“This article was originally written for bankrate.com by James Royal."
Cryptocurrency has taken the world by storm, especially during the last few years. The total value of all these digital currencies has swelled to more than $2 trillion, says Bloomberg. Of these, Bitcoin is the most popular, worth more than $1 trillion itself, according to CoinMarketCap.com. Investors have swarmed to this digital gold rush, often with little knowledge and a lot of hope.
Cryptocurrency’s rapid appreciation has many investors questioning the place of stocks in their portfolios. But there are numerous differences between stocks and cryptocurrencies. The most important is that a stock is an ownership interest in a business (backed by the company’s assets and cash flow), whereas cryptocurrency in most cases is not backed by anything at all.
If you’re buying cryptocurrencies, it’s important to understand what you’re purchasing and how they compare to traditional investments such as stocks, which have a solid long-term track record.
Should you invest in cryptocurrency or stocks?
Any savvy investor needs to know exactly what they’re investing in. It’s crucial to weigh the risks and rewards of investing, and what will drive the investment’s success. If they don’t have this kind of information, they can’t make the calculation. In this case, it’s not really investing — it’s much more like gambling.
Here are the key things investors need to know about stocks and cryptocurrency.
A stock is a fractional ownership interest in a business. It’s easy to lose sight of this, if you become overwhelmed by the wiggling stock prices — and the potential for profit. As a legal ownership stake in the business, the stock gives shareholders a claim on the assets and cash flow of the business. These back your investment and provide a basis for its valuation.
Why stocks rise and fall: A stock price moves as investors assess the future success of the company. While investors may become overly optimistic about the stock in the short term, the stock price ultimately depends on the company’s ability to grow its profits over the long term. That is, a stock rises in the long term due to the success of the underlying company.
For a stock to be a successful investment, the underlying company must perform well over time. (Here’s a step-by-step guide for how to invest in stocks.)
Generally, cryptocurrency is backed by no hard assets (specialized stablecoins being an exception), and that’s the case for the most popular crypto coins such as Bitcoin and Ethereum. A cryptocurrency may allow you to perform certain functions, such as sending money to another person or using smart contracts that automatically execute after specific conditions are met.
Why cryptocurrency rises and falls: Because cryptocurrency is not backed by assets or cash flow, the only thing moving crypto prices is speculation driven by sentiment. As sentiment changes, prices shift — sometimes drastically. So cryptocurrency is driven only by the hope that someone will buy it for more in the future — what’s called the “greater fool theory of investing.”
For a cryptocurrency to be a successful investment, you must get someone to buy it from you for more than you paid for it. That is, the market must be more optimistic about it than you are. (Check out this beginner’s guide to investing in cryptocurrency.)
Cryptocurrency and stocks: What to consider
Risks and safety
If you’re thinking about investing in any market-based investment such as cryptocurrency and stocks, you need to carefully consider your risk tolerance. Can you handle the volatility in these kinds of assets? How well do you respond to gains and losses in your investments?
- Stocks are an ownership interest in a company, so a stock’s performance over the long term depends on the underlying company’s success.
- If investors don’t like a stock, they can sell it and push down the price, but ultimately the company has to go out of business for the stock to be worthless.
- Volatility is high with stocks, and many stocks can rise 100 percent or more in a year and may fall just as quickly.
- The stock market is an established way to invest with a strong track record, generally.
- Investors who don’t want to buy individual stocks can own funds such as those based on the Standard & Poor’s 500, which has gained 10 percent per year on average over time.
- Since cryptocurrency is generally not backed by assets or cash flow, it relies only on sentiment becoming more favorable to push up its price.
- If traders decide they don’t want to own a cryptocurrency, it could plunge to zero, because it’s not backed by anything.
- Volatility is particularly drastic here, with cryptos rising or falling 50 percent or more in a year commonplace.
- Countries could ban cryptocurrencies entirely, as China did in 2021.
- Because it’s relatively new, cryptocurrency is not yet firmly established as an asset class.
As risky as stocks can be, cryptocurrencies are even more speculative.
Your time horizon — when you need the money from an investment — is a key criterion. The shorter your timeline, the safer your asset should be, so that it’s there when you need it. The more volatile an asset, the less suited it is for those with a short timeline. Generally, experts suggest investors in risky assets such as stocks need at least three years to ride out volatility.
- Stocks are often volatile, but they tend to be less volatile than crypto. Individual stocks are more volatile than a portfolio of stocks, which tends to benefit from diversification.
- Stocks are better suited to investors who can leave their money alone and don’t need to access it. Generally, the longer you can leave it invested, the better.
- Some stocks can be more volatile than others. For example, growth stocks tend to fluctuate much more than value stocks or dividend stocks.
- Investors may shift from more aggressive stocks (growth stocks) to safer ones (dividend stocks) as they need to tap their money, such as when they approach retirement.
- While stocks are volatile, cryptocurrency is ridiculously volatile. For example, during 2021, Bitcoin lost more than half its value in a few months and later gained 100 percent. Such volatility makes crypto unsuited for short-term investors.
- Crypto is better suited to traders who can leave their money tied up and wait for it to recover. Think years rather than weeks.
As you’re thinking about constructing your portfolio, you don’t have to make an either-or choice between cryptocurrency and stocks — or other kinds of asset such as bonds or funds, either. It’s all about weighting your portfolio in a way that fits your risk and time horizon.
- Given its inherent risks, cryptocurrency works better with a small allocation in your overall portfolio. Think 5 percent or less.
- Even a small allocation could do wonders for your portfolio if cryptocurrency really takes off. Also, limiting to a small allocation protects you against a complete loss if crypto goes nowhere.
- If crypto grows to be a significant portion of your portfolio, you can re-allocate more of your money to stocks to lower your portfolio’s overall risk.
- Given stocks’ strong long-term record, a diversified collection of stocks should make up the majority of your portfolio, especially if you have decades until you need to tap it.
- If you’re investing in individual stocks, you’ll need to research your stocks carefully to achieve good returns.
- If you’re investing in funds, you can buy a broadly diversified fund such as an S&P 500 index fund without significant research and enjoy the potential for high returns.
Cryptocurrency has soared in price, but investors need to understand what they’re investing in, instead of just rushing in because other traders are. If you decide to take a stake in crypto, consider how it fits with your own risk tolerance and financial needs. Investors can earn good returns without investing in cryptocurrency, and some investors, including legends such as Warren Buffett, won’t touch cryptocurrency.
Disclaimer: this article was written by the writer to provide guidance and understanding of cryptocurrency trading. It is not an exhaustive list and should not be taken as financial advice. Obiex Finance will not be held liable for your investment decisions.