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In the first episode of our how to invest in cryptocurrency series, we look at the fundamentals of volatility, utility, and risk appetite.
If you’re new to cryptocurrency, the prospect of investing in currencies such as Bitcoin and Ethereum can be intimidating.
But don’t worry, we’re here to teach you how to invest. In this series, we’ll take you from the ground floor to the boardroom, in collaboration with AAX, the world’s first digital asset exchange powered by the London Stock Exchange.
We’ll show you the investment landscape, the different types of investments and what are the risks and rewards of choosing different tools to invest in.
But before that, let’s start with the basics.
Investing in cryptocurrency
At it’s very simplest, buying cryptocurrency is like buying other types of asset: you find a broker or exchange, agree a price, and that asset is sent to storage. The hope being the value of that asset rises over time and you then sell that asset at the higher price.
With cryptocurrency it’s no different. But if you’ve come from the fiat world, where you may have invested in things like ISAs and pensions, the performance of these assets is very different.
For example, if you have a savings account, with interest rates so low in most Western countries, the performance of those savings would be a few percentage points per year.
f you invested in Bitcoin meanwhile, depending on when you invested you could be way up, or down. In the past year, volatility has been as high as 10%, and as low as 1.5%
For comparison, the volatility of gold averages around 1.2%, while other major currencies average between 0.5% and 1.0%.
So investing in cryptocurrency should be seen as part of a balanced portfolio that contains a mix of assets with different risk profiles.
If you’re interested in why is Bitcoin so volatile, we’ve got an article on that, here.
Now that we’ve cleared that up, let’s dig into the different types of cryptocurrency.
The different types of cryptocurrency
If you look at the biggest cryptocurrencies by market capitalization – the total value of the tokens currently in circulation multiplied by the current price – you’ll see a whole host of different projects that use tokens for different things.
So you’ll notice Bitcoin, a cryptocurrency that can be used as a store of value, a means of trade, or a unit of account. This concept has long been discussed, and we discuss it here.
Because Bitcoin is open-source, hundreds other currencies use the same code that Bitcoin is based on. Bitcoin Cash, Litecoin, and Bitcoin SV are popular examples. They are not, however, the same as Bitcoin. They have various tokens, communities, and features that the communities to which they are linked may have added.
Stablecoins are another popular sort of cryptocurrency, particularly among investors. These are currencies pegged to the value of something else, typically the US Dollar. Examples of these include Tether and USD Coin.
They are popular with investors because they are typically viewed as a stable on-ramp into cryptocurrency, and they are frequently developed and deployed by companies licenced by financial authorities. What you buy for a dollar remains the same price (generally speaking).
You also have utility tokens, which are essentially little pieces of a product. One of the most well-known is Filecoin, whose FiL token allows users to use its decentralised storage. Hundreds more utility tokens are also built on Ethereum. Utility token prices tend to fluctuate in accordance to how much the token is used for its intended function.
There are security tokens, too, but because the definition of these tokens is not a legal distinction, but rather a technical one, we won’t go into too much detail.
There are a whole host of other definitions: privacy coins, meme coins, governance tokens, the list goes on. But at this stage, what’s important to note is that the value of these tokens, and in turn what influences that value comes from different sources.
Some tokens will see increases in value when exchanges decide to offer them as a trading pair with a more well known token, like Bitcoin. Other tokens rise – and fall – in value when the projects that run them announce or change features. Some will respond to headlines, and others might be being manipulated by organised groups using the network to inflate value so they can sell off the tokens at a profit.
One of the core ideas to think about when it comes to crypto is that the community is relatively small, as is the money contained within them, especially when you put cryptocurrency alongside other asset classes, which are collectively worth $256 trillion.
That means that when a piece of news, or a movement of cryptocurrency from one token to another takes place, the effects of those movements are often larger than you’d see in other asset classes. Think of it as a large pebble being dropped into a small pond. There will be ripples.
What you should think about when choosing what to invest in?
First and foremost, it’s important to understand your appetite for risk. While Bitcoin’s volatility has levelled off in 2020, it remains significantly higher than that of other asset classes and stocks.
The good news is that in the last year, there has been a considerable increase in the level of sophistication associated with investing in cryptocurrency.
While many crypto investors prefer to buy and hold a single cryptocurrency in a wallet, there are now institutional investment grade products and services that can shield you from direct exposure to an asset’s performance, hedge the performance of one cryptocurrency with another, and even allow you to earn interest for participating in a network, which we’ll discuss in part two of our investigation.
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