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What You Need to Know About Cryptocurrencies Like Bitcoin

Jan 28, 2022 admin

Cryptocurrencies such as Bitcoin are all the rage. Most white coat investors have questions about cryptocurrencies but do not know where to turn for reliable answers. What is cryptocurrency? Should you invest in cryptocurrency? What is the best cryptocurrency?

In this post, I will address all of these questions and more. Buckle your seatbelt, though. It will be a long post. If you just want to skip around, take advantage of the Table of Contents.

What Is Money?

Before we get to cryptocurrency, we need to talk about money as a concept. Money serves two purposes. The first is a medium of exchange. Societies without money are limited to the barter system. If you want to trade something you have for something that someone else has, you had better hope that 1) they want what you have and 2) they are willing to give up what you want for it.

Needless to say, this is an incredibly inefficient system, and it will dramatically hold back an economy. The invention of money as a concept is, in large part, responsible for the fact that you don't live in a cave and spend all your time trying to find something to eat. Historically, metal was used as money as early as 5000 B.C.E. By 700 B.C.E. the Lydians were using metal coins in Western Turkey. Paper money showed up in China in 960 A.D. For many centuries, money was “representative,” in that it could be exchanged for something that actually had value, such as silver or gold. These days, most money is considered to be “fiat,” in that it is made of paper or coins that don't have much value by themselves but are declared by a government to have value.

The second purpose of money is to store value. Your daily work has value. Your employer or your clients give you money in exchange for it. Rather than being paid with chickens, which have to be fed and might die anyway, you can be paid with something now, you can store it for many years, and you can then spend the earnings from your daily work.

In reality, money is whatever people say it is. Whether a bag of salt, a piece of metal, gold coins, paper bills, zeros and ones on an electronic bank ledger, or anything else, it can only be used as a medium of exchange or a store of value so long as people agree to use it.

What Is Cryptocurrency?

In its simplest form, cryptocurrency is software used as money. Crypto refers to the encryption algorithms and techniques that provide security for the currency. Rather than fancy printing techniques (you'll know what I'm talking about if you've visited the US Bureau of Engraving and Printing in Washington DC or Fort Worth), cryptocurrency uses fancy software techniques to safeguard the currencies.

The dictionary defines cryptocurrency as a digital form of money in which transactions are verified and records are maintained by a decentralized system (the blockchain) using cryptography, rather than by a centralized authority. So, a cryptocurrency is digital. It cannot be held in your hand, and it requires a decentralized method to record and monitor any transactions done. Digital currency is nothing new—the vast majority of your wealth and mine are simply “1”s and “0”s sitting in a bank or investment account. The real innovation behind cryptocurrency is the decentralization of the record-keeping. There are now thousands of identical records of the transaction. Blockchains have some confidentiality features that help, but it's not quite as “hidden” as the name would imply.

The bottom line is that cryptocurrency is software. It's code. But it's code that people value, so it can be used as money.

What Problems with Money Are Cryptocurrencies Supposed to Address?

The vast majority of money in use in the world today is fiat money, backed by the government that issued it and useful only because the majority of people believe it has value. Fiat money is subject to government mismanagement. Perhaps the biggest temptation for a government is to print more money. This results in inflation, a decrease in the purchasing power of the money you have. Sometimes inflation is well-controlled—for example, the US Federal Reserve aims for inflation of 2% a year.

Sometimes inflation is too high, like inflation of more than 5% in the US in the fall of 2021 or in the double digits in the 1970s. Occasionally, a country suffers through hyperinflation where people are using wheelbarrows of paper currency to buy their groceries. Inflation is one of Bill Bernstein's Deep Risks, along with Deflation, Confiscation, and Devastation. These are the true long-term risks that investors face because they result in a permanent loss of capital. They should be distinguished from the “shallow risk,” or volatility, that most investors think about when considering the risk in their portfolios.

