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November 18, 2024
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Technology • November 18, 2024
The Potential Risks of Cryptocurrencies: What Investors Need to Know
Hoxton Blog • The Potential Risks of Cryptocurrencies: What Investors Need to Know
From its beginnings as fringe technology discussed on internet forums, cryptocurrencies have pushed into the mainstream in recent years. Crypto proponents share promises of high returns, a new way to diversify investment portfolios, and even the potential for a new monetary system.
Lofty goals.
But before you dive head first into this digital gold rush, it's essential to understand the risks involved. After all, there’s a reason why so many traditional investors are still hesitant to add bitcoins or other digital assets to their portfolios.
In this article, we’ll break down the key risks of investing in cryptocurrency. Don’t worry though, we’re keeping things balanced, with another article focused solely on the opportunities that cryptocurrencies can offer.
What is Cryptocurrency?
Before we get into the risks, let’s take a closer look at what cryptocurrency actually is. Simply put, cryptocurrency is a type of digital or virtual currency that uses cryptography for security.
Unlike traditional currencies, cryptocurrencies are decentralized and typically operate on a technology called blockchain, which records transactions across many computers to ensure transparency and security.
What does that mean? Traditional currency, like the US dollar, is centralized and controlled by a government or organization, such as the United States Treasury. In contrast, most cryptocurrency, like Bitcoin and Ethereum, have no single point of control, with a vast network of unrelated servers used to print new coins (called ‘mining’) and approve transactions.
Bitcoin, the first and most famous cryptocurrency, was launched in 2009, and since then, thousands of other digital currencies have been created.
Crypto as an Investment
While the original vision for Bitcoin was a new world currency outside the control of the government, it’s the investment potential which has thrust crypto into the mainstream. There’s no denying that the allure of cryptocurrencies has captured the imagination of both new and seasoned investors.
The excitement often stems from stories of incredible gains, where early adopters turned small investments into substantial fortunes. Many new investors are drawn in by this potential for high returns, particularly when traditional investment opportunities seem to offer more modest gains.
But as the saying goes, there’s no such thing as a free lunch, and the flip side of these periods of massive growth are substantial risks that have caused many investors to lose huge sums of money.
Bitcoin is often referred to as ‘digital gold’ and it does share some investment characteristics with the precious metal. It doesn’t produce an income, there is a finite amount available, and investment returns are created through rising and falling prices.
Key Risks of Investing in Cryptocurrency
So, what are the potential pitfalls of getting involved in the crypto market? Here are the main risks every investor should be aware of:
Volatility
One of the most significant risks of investing in cryptocurrency is its extreme volatility. Unlike traditional assets like stocks or bonds, the price of digital currencies can fluctuate wildly in a very short period. We’ve all heard stories of millionaires being made with bitcoin practically overnight, but since its creation in 2009 it has dropped by more than 50% seven times.
That includes a crash in 2011 which saw the value fall by 99%, an 83% fall in 2013, and an 84% drop in 2018.
For some investors, this volatility is part of the appeal — they see it as an opportunity to make quick gains. However, for most, it’s a source of uncertainty and stress. It’s important to remember that what goes up can come down just as quickly. If you’re not prepared for these dramatic shifts, investing in cryptocurrency could lead to significant losses.
Security and scams
Cryptocurrencies rely on digital wallets for storage, and while this technology can be secure, it also makes crypto assets vulnerable to hacks, scams or accidental loss. Unlike money in a bank, which is protected by regulatory safeguards, there’s no safety net for digital wallets. If your wallet is hacked or you fall victim to a phishing scheme, your funds could be stolen without any recourse.
Crypto that isn’t held on an exchange, such as in a mobile wallet app or a hard drive (known as a ‘cold’ wallet) can also be lost forever if you forget your password or lose the physical drive.
The anonymity of cryptocurrencies makes them attractive for scammers who prey on unsuspecting investors. From fraudulent Initial Coin Offerings (ICOs) to fake exchange platforms, there are plenty of ways that scammers attempt to take advantage of new investors.
Always do thorough research and be cautious of deals that sound too good to be true.
Lack of regulation
Another major risk associated with cryptocurrency is the lack of regulation. Traditional financial markets are heavily regulated to protect investors, but the crypto market operates largely outside of these established frameworks. This means there’s less oversight, which can lead to market manipulation, fraud, and other shady practices.
In essence, crypto is the Wild West of financial markets.
The absence of regulation also means that your investments in cryptocurrencies are not protected in the same way as traditional assets. This lack of safety net is a significant reason why many traditional investors are wary of the crypto space. While some governments are starting to introduce regulations, the landscape remains largely uncharted, and changes could come quickly and unpredictably.
Future uncertainty
The future of cryptocurrency remains uncertain. While some see it as the future of finance, others believe it’s a speculative bubble that will burst and disappear. Factors like government crackdowns, changes in regulations, and technological challenges could all impact the future of the crypto market.
For example, recent crackdowns in China have completely banned crypto mining and trading, which has severely impacted the cryptocurrency industry. Other countries could follow suit.
New regulations, if introduced, might make it harder to trade or even hold certain cryptocurrencies. These uncertainties make investing in digital currencies a risky strategy, especially for those seeking stability in their investments.
Tax complexities
Taxation is another critical area that often gets overlooked when people invest in cryptocurrency. Depending on where you live, profits from crypto trading may be subject to capital gains tax, and failure to report these gains can lead to legal trouble. However, the tax rules around cryptocurrencies can be complicated and differ significantly from country to country.
Even calculating these gains can be challenging, especially when cryptocurrencies are traded for others multiple times throughout a tax year.
It's essential to keep accurate records of your transactions and be aware of how your investments will be taxed. Consulting with a financial advisor, like those at Hoxton Wealth, can help you navigate these complexities and avoid any unwelcome surprises come tax season.
Crypto: Proceed with Caution
As you can see, investing in cryptocurrency is not without its risks. While there’s plenty of excitement around digital currencies, there are also significant challenges that can’t be ignored. The volatility, security concerns, lack of regulation, uncertainties, and tax implications all make the crypto market a tricky one to navigate.
However, this doesn’t mean that all opportunities are off the table. If you’re still interested in exploring crypto as part of your investment strategy, take a look at our companion article where we’ll get into the potential benefits and opportunities in the crypto world.
For now, it’s important to approach the risks with your eyes wide open. For traditional investors, dipping a toe into the crypto waters might seem tempting, especially with all the buzz around bitcoins and other digital assets.
However, it’s crucial to be aware of the risks before making any decisions. The crypto market can be unpredictable, and without the safety nets found in traditional finance, there’s a lot at stake.
At Hoxton Wealth, we understand that the world of digital currencies is still evolving. If you’re considering adding cryptocurrency to your investment portfolio, our financial planning and investment services can help you weigh the risks and make informed decisions.
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If you would like to speak to one of our advisers, please get in touch today.
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