Anyone who's read up on basic principles of investing knows the golden rule for making any investment portfolio work over the long term: diversification. When you invest in multiple types of assets, with multiple levels of associated risk, you spread your risk out and reduce the possibility for any one investment to crash the value of your portfolio disproportionately. You also increase your chances of finding a better-than-average return, and through rebalancing, you can adjust your portfolio to reflect your current risk and return goals as they develop.
Typical assets in the past have included stocks, bonds, index funds, and real estate, but with the rise of cryptocurrencies--especially Bitcoin--more investors and professionals are turning to new frontiers in their portfolios.
So is it a good idea to diversify your portfolio with a cryptocurrency?
What Cryptocurrencies Are
In a nutshell, cryptocurrencies are electronic cash systems that rely on peer-to-peer exchanges. They're fully decentralized and have no central authority or central server to manage those transactions. Instead, they rely on a network of individual computers to recognize, validate, and record transaction data; every device on the network needs to agree that a transaction can be verified, and once it is, it's added to a permanent, unalterable ledger that exists on that network--as a new "block" on the chain of data (otherwise called the blockchain). Other than their method of exchange, cryptocurrencies function just like other currencies, rising and falling in value.
There are some big advantages to investing in cryptocurrencies as part of your overall portfolio:
- Security. Despite the apprehensiveness you may feel about an all-digital currency, transactions using the blockchain are highly secure. Its novelty means the potential for exploitable loopholes hasn't been completely ruled out, but in theory, the blockchain system is permanent and unalterable, and by all accounts is unhackable. Fraud and hacking aren't threats that compromise the investment's potential value.
- Potential. Centralization and regulation have been problematic institutions for the money chain for decades. Digital currency is decentralized, meaning it won't be directly regulated by governments and banks. It also has significant long-term potential, potentially even more so than the systems of cash we've become reliant on. That means almost any cryptocurrency, especially the major players, has a huge potential upside--especially over the course of a few decades.
- Independence. Because it's decentralized and not tied to any one government, physical asset, or market, Bitcoin is wholly independent from other systems. That means it's hypothetically more valuable as a diversification asset, since it probably won't grow or shrink in direct correlation with any of your other assets.
But there are some downsides to consider as well:
- Current position. Bitcoin's value, and along with it interest in cryptocurrencies, has skyrocketed and now sits at an all-time high. It's true that the prices could keep rising, indefinitely, but some experts believe we've already entered the early stages of a financial bubble. Put simply, that means the price has risen faster than the actual value of the currency, and someday soon, a catalyzing event could send the price into a tailspin, creating losses for all investors involved.
- Volatility. Even if the price isn't in a bubble, you should know that the newness and excitement around cryptocurrencies make them a highly volatile investment. It's almost certain that the price will fluctuate up and down, sometimes wildly, before it stabilizes. For low-risk investors, this should be a red flag.
- Uncertainty. Cryptocurrencies are still very new, and even lawmakers aren't sure what to do with them yet. The SEC is starting to crack down on initial coin offerings (ICOs) and other digital currency regulations, and their actions may seriously change the game. There's too much uncertainty to make any definitive guess about their future.
- Competition. There are hundreds of cryptocurrencies popping in and out of existence, like penny stocks. Investing in anything other than the mainstream digital currencies is a high risk with high uncertainty.
So is it a good idea to invest in cryptocurrency as a way to balance out your portfolio? Like with any investment, that depends on your current portfolio, your current risk tolerance, and how much you're investing in which assets. If you want a highly stable portfolio, cryptocurrencies may not have a place, but if you're open to high-risk, high-reward, it may be worth dedicating a small portion of your assets to this fundamentally new vehicle.