Fiat money is also centralized, meaning a few people have a large amount of control over it. If those people cannot be trusted, the currency cannot be trusted. While those people are incentivized to maintain trust in the currency, they also face lots of other incentives.

Fiat money and even precious metals are also relatively hard to store, hide, and transport. They can be stolen and destroyed, and there are costs to protecting it. As money moves through the banking system and the world reports are made to governments in an effort to prevent criminal activity, this also reduces privacy and increases the risk of confiscation. Likewise, if you suddenly had to flee your homeland. It is easy to find coins and bills on your body, and bank transactions are easy to monitor.

Sometimes it is very cumbersome and expensive to send money from one place to another. For example, sending $50 into or out of Russia via Western Union costs $8.75. That's 17.5%! Imagine if you lost 17.5% of your money every time you transferred it from one place to another.

Some people are dishonest or have legitimate disagreements about what they agreed to do. Imagine if the money itself had the power to enforce the agreement that was made?

Fiat currency is also subject to counterfeiting. The complexity involved in making a $20 or $100 bill to prevent counterfeiting is impressive, but remember that there is apparently $70 million or more in counterfeit US currency in circulation at any given time. Cryptocurrency is far more difficult to counterfeit.

All of these problems have been addressed by one type of cryptocurrency or another. Cryptocurrencies have their issues for sure, but it is great to see the technological advancement of money continue.

How Many Cryptocurrencies Are There?

It depends on who you ask, but most sources suggest there have been more than 8,000-10,000 so far. There were more than 6,500 cryptocurrencies by the fall of 2021. As of May 2021, over 2,000 cryptocurrencies had failed. Why do some fail and others do not? They may not be very useful, they may have no community supporting them, or they may not be very secure. Or they simply were not the “first mover,” i.e. the first cryptocurrency with a given advantage. Popularity and marketing matter.

Blockchain and Cryptocurrency

One of the most important new technologies of the 21st century is the concept of a blockchain. The blockchain is the decentralized ledger that keeps track of cryptocurrency transactions. This typically occurs across a linked network of multiple computers, or nodes. The idea is that the record on the blockchain is very difficult to change, hack, or steal. There are lots of other uses for a blockchain besides keeping track of cryptocurrency transactions, and people are coming up with more all the time. Wrapping your head around what a blockchain actually is can be difficult.

Example of How Blockchain Works

Imagine that two people wish to do a transaction, such as purchasing a car. Instead of one of them going to a central authority (the bank) to get a cashier's check and then the other one going to a central authority (the bank) to cash the cashier's check, they instead go to an auditorium filled with accountants. Standing on the stage together, they announce “I, Joe, am giving Rudra this Bitcoin in exchange for his car.” The accountants all turn to the page for that particular Bitcoin in their ledgers, and they scribble down that Joe gave it to Rudra. The accountants in this example are the nodes. Each node keeps a separate record of the blockchain.

cryptocurrency bitcoin etherieum litecoin

What Are Crypto Coins and Crypto Tokens?

A cryptocurrency has its own blockchain. The individual units of that currency are called coins. A token is recorded on some other blockchain. It can have value, like a coin, or may simply represent a contract, deed, or another asset. Think of the cryptocurrency as the native asset on a blockchain and tokens as guest assets.

Proof of Work vs. Proof of Stake vs. Proof of History

First- and second-generation blockchains and cryptocurrencies use proof of work to help secure the blockchain. A more recent technology is proof of stake. Whereas proof of work requires each node (computer) in the blockchain network to solve a computational problem, proof of stake only requires the node to hold a certain amount of currency. The issue with proof of work is that nodes are awarded computational power based on energy consumption and computing power. This is massively energy-intensive and, honestly, unsustainable. With proof of stake, mining power comes from the “stake” of the node, meaning how much of the currency it holds. This is much less energy-intensive. Proof of stake is also considered more secure, as it solves the “tragedy of the commons” issue that proof of work networks will run into once all of the currency has been mined.

