What You Need to Know About How Cryptocurrencies Work

In today’s post, I’ll attempt to unpack the complicated topic of cryptocurrency. You can look at this as your guide to understanding cryptocurrency.

Are cryptocurrencies a fad? Can they a viable investment? Are they safe? Is the risk as bad as everyone says it is? If I want to invest, how do I go about it? Should cryptocurrencies be part of a well-diversified portfolio? Or should you stick with the traditional stock and bond investments or go with a robo advisor?

We’ll answer some of those questions and offer insight into the mysterious world of cryptocurrency.

How Cryptocurrency Works: The Essential Guide

December 17th, 2017, was a historic day. Bitcoin, the primary cryptocurrency, marked its all-time high slightly above 20,000 US-Dollars. At this time, Bitcoin had a market capitalization of ~336 Billion US-Dollars.

One year later, Bitcoin lost more than 75% from its highs and is being traded for ~5,000 USD.

Chart showing Bitcoin price movements

However, in the sector of speculative investments, cryptocurrencies are still among the most exciting growth markets today. So I decided to put down this guide with the most critical essential information about cryptocurrencies.

What Is Cryptocurrency and What Can It Be Used For?

Before we can understand how cryptocurrency works, we have to understand what it is and how we can use it.

A cryptocurrency is a digital or virtual form of currency that relies on encryption techniques. These currencies operate on decentralized platforms. Understand it as a digital cash system that works without a central entity.

Do you remember the old days where you have been using a P2P-network for file-sharing? You shared a file, and all the bytes were stored on different servers in different locations. Cryptocurrencies take it a bit further.

Cryptocurrencies can be bought mainly by using exchanges in conjunction with your wallet. Alternatively, you can trade different cryptocurrencies with a classical online broker, as well. So, first of all, you have to decide whether you want to buy or trade cryptocurrencies.

Using a wallet and buying a cryptocurrency with a popular exchange like Coinbase, Coinsquare, or Kraken will make you a real owner of physical but digital currency.

However, trading by using an online broker is comparable with buying and selling stocks, but you will never be a real owner of the bits and bytes of a cryptocurrency.

How to buy and trade Cryptocurrencies

The first step is to get a wallet for your coins (preferably a hardware wallet), then sign up on a reputable and affordable exchange. After signing up, you will be able to buy the cryptocurrency of your choice, then store it with other currencies in the wallet.

However, those wallets and exchanges have one particular additional risk – the risk of being hacked.

Your funds are not secured at all when you are using wallets.

Why?

Because once your coins got stolen, you cannot prove that you owned the coins, and it will be impossible to convict the perpetrator.

By using an online broker, it is different. You trade investment vehicles based on the bitcoin price. Robinhood recently announced that they are offering to trade crypto markets with their product “Robinhood Crypto” along with traditional stocks and ETFs.

As you can see, investing in cryptocurrency is easier than ever before.

The best strategy is to invest in the long-term. However, we talk about a speculative part of your overall investment strategy.

Enough people invested their full liquid assets into Bitcoin right at the top and lost >75% meanwhile.

You do not want to be one of these people. Keep it realistic. Bitcoin can easily triple within a few months, but it could also fall another 2/3rd within a few months. This is high risk, no matter what people tell you in typical advertisements, eBooks, video courses, and so on. The real potential comes in the long run.

I see it this way:

When I invest in cryptocurrencies right now, then I invest a fixed amount that I can afford to lose. This is the maximum risk. On the other hand, there is infinite potential.

Let’s do the math

Before investing, always prepare. Let us assume that you have $50,000 liquid assets right now.

You could go with plan A:

Invest all your money into stocks, ETFs, etc. Let us assume that you make +5% on average every year.

Year 1    50,000    52,500

Year 2    52,500    55,125

Year 3    55,125    57,881

Year 4    57,881    60,775

Year 5    60,775    63,814

Profit:                  13,814

That’s the traditional way of investing in the long run. Let us assume that you are looking for an alternative to reach at least the same potential amount of profits within five years without investing that much money.

If cryptocurrencies go through the roof again, then the same profit could be made by investing $1,000 or even less. But still, it is a real risk that you lose those $1,000 within the next five years.

Regulations, new currencies, new technologies, and other factors could have such a hard impact, that you could lose all your money invested in cryptocurrencies.

Next, let us have a look at the most popular cryptocurrencies.

Popular Cryptocurrencies

There are many cryptocurrencies available for investment. More come to the market all the time. Facebook recently got into the business with its own cryptocurrency. Others will follow.
Below are some of the more popular fiat currencies (cryptocurrencies)

Bitcoin: Bitcoin was the first cryptocurrency to be established and currently boasts the largest market share. As at the time of writing this article, Bitcoin’s market share stands at > 50%, with a market cap of $53 billion. The coin is highly liquid, and the most expensive today.

