled in just over two months. During its meteoric rise, early subscribers to Bitcoin watched their values increase and some made huge gains. The news stories of crypto millionaires piqued interest and many people wanted a part of the action. Unfortunately, past results do not predict future performance. If you only buy because the asset has gone up and then sell when the price goes down, you are buying high and selling low, which is the exact opposite of what you want to do. People often say how they wish they would have bought Bitcoin when it was four dollars; the problem is, they had never heard of it then. They only knew what Bitcoin was because it was already popular and increasing in price. You should not buy something because some people have made money on it. By then, you are likely too late.
Speculation
The S&P 500 is an index made up of 500 leading companies and covers approximately 80% of available market capitalization. [4] Although companies move in and out of the index for various reasons, many are among the most innovative and profitable companies in history. When markets shift and technology advances, they likely can fight and evolve to stay relevant with new revenue streams or enhance existing ones. Cryptocurrency is an innovation, but it operates more like gold than equities. There is no active leadership, changing with shifting markets. It just is. Cryptocurrency gains value through scarcity and demand, it operates like a currency, but without a federal reserve or the ability to tax citizens. You can invest in companies because they are creating value and pursuing profits. The draw for crypto is to get in early and hope it takes off, but which of the over 2,500 cryptocurrencies is the next one to take off?
Regulatory Risk
At best, cryptocurrency regulation is a grey area. The IRS, SEC and CFTC classify it differently; property, nonsecurity and commodity respectively. [5] The disconnect is not only in the US, 2021 saw a major shift in China’s policy towards crypto. China barred financial institutions and payment companies from any cryptocurrency transactions or trading. When the world’s second largest economy shuts down an industry, its going to move the needle, but considering that in 2017 China’s local exchanges accounted for 90% of the global bitcoin trading, any change in Chinese policy is monumental. That is what happened this year when China banned most of their Bitcoin mining operations. As of now, China shut down 90% of its domestic Bitcoin mining, which accounts for about one third of global production. Cryptocurrency is still in its infancy and while governments are figuring out where they stand there will most likely be more volatility in the future.
If you must
I am not afraid of change, nor do I scream at kids to get off my lawn. I am fascinated and excited by innovation, but at this point cryptocurrency feels more like gambling than investing. Sure, you can hit it big, but I am more than happy with long term consistent wealth building in the stock market. I do not recommend buying cryptocurrency, but if you want to, buy only enough that will not materially hurt you and be prepared to lose your entire investment. For every story you hear of someone investing everything into Dogecoin and making a fortune, there are many more who have lost a substantial amount of money. At this point it seems that cryptocurrency is here to stay, but with it; extreme volatility, everchanging regulation and value built on hysteria.
[1] Ponciano, Jonathan. “Crypto Crash Intensifies as Losses Eclipse $1.3 Trillion Just Two Weeks After Market’s All-Time High.” Forbes, Forbes Magazine, 23 May 2021.
[2] Kale, Sirin. “I put my Life in Crypt: How a Generation of Amateurs got Hooked on High-Risk Trading.” Guardian News and Media, 19 June 2021.
[3] Frankenfield, Jake. “Cryptocurrency.” Investopedia, 25 May 2021.
[4] s&pglobal.com. S&P Dow Jones Indices.
[5] Sharma, Rakesh. “Bitcoin has a Regulation Problem.” Investopedia, 14 Jun 2021.
 | Phil Parker Wealth Manager & Employee Engagement Consultant |