Want something even faster than proof of stake? Check out proof of history, which is a verifiable delay function. Think of it as a cryptographic time stamp.

How to Mine (Create) Cryptocurrency

Where does cryptocurrency come from? Well, in the case of many cryptocurrencies, it is “mined” by sophisticated computers solving difficult mathematical problems that require a great deal of computer resources, time, and energy. Computers are competing with each other to arrive at the solution first. When a computer gets the solution, it is awarded the next chunk of cryptocurrency, and the process begins anew. Remember “proof of work?” That's what mining is.

What is the problem to be solved? It is actually coming up with the next hash, that 64 digit hexadecimal number used to identify each block on the blockchain. It's not exactly advanced math. It's more just a process of trial and error with A LOT of possible answers to guess from. If you want to win, you need a high hash rate. What is a high hash rate? Well, it is continually improving, but expect it to be 1,000-10,000 “terahashes per second.” Tera means trillion.

Some cryptocurrencies are not mined. The code determines how they are created. In addition to or instead of mining, cryptocurrency may be created at launch as a developer reward or as interest to holders of a token. Most people who own cryptocurrency did not mine it. They simply bought it or received it as a gift.

What Is Halving?

Halving is a Bitcoin-specific term for events, where the reward for mining is cut in half. This has occurred approximately every four years on the following dates:

November 28, 2012
July 9, 2016
May 11, 2020

The next halving is projected to be in 2024. The idea behind halving is to decrease the reward given to a miner for a new block in the chain. Originally 25 Bitcoin, it is currently 6.25 Bitcoin. This produces an artificial rate of inflation until the last Bitcoin is mined, projected not to occur for more than 100 years despite the fact that about 90% of Bitcoin has already been mined.

What Is Gas Price?

Gas price, not to be mistaken with an actual token named “Gas,” is the concept of the cost of doing a cryptocurrency transaction. The more you pay, the quicker your transaction happens. Miners always record transactions in order of which ones will pay them the most. If you don’t add enough gas, your transaction may not go at all. To make matters worse, you have to wait until your transaction finally drops off the network before you can submit it again. It’s a terrible game.

At least when you send money to Russia via Western Union, you know what the fee will be ahead of time. Bitcoin transactions are more like hailing an Uber. When the prices are rising and more people want to buy or sell, the amount of gas required to get your transaction written to the blockchain goes up with surge pricing. Remember when brokerages charged transaction fees for buying and selling stocks? Imagine that world, except there was no way to know what the fee would be until you were moments from submitting your trade. One day, it may cost you $2 to make a trade, but the same trade during a busy week may cost $50. Occasionally, network participants are willing to pay more than the going rate for gas, resulting in a “gas war” where the price of gas rapidly rises. If gas prices get too high, it makes cryptocurrency less useful to the end user, but without enough incentive for the nodes to continue to do their thing, the blockchain would become less secure. Improvements to this process have been made, and hopefully, it will get cheaper and faster as time goes on. But there will always be a fee of some kind.

What Is Use Case?

Many blockchains and the tokens on them are not primarily designed for cryptocurrency, despite the fact that some people use them for speculation. The use case is the use or uses that a particular blockchain, token, or cryptocurrency is best for. For example, the use case for Bitcoin in the original white paper and for many years after included use in daily transactions. Most fans at this point have acknowledged that the use case for Bitcoin has significantly narrowed from there as it has proven to be impractical for that particular use.

How Does Cryptocurrency Gain Value?

This is the biggest beef that most traditional investors (including me) have with Bitcoin and other cryptocurrencies. As an investment, it is purely an instrument of speculation. It goes up in value because someone else is willing to pay you more for it because they believe that, down the line, someone else will pay them more for it. The entire premise of the “investment” relies on the “Greater Fool Theory,” i.e. there is someone who is an even greater fool than me who will pay more for this than I did. Cryptocurrency produces no earnings, no interest, and no rents. Like empty land, gold, silver, or Beanie Babies, it is worth only what it can be sold for, and there is no objective way to value it. It is a bit of a popularity contest, so a solid understanding of crowds, psychology, and popular sentiment—or at least a little luck—is essential to long-term success. Just learning more about the technology is not enough to ensure a profit.

