Cryptocurrency has taken the world by storm, especially in the last few years. The total value of all these digital currencies has swelled to over $ 2 trillion, according to Bloomberg. Of these, Bitcoin is the most popular, worth over $ 1,000 billion, according to CoinMarketCap.com. Investors have flocked to this digital gold rush, often with little knowledge and a lot of hope.
The rapid appreciation of cryptocurrency is leading many investors to question the place of stocks in their portfolios. But there are many differences between stocks and cryptocurrencies. Most importantly, a stock is a stake in a company (backed by the company’s assets and cash flow), while cryptocurrency in most cases is not backed by anything at all.
If you are buying cryptocurrency, it is important to understand what you are buying and how it compares to traditional investments such as stocks, which have a strong long-term track record.
Should you invest in cryptocurrencies or stocks?
Any smart investor should know exactly what they are investing in. It is essential to weigh the risks and rewards of investing, as well as what will contribute to the success of the investment. If they don’t have that kind of information, they can’t do the math. In this case, it’s not really about investing, it’s more of a game.
Here are the top things investors need to know about stocks and cryptocurrency.
A share is a fractional interest in a company. It’s easy to lose sight of this if you are overwhelmed by the fluctuations in stock prices and the potential for profit. As a legal interest in the business, shares give shareholders a right to the assets and cash flow of the business. These support your investment and provide a basis for its evaluation.
Why stocks go up and down: The price of a stock changes as investors assess the company’s future success. While investors may become overly optimistic about the short-term stock, the stock price ultimately depends on the company’s ability to grow profits over the long term. That is, a stock rises in the long run 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 on how to invest in stocks.)
Typically, cryptocurrency is not backed by any physical assets (specialized stablecoins being an exception), and this is the case with more popular crypto coins such as Bitcoin and Ethereum. A cryptocurrency can allow you to perform certain functions, such as sending money to another person or using smart contracts that run automatically once specific conditions are met.
Why cryptocurrency goes up and down: Because cryptocurrency is not backed by assets or cash flow, the only thing that moves crypto prices is sentiment driven speculation. As sentiment changes, prices change, sometimes drastically. So, cryptocurrency is only motivated by the hope that someone will buy it more expensive in the future – something called the “Biggest Fool of Investing Theory”.
For a cryptocurrency to be a successful investment, you need to get someone to buy it from you for more than you paid for it. That is, the market must be more optimistic about this than you are. (Check out this beginner’s guide to investing in cryptocurrency.)
Cryptocurrency and stocks: what to consider
Risks and security
If you are considering investing in a market-based investment such as cryptocurrency and stocks, you should carefully consider your tolerance for risk. Can you handle the volatility of these types of assets? How well do you react to the gains and losses of your investments?
- Stocks are a participation in a business, so the long-term performance of a stock depends on the success of the underlying business.
- If investors don’t like a stock, they can sell it and drive the price down, but at the end of the day, the company has to shut down for the stock to be worthless.
- Volatility is high with stocks, and many stocks can go up 100% or more in a year and fall just as quickly.
- The stock market is an established way of investing with a strong track record, in general.
- Investors who do not wish to buy individual stocks may own funds such as those based on the Standard & Poor’s 500, which has gained 10% per annum on average over time.
- Since cryptocurrency is generally not backed by assets or cash flows, it only relies on increasingly favorable sentiment to drive its price up.
- If traders decide they don’t want to own cryptocurrency, it could drop to zero because it’s not backed by anything.
- Volatility is particularly drastic here, with cryptos rising or falling by 50% or more over the course of a year.
- Countries could ban cryptocurrencies altogether, as China did in 2021.
- Because it is 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 deadline, the more secure your asset should be, so that it is there when you need it. The more volatile an asset, the less suitable it is for those with short maturities. Typically, experts suggest that investors in risky assets such as stocks need at least three years to overcome 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 best suited for investors who can leave their money alone and don’t need to access it. As a general rule, 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 switch from more aggressive stocks (growth stocks) to safer stocks (dividend stocks) because they need to put their money to use, for example as they approach retirement.
- While stocks are volatile, cryptocurrency is ridiculously volatile. For example, in 2021, Bitcoin lost more than half of its value in a few months and then gained 100%. Such volatility makes crypto unsuitable for short-term investors.
- Crypto is best suited for traders who can leave their money tied up and wait for it to recover. Think of years rather than weeks.
When you plan to build your portfolio, you also don’t have to choose between cryptocurrency and stocks, or other types of assets like bonds or funds. It’s about weighting your portfolio in a way that matches your risk and your time horizon.
- Given its inherent risks, cryptocurrency performs best with a small allocation in your overall wallet. Think about 5 percent or less.
- Even a small allowance could do wonders for your wallet if cryptocurrency really takes off. Additionally, limiting to a small allocation protects you against a complete loss if the crypto doesn’t go anywhere.
- If crypto becomes an important part of your portfolio, you can reallocate more of your money to stocks to reduce your overall portfolio risk.
- Given stocks’ strong long-term track records, a diverse collection of stocks should make up the majority of your portfolio, especially if you have decades left before you need to mine.
- If you invest in individual stocks, you will need to do extensive research on your stocks to get good returns.
- If you invest in funds, you can buy a broadly diversified fund such as an S&P 500 index fund without significant research and take advantage of the potential for high returns.
At the end of the line
The price of cryptocurrency has skyrocketed, but investors need to understand what they are investing in, instead of rushing because other traders are doing it. If you do decide to take a stake in crypto, consider whether it suits your own risk tolerance and financial needs. Investors can get good returns without investing in cryptocurrency, and some investors, including legends such as Warren Buffett, will not touch cryptocurrency.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past performance of investment products is not a guarantee of future price appreciation.