Cryptocurrency remains an emerging phenomenon, and while the time has not yet come to endorse or condemn it, no doubt you are getting questions about it. With clients increasingly looking for advice, most financial advisors are wise to tell their clients it is highly speculative and best to approach it with caution.
Prior to investing in a cryptocurrency, advisors are having clients consider expanding their investments in top performing mutual funds and ETFs. Clients with a high risk tolerance are more likely to buy a cryptocurrency mutual fund or crypto ETFs.They should, however, have a clear understanding of what a cryptocurrency is and how the crypto market works.
What is Cryptocurrency?
We believe cryptocurrency is similar to many traded commodities like soybeans, corn, coffee and sugar. They all have fluctuating values that are impacted by usage, demand and availability. Cryptocurrency vendors control their own supply, but cannot prevent new vendors from entering the market. There is actually no limit to how much cryptocurrency may be mined. Anybody can enter this industry. According to CoinMarketCap, a crypto tracker, in 2019 there were over 2,100 cryptocurrencies created and today there are at least 5,520 cryptocurrencies available. This is what makes calculating cryptocurrency prices based on usage quite challenging.
There are a number of factors that contribute to cryptocurrency’s fluctuation. Crypto has no backing in the form of a nation, major bank or precious resource, and there is no guarantee of its base value. Bitcoin, Dogecoin, Unobtanium — all these cryptocurrencies — are only worth what the market says they’re worth. In 2020 and 2021, expectations that national fiat currencies would undergo devaluation in the wake of the COVID-19 pandemic (among other factors) led to a surge in the value of crypto, as its projected worth increased. But, the latest Chinese vigilance against cryptocurrency had the exact opposite effect as expectations clashed with the reality of government intervention.
And such intervention is not likely to stop anytime soon. Governments simply have a lot to lose and not much to gain by allowing the cryptocurrency revolution to supplant their own fiat money. So crypto must rise despite the intervention of some of the world’s most powerful fiscal and temporal institutions. Demand for digital currencies may well erode further if the U.S. Federal Reserve begins raising interest rates in the near future, and countries like China and Russia seek to create their own digital currencies with national backing.
Cryptocurrency is a new commodity, and that very novelty contributes to its volatility. Cryptocurrencies don’t have a long track record so experts cannot collate massive amounts of data about its inherent trends, risks and rewards. Investors, therefore, lack the knowledge to make truly informed choices.
Volatility and Speculation
Cryptocurrencies do not accrue interest over time and are now subject to capital gains taxes. This suggests that digital currencies should be considered a speculative trading tool more than anything else. It could potentially offer rich payouts if an investor can manage to buy low and sell high, but carries with it the risk of any volatile asset without the guaranteed upside of interest.
Most retail investors understand that investing always carries some degree of risk. For investors that relish the Wild West atmosphere around Bitcoin and other digital currencies, advisors have the task of telling their clients that cryptocurrency’s volatility makes it a very speculative asset class and it should, therefore, be treated as an alternative investment. As a rule-of-thumb, institutional investors invest less than 1% of their overall assets in alternative investments. Individual investors buying cryptocurrencies need to consider their risk tolerance.
The Last Word is Pending
Some things appear to have a value just because they are popular, but as their popularity falters, so does their value. Some people have become overnight millionaires buying cryptocurrencies, and this has driven the demand for investors to get in on the action.
Yet, the big question remains: “Can cryptocurrency continue to grow in value and is it a good or bad investment?” It remains to be seen if those overnight millionaires will be able to hold on to their wealth. At this time, many factors point to crypto being a highly speculative investment where many investors could find themselves at the short end of the stick.
Christopher Crawford is head of Sales and Marketing at Buffalo Funds. With over 10 years of experience working with financial advisors and family offices, Christopher notes that success for advisors begins with being a good communicator and a better listener. Buffalo Funds is an asset manager with 10 actively-managed, no-load mutual funds.