Is Cryptocurrency Useful as a Medium of Exchange?

At the top of this article, we talked about how money is useful because it is a medium of exchange and a store of value. Cryptocurrency attempts to be money. However, there is currently no cryptocurrency on the planet that is even 1% as useful as the US dollar as a medium of exchange. Just because you can find a handful of websites or even brick-and-mortar businesses that will accept a cryptocurrency or two as payment does not mean that cryptocurrency is ready for prime time. When you can use a cryptocurrency for your daily transactions (gas, groceries, lunch, etc.) then you can consider it “real money.” Until then, it remains an instrument of speculation that might eventually become useful as money.

Is Cryptocurrency Useful as a Store of Value?

The second main use of money is as a store of value. That is, you trade your time or valuable assets for the money now, and then in a few months or years, you expect to be able to trade that money for a product or service of similar value. The problem with using cryptocurrency as a store of value is that it is entirely too volatile for that purpose. A 2021 paper by Baur, et al, concludes that Bitcoin, currently the most popular cryptocurrency, is 10 times more volatile than typical currency exchange rates. While that volatility decreased for a few years, it really has not for the last seven. For a cryptocurrency to be used as a store of value, the volatility must be much lower than what is seen with the most popular cryptocurrencies out there (with the exception of the “stable coins”).

What Is a Cryptocurrency Wallet?

A cryptocurrency wallet, like a regular wallet, stores money. However, it only exists electronically. It is a software application. You can move cryptocurrency (really the keys or codes to access the cryptocurrency) from the exchange where you buy, sell, and trade it into your wallet. This prevents you from losing the cryptocurrency should the exchange be hacked. When you are ready to trade it, you can move the cryptocurrency from your wallet back to the exchange. There are dozens of companies that provide (sell you) wallets including Exodus, Electrum, Mycelium, Ledger, and Trezor. They generally charge you either an upfront price ($0-$200), a flat fee per transaction, or a percentage of each transaction. Hot wallets are connected to the internet, and they can provide faster and easier transactions. Cold wallets are not connected to the internet and, thus, are less vulnerable to hacks.

Why Is Cryptocurrency So Volatile?

Volatility is a major problem with cryptocurrency. Traders and gamblers love that aspect, but serious users—even serious speculators—are not so fond. The reason it is so volatile is simply that no one is really sure what it is worth. Consider other marketable assets, such as the stock of a blue-chip company. Its value goes up and down each day a percentage point or two as investors consider the impact of macroeconomic changes and the individual fortunes of that company. A particularly bad day when an unexpectedly bad earnings report occurs may involve a 5% or even a 10% drop in value. But there is some reasonable way to value the company and its stock. You simply take its earnings and multiply it by a reasonable multiple for its industry and the current market, and that gives you a value.

That is not the case with cryptocurrency. There is no way to value it. It is guesswork. Talking heads on CNBC might put a “target” on the value, but they're just completely making that up. An investor might conclude, “I think it will go up still,” but there is precious little way to quantify that. By necessity, when there is no consensus as to the value of the asset, its price is going to be volatile. Likewise, it will not take much to move that price substantially. Consider the 14-character tweet made by billionaire Elon Musk in December 2020: “One word: Doge,” Its effect? A temporary 20% rise in cryptocurrency Dogecoin. Now that's volatility!

What Is a Stablecoin?

Stablecoins are designed to solve the volatility problem of cryptocurrency by tethering the price of the currency to something that is more stable, such as a more traditional fiat currency. The most common one is the US dollar. They may also be tied to the price of gold or another precious metal or commodity. Fiat currencies are more stable due to reserves (often of gold) that back them and due to the actions of those that control them, like the US Federal Reserve.

