Five Questions to Ask Before Investing in Crypto
The world of digital assets—cryptocurrencies, NFTs, and decentralized finance—were the hottest topics of 2021. Should you include them in your investment plan? There’s a lot to unpack, so before putting money into digital assets start by asking a few key questions.
(1) How is my financial foundation?
Before taking on additional risk make sure your financial basics are covered. A strong financial foundation consists of a robust emergency fund, making consistent contributions towards traditional retirement accounts, no high-interest debt, and being on pace to reach any other goals you’ve identified. Digital assets can come with a significantly higher amount of risk than traditional investments, so you want to ensure you have a foundation that can bear that risk.
(2) What’s my purpose behind making this investment?
Before making any investment, you need to have a purpose.
Because the purpose will guide your approach to the investment. If you’re investing in cryptocurrency for the long term and believe in the overall movement, the day-to-day volatility won’t be as difficult to weather.
With digital assets being such a new space, new investment opportunities appear every day, and while some investors have made significant profits, many have lost it all. NFTs were the hottest digital investment of the summer and fall but have since seen an overall drop in price.
While seeing headlines about teenagers making millions can give anyone FOMO, a desire to get-rich-quick isn’t an advisable investment rationale. Always be guided by your true purpose.
(3) Have I done enough research?
A classic piece of investment advice is to only invest in things you understand. Because the space is still growing, many assets lack extensive history and information regarding their performance and reliability as an investment. However, research should be done with what information IS available.
Beginning due diligence includes researching the history of the coin. This would include research on the team behind its development, the asset’s purpose and utility, the support it has received from investors, the price history, direct competitors, and overall market cap.
While you can do your own research on certain cryptocurrencies, it’s worth noting that they lack institutional backing and traditional traits. There aren’t balance sheets or technical analysis from investment firms for you to evaluate. There isn’t extensive price history to base projections on. As such, these investments are considered quite risky, which leads to question Number 4…
(4) Do I understand the potential risks?
Cryptocurrencies are unique assets that come with many different levels of risk.
Security risk – These are digital assets, and many are vulnerable to hacks. You’ll need to be aware of all the ways to safeguard your investment, and these may be different than anything else in your portfolio.
Regulation risk - There's no regulatory body that oversees crypto activity, and while some view this as a good thing, it really means that investors are unprotected. The SEC recognizes this and is actively working to create regulations around cryptocurrencies. Since many crypto investors are drawn to the asset class because of the lack of regulation, government efforts to regulate digital assets could have a negative impact on their return.
User risk – The fact is that crypto is not user-friendly right now. One erroneous keystroke, and you’re sending money into the void, never to be found or returned. Taking the time to learn the basics and understand how different pieces of the crypto puzzle work is highly recommended before making investments.
(5) What’s my investment thesis and exit plan?
What would you do if your crypto investments tripled in value in the first month? What if it lost 95% of its value in the first week? Your investment thesis and plan would provide answers.
Here’s a hypothetical example showing how you should think about a crypto investment thesis:
An investor decides they want to put money in crypto but, because there are so many different investment options, they opt for the two coins with the largest market cap - Bitcoin and Ethereum. They believe crypto adoption is only in its infancy, so they want to hold for five years before evaluating whether it makes sense to sell. If they come out on top, any profits will be used for a sabbatical.
Within a year, the crypto market crashed, and their investment was worth half as much as when they started. Rather than selling, they revisited their thesis and stuck to it. The following year, crypto entered a bull market that ran well past the five-year window. However, the investor reviewed their thesis at the five-year mark, and saw that the portfolio had gained enough to pay for a two-year sabbatical even after the taxes on the gains were paid. They sold out and moved on.
Now, they could have seen the ongoing bull market and stayed invested, but that would’ve gone against their initial thesis, and the market could’ve dropped the next day, wiping out all returns.
With how fast the digital assets space moves and new investments appear, not having a thesis can lead you to invest outside of your comfort zone. However, if you’re presented with new information that drastically impacts your investment thesis, it’s okay to revisit and recalibrate.
When making individual investment picks, it’s important to have conviction, stick with your thesis - whatever it may be, and only change course when necessary.
There’s a lot to think about when it comes to investing in cryptocurrencies. However, traditional principles still apply. Always understand what you’re investing in, take your own situation into account, and ask yourself a few of these questions before making an investing decision.
Dr. Brad Klontz, Psy.D., CFP®