Ripple: Ripple is the second-largest cryptocurrency after Bitcoin. Ripple is both a currency exchange platform and a coin.

It is an ERC-20-based token, meaning, it is natively established on the Ethereum network. The coin has managed to forge beneficial partnerships with financial institutions, earning it a top stop among the big three.

Unlike most other coins, Ripple cannot be mined; the only coins that exist are the 100 billion coins (XRP) created by the company.

Besides, Ripple offers higher transaction speeds of up to 4 times faster compared to Bitcoin’s and is also highly liquid. The market cap is $12.3 billion right now.

Ethereum: The coin was established to cater to the weaknesses exuded by Bitcoin, including lower transaction speeds and insecurity. Ethereum works with smart contracts, which enhance the transparency and security of transactions on its blockchain.

Today, the coin has a market cap of $9.4 billion, coming a distant second after Bitcoin.

Image of chart of top 3 of 100 crypto currencies

 

Is It Safe to Invest in Cryptocurrency?

Most platforms have put in place some of the best security measures, including user data privacy, information encryption, two-factor authentication, passwords, and so on.

This means that hacking of these platforms is becoming harder by the day, but a lot more may still need to be done. A few platforms have already gone the extra mile of securing insurance policies for their assets. Having the insurance in place ensure that their users get compensated in case of a security breach.

The same goes for the different cryptocurrency wallets, but here, users have a role to play. As a wallet user, you have to keep your account details such as secret words or passwords private to reducing the risk of being hacked or mugged.

On the other hand, your bank has the highest security standards. Cryptocurrency trading in central banks and the traditional bank account was not the original intent of blockchain technology. However, in my opinion, the safety of the funds is the most important thing when investing in cryptocurrencies.

So, either you want to live the spirit of cryptocurrencies dealing with some additional risks, or you decide to invest as securely as you can by protecting your investment for the best future potential.

Imagine, your investment would tenfold within five years, and in 5 years, you would realize that your wallet got hacked? Ouch!

Final thoughts

The one truth is, investing in cryptocurrencies is an excellent way of diversifying your portfolio. The potential is massive regarding returns. However, another fact is that the technology still needs to deal with the ever-rising cases of fraud and hacking.

Yes, this is an issue that cryptocurrency users need to be wary of, and the reason as to why a good number of users do/should opt to store their funds offline as soon as they purchase/trade them.

Because once you lose your funds, they’re gone forever. The exchange or wallet doesn’t have it anymore, and this means that it may not be possible for you to recover your money.

The risk is always high where there are potentially high returns, and this is especially true of cryptocurrencies. The profits usually are massive, but the chances are equally high.

Now it’s your turn. Tell us what you think. Was the article helpful in getting to know how cryptocurrency works? Have you invested in them? Are you considering them? We welcome your thoughts and feedback.

10 thoughts on “What You Need to Know About How Cryptocurrencies Work

  1. Hey Riley,
    Even though I don’t recommend crypto, I know a lot of people have an interest in at least gaining an understanding of what they are and how they work. Alexander does a good job doing that. Thanks for reading and your comment. I always appreciate them.

  2. I completely agree. A lot of people are curious and confused by cryptocurrency. The post was not meant to recommend but to educate.

  3. Thank you for your comments. Yes, there are many risks in cryptocurrencies. But as with every emerging trend, there is always a “first one”. Whether electromobility, rocket science or digital currencies. Trends emerge because people believe in them. Wheter Bitcoin will remain the market leader in the long run is just as questionable as Tesla’s current position in the market. We don’t know, but electric mobility and blockchain technology willstill exist for a long time to come. Independendly from the company’s name or product.
    For me, as with all new hyped products, it is essential to exercise the neccessary degree of caution.

  4. When all the media was buzzing about how bitcoin was going through the roof and making millionaires overnight, I admit I had the FOMO feeling and part of me wanted to at least get in on some of the action. Luckily I did not as crypto fell from its highs quite dramatically (proving the old adage correct that by the time you hear about it on social media the ship has already sailed).

  5. I got into cryptos at the exact wrong time. I’m just holding what I have. I’m personally staying out of the crypto market until I get my base financial situation ironed out with more “secure” investments. I think crypto has a future but is very risky. Until there are more regulations, I think you should only invest money into cryptocurrencies you are willing to lose.

  6. This a very informative article, but no matter how much I read I can’t wrap my mind around cryptocurrency. There’s risk in all investments but this one seems especially scary to me! Hopefully my fear doesn’t cause me to miss out on the next big thing!

    1. I agree with you on crypto. However, I thought this was a great post to explain what they are and how they work. It may not be for me, but I want to offer education for anyone interested in learning. Thanks for reading and commenting.

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