The reduced volatility of a dollar-backed stablecoin is nice, but to get it, you have to give up one of the primary benefits of cryptocurrency (decentralization) to start with! Think of it as a bridge asset between traditional fiat currencies and “traditional” (if such a thing can be said) cryptocurrencies. This bridge position does cause somewhat higher scrutiny among regulatory authorities, given the increased potential to affect the fiat currency markets and the overall economy.

What Is a Memecoin?

A memecoin, like a memestock, is simply a particularly popular cryptocurrency. It is usually associated with a theme and more of a joke than a serious project. However, sometimes memecoins, like memestocks, can grow out of their meme status into more legitimate investments.

What Are the Most Popular Cryptocurrencies?

What is the top cryptocurrency? The popularity of a cryptocurrency can be measured in many ways, such as how frequently it trades, how many people own it, or how many transactions it is used for. However, the most commonly used measurement is simply market capitalization. You can calculate the capitalization of a cryptocurrency by multiplying the price of a coin by the number of coins in circulation.

As of November 2021, the market capitalization of the biggest cryptocurrencies by market cap are as follows (hat tip to the Statistics and data YouTube channel):

Compare that to the top-15 from mid-September 2021, and you'll see a fair amount of change.

If you want to watch the changes in video form from the past several years, check this out. Notice that only three of the top-10 in 2017 were still in the top-10 in 2021.

What Can Cryptocurrency Be Used For?

Just because cryptocurrency is not useful for the primary functions of money does not mean it has no uses at all. Here are some of the most common uses of cryptocurrency:

Speculation
Gambling
Concealing illegal business activity
Squirreling money out of a country during a crisis
Impressing others and having fun
Getting a head start on a possible future currency
Hedging against bizarre global financial catastrophes
Assisting with some underdeveloped world banking activities

The vast majority of those who own cryptocurrencies are simply speculating. They believe the value will go up in the future and that they can sell it for far more than they paid for it. So far, that has mostly been true with the most popular cryptocurrencies, but only time will tell if that will continue.

Is Cryptocurrency Legal and Safe?

Yes, buying, selling, trading, and spending cryptocurrency is perfectly legal. There are government rules that you are supposed to comply with, and there are penalties for those who are caught breaking those rules. The very nature of cryptocurrency makes it a little easier to skirt government rules, but governments are rapidly finding ways to catch and punish the lawbreakers.

There are risks with cryptocurrency that do not exist in the fiat money system. The first is that, as a new technology unfamiliar to many people and with massive cash flows and asset volatility, the cryptocurrency space is a magnet for scammers, bad business people, and outright criminals.

Another risk is the flip side of one of the benefits—additional privacy that comes from decentralization. Yes, you can do a transaction without anyone else knowing about it, but that also means there is no authority to appeal to when something goes wrong. You can't get Paypal, a credit card company, the government, or a bank to reimburse you if you get scammed. If you forget the “password to your account” (commonly referred to as a key), you can't just call up the bank, tell them your mother's maiden name, and get it back. Your money isn't gone, but neither you nor anyone else will ever get to it. Reasonable estimates of “lost” Bitcoin run as high as 20%-25%. A big chunk of all the Bitcoin that will ever exist has already become inaccessible to its owners!

Cryptocurrency exchanges also seem to get hacked more frequently than more traditional financial institutions. The consequences of these hacks vary, but the potential for massive consequences exists.

In addition to these risks of permanent loss of capital, cryptocurrencies are massively volatile. Nobody knows exact numbers, but there are surely thousands or even millions of investors who have bought high and sold low, losing substantial amounts of money they used to have.

So no, while cryptocurrencies are legal, they are not perfectly safe. They have a different, unique, and possibly higher risk profile than most other financial assets. Caveat emptor!

Is Cryptocurrency Primarily Used by Criminals?

No, as mentioned above, the primary use for cryptocurrencies at this time is speculation. According to a 2019 paper, 46% of Bitcoin transactions were a result of criminal activity. However, other studies have suggested that number is as low as 0.34%. True crypto fans like to point out that far more fiat money (like 2%-5% of annual global GDP) is used for illegal activities than cryptocurrency. Critics point out that there is a lot of illegal activity that remains undetected, particularly the laundering of money through cryptocurrencies. Criminals certainly embraced cryptocurrency early on, as it had obvious useful applications for them, but their use has since probably been outweighed by non-criminals who are simply speculating with it.

While the blockchain has anonymous elements (your name is not technically assigned to your address on the blockchain), there is still the fact that EVERY transaction is monitored and recorded. This provides a record that can be tracked, and criminals don't like being trackable. Private firms and law enforcement can and have tracked criminals by tracing transactions through the blockchain to places that know the identity of their users, like cryptocurrency exchanges. So while cryptocurrency can help a small-time criminal stay hidden, it isn't going to work on a large scale or in any sort of crime that gets wide publicity. In August 2021, the largest known hack of Bitcoin ($600 million worth) occurred. The hacker returned all the money—and probably not just out of the goodness of their heart, given the traceable aspect of the blockchain.

Investing in Cryptocurrency

Let's decide for a moment, that you actually want to invest (speculate might be a better word) in cryptocurrency. How would you go about doing it? There are actually a surprising number of ways to invest in cryptocurrency, but some are far easier than others.

Should I Invest in Cryptocurrency?

Many doctors, including some white coat investors, buy cryptocurrency. Most of them readily admit they are simply speculating with a tiny percentage of their portfolio. However, if you are considering investing real, serious money into cryptocurrency, you need to spend some serious time thinking about if you actually should. Ask yourself why you want to invest in it. If you cannot make a clear, logical case for it improving your portfolio performance, then I would suggest you stick with play-money type amounts.

Am I Stupid for Not Investing in Cryptocurrency?

No. Chances are good you don't understand cryptocurrency and you should never invest in anything you don't understand. Once you do understand cryptocurrency, you probably won't want to invest in it anyway. It is super interesting to learn about, but that doesn't mean you need to put a quarter of your life's savings into it.

I do not invest in cryptocurrency and have no plans to do so going forward. I have been accused over the years of not understanding it. The argument goes, “If you only understood it, you would not only invest in it but beg your entire audience to do so as well.” Honestly, it's the same thing the whole life insurance salespeople say. I assure you that I understand it enough to make a decision of whether to invest in it. I have my reasons.

How Can I Avoid FOMO with Cryptocurrency?

Fear of Missing Out (FOMO) is the investor's enemy. The sooner you get over it, the more likely you are to be a successful investor. I wouldn't even want to hang out for long with someone who spends a lot of time bragging about their crypto speculation success. However, if the FOMO is really bothering you, buy a little. Just enough to cure your FOMO. Heck, you can do it with your Venmo app.

Is Cryptocurrency Good for Hedging Against Market Declines or Inflation?

Cryptocurrency does not seem to correlate with the value of any other asset class. In that respect, it can make for an excellent asset class in a portfolio. However, correlation is not everything. First, there is not much of a track record for any cryptocurrency. Nobody you know had any money in cryptocurrency during the last big bear market in 2008-2009. Second, correlations vary over time. More important than the correlation is the return of the asset. If the price of the cryptocurrency you buy goes up like a rocket, who really cares what the correlation is? Likewise, if it loses 96% of its value in the next year, do you really care that it had a correlation with your stocks of 0.02? Not really. You can get zero correlation with a pile of manure, but that doesn't mean it is a good asset class to include in your portfolio.

Some people think that cryptocurrency will protect you from inflation of the US dollar. Maybe it will, maybe it won't. Many cryptocurrencies can inflate just as much as the dollar. So if this is your goal, be sure you buy one with a limited number of coins. There are lots of ways to protect yourself from inflation (stocks, real estate, TIPS, I Bonds, debt, short-term bonds, commodities, precious metals) that don't require anywhere near as much speculation as cryptocurrency.

What Should I Know About a Particular Cryptocurrency Before Buying It?

“You didn't talk me out of it. I still want to invest serious money into cryptocurrency,” you say. Well, here's what I think you should know about a cryptocurrency before you speculate in it.

If available, read the entire white paper, a document that contains information from the company about the product.
Read the entire website, if available.
Is it deflationary or inflationary?
Where do new coins come from?
What blockchain(s) does it use?
What is its volatility?
What are its uses?
How fast is it?
How much energy does it use?
Is it popular?
Was it the first of its kind in some way?
Does it have a dedicated community behind it?
What is its current momentum?
Are coins ever destroyed? Why and how?
Is it open-source, run by a nonprofit, or run by a for-profit company?
What scandals, scams, scammers, and crises have there been associated with this cryptocurrency?
Is it a stablecoin?
Is it a memecoin?

Which Cryptocurrency Is Going to Win?

Cryptocurrencies come and go in popularity, and it leaves the investor wondering which cryptocurrency is going to win in the long term. Which one will achieve mainstream use and actually function as a reasonable medium of exchange and store of value? In the video above, there are two clear themes:

As new technology is developed, cryptocurrencies rapidly drop out of the top-10.
Bitcoin is still ahead for now, but it's only a matter of time.

The lesson there is that, in the long run, Bitcoin is not going to win. In fact, it seems highly likely to me that the winner is not even yet in that video. It has not yet been invented. However, my crystal ball is admittedly very cloudy, and I truly have no idea what cryptocurrency, if any, will be widely used in 2030 or 2050. I do know it won't be Bitcoin, though. Bitcoin and other cryptocurrencies of its generation simply cannot become widely used. They're not fast enough, and they use too much energy.

How to Create a New Cryptocurrency

There is almost zero barrier to entry when it comes to making a new cryptocurrency. That's why there are so many. The general pathway looks like this:

Choose a consensus mechanism
Pick a blockchain platform (unless you want to create your own blockchain, too)
Design the nodes
Establish the internal architecture
Integrate the Application Programming Interface (API)
Design the interface
Follow any applicable regulations
Create a white paper
Make a fancy-looking website
Advertise and list your Initial Coin Offering (ICO)

That's it. You want your own cryptocurrency? Go for it.

How Is Cryptocurrency Taxed?

This is an important thing to understand BEFORE you start dabbling in cryptocurrency. The IRS has decided to treat cryptocurrencies like any other investment. That means when you sell it, you will either have a capital gain or a capital loss. And you will have to report it. And pay taxes on it. It is not a currency; it's an investment as far as the IRS is concerned. It's now a very specific question at the top of your IRS Form 1040.

So, if you go out and start buying pizzas and gasoline with Ethereum, every transaction you make is going to end up on Schedule D at the end of the year. That's gonna suck. So treat it like an investment with infrequent trades, not daily uses. If you own it for less than a year, you're going to be paying short-term capital gains rates on those gains. It's better than a loss, but if it makes sense to hold for at least a year, your tax bill will be lower.

Although Congress is set to change this law, cryptocurrency had one huge tax advantage over stocks up until this point. When you tax-loss harvest cryptocurrency, there is no 30-day waiting period to prevent a wash sale from disallowing your use of that loss on your taxes. Take advantage. If you're a believer in the long-term merits of that cryptocurrency, sell it, get your loss, and buy it right back!

Cryptocurrency is becoming a larger part of our financial system. It is best to understand it, even if you choose not to invest in it. But don't feel like you must invest in it. Beware of scams and remember that the investor matters more than the investment. Fight FOMO and beware the animal spirits of the crypto marketplace.

What do you think? Do you “invest” in cryptocurrency? Which ones? How much of your portfolio do you put into it? Which cryptocurrencies do you think we'll all be using in a decade or two? Which is your favorite? Comment below!

The post What You Need to Know About Cryptocurrencies Like Bitcoin appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.

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