Bitcoin 101 – How it Works, What it is, and How to Invest
First, let me say this. I’m not “certified” in any way, shape, or form to give specific investment advice. Investing is risky and you could literally lose everything. So only invest money you can afford to lose. This is strictly my opinion and is not intended as investment advice. If you want real investment advice, seek a professional.
First, what the heck are cryptocurrencies.
A cryptocurrency is a digital asset designed to work as a medium of exchange. It’s simply a money that’s fully digital. It is not backed by the gold standard or any such thing.
Most popular cryptocurrencies are also decentralized. This means (unlike most major currencies) that one party does not control the supply of currency.
For example, if the Federal Reserve decided to add $900 trillion to the US economy tomorrow, your savings would basically become worthless.
And there’s nothing stopping the Fed from doing that.
How Bitcoins are Made:
With Bitcoin (the example I’ll talk about most), there are limits on how many bitcoins can be produced.
This limit is primarily due to the expense of producing more coins.
Coins are “mined” (aka created) using software. This software runs complex algorithms. These complex algorithms take a ton of time to run, so that limits the supply.
Once a coin is “mined” it can be traded to anyone with a BitCoin Wallet.
With BitCoin all of these transactions are public. Every single one.
The miners are the ones who lock transactions in place between users.
Think of it like a fly trapped in amber.
Overtime, more and more layers are added. If the fly has a lot of amber around it, you can be fairly sure it’s been there a long time.
Each transaction is like the fly. The algorithms are the amber.
Miners are the ones who lay down this amber to ensure the network transactions are properly recorded.
They are awarded coins for their efforts.
Anyone can mine coins. Miners are the ones who power the whole network.
As more coins are discovered, new coins become harder to discover. This means that over time it will become all but impossible to create new coins.
The “supply” of BitCoin will eventually hit a hard limit (21 million). Most other cryptocurrencies are mined in a similar fashion. Some, such as Etherium are limited to a certain amount each year.
What does this mean to investors?
It means that bitcoins are treated from an investment standpoint like a digital version of gold. Just as the supply of gold in the world is extremely limited, so are most cryptocurrencies.
Thus, cryptocurrencies (in an ideal world) are a good hedge against inflation.
All cryptocurrencies are extremely volatile at this point. They often come up and down large percentages every day.
They are also still incredibly new. The goal originally was to have them used as an interactive currency. Meaning you’d use them the same way you’d use your credit card to make purchases. Except Visa and MaserCard wouldn’t get a cut.
But they have yet to catch on in such such daily transactions. Instead, they are often treated as a unique asset class as part of a larger portfolio.
Here are the reasons one might go long on (buy and hold) cryptocurrencies:
- If you think that eventually all currencies will be decentralized via crypto, then it makes tons of sense. Many people believe that eventually all currency will be crypto based rather than government backed. I don’t think we’ll see that in our lifetime unless we see the collapse of one or several of the major currencies.
- If you think that people will in time distrust government and large banks more, then crypto makes sense. It’s decentralized – meaning no one body controls it. It’s truly democratic.
- If you think bitcoin and other currencies will continue to gain in popularity, then it makes sense to invest in them. Limited supply and increased demand will drive up prices.
Risks: There are several steep risks with cryptocurrencies. Here are some of the most prominent ones:
- Fall Out of Favor – If demand for crypto drops suddenly (due to it becoming illegal, replaced by some other asset, or just generally falling out of favor), then you’ll see a huge drop in values. If you believe it’s a “bubble”, then this is the biggest risk.
- Breaking Cryptography – It’s very unlikely (although possible) that someone will be able to crack the cryptography behind Bitcoin and other currencies. Now these assets use strong cryptography, but this is always a possibility. For me, it seems remote, but it’s worth mentioning. (Also, if the currencies are cryptographically broken, then most online security and banking is likely to also be broken. That’s why I see this as a very low risk.)
- Hostile Takeover Using Hash Power – The value of currencies like BitCoin is their decentralized nature. But with enough computing power, theoretically a government (or other entity) could put enough processing horsepower on the network to control more than 51% of mining. This would be extremely expensive and prone to issues. However, if it did happen they could mess with current transactions and cause havoc on the networks.
- Security and Storage – Another major risk is security and storage. This isn’t a risk to the currency itself, but instead it’s an individual risk to your coins. Most people don’t have the technical knowledge to store and manage their own cryptocurrencies. If your computer was hacked, someone could steal all your coins easily. On the flip side, there are some companies you can pay to be “custodians” of your currency. But then you’re putting your currency in their hands. There are some famous examples of companies ripping off users and stealing their coins. Or being hacked and having their coins stolen (Mt. Gox). Simply put, there’s risks either way. And these deposits aren’t usually insured, so you’re on your own. Trust yourself or trust another company. Either way is risky.
If you start investing:
This is not investment advice. In fact, most investment advisors will probably tell you to leave cryptocurrencies alone. It’s a high risk, highly volatile investment. I highly recommend talking with an investment professional (just not one paid by big banks). But should you want to move forward, here are some things to think about.
Step 1: Find an exchange you trust.
Some of the most common are:
I cannot recommend one over the other. But they all *seem* legitimate. So take your chances.
Step 2: Secure Your Account
Enable two factor authorization (using the Google Authenticator or similar app, not just a phone number). Connect your email address. Then enable two factor on your email as well. Don’t open random messages. Do all the things to make your computer secure.
Step 3: Buy
Using a credit or debit card, bank account, or other method of payment, convert your local currency (likely USD) into whichever cryptocurrency you want.
Step 4: Trade or Wait
You can buy and hold. You can trade. You can do whatever you want.
The trend has largely been up. Others say it’s a bubble. It’s up to you how you proceed.
Step 5: Cash Out
When you’re ready, you can cash out. Hopefully you’ve made money. But I’m told you’re legally required to pay taxes on that money.
Talk to your accountant or financial advisor to determine the best way to do that.
Crypto is a huge opportunity. But it comes with a lot of risks. I’d only allocate money into crypto that I could afford to lose. In fact, I’d plan on losing it.
You also have to be OK with volatility. Often the value moves 20% in a few hours. THAT’S A LOT OF VOLATILITY! You have to be OK with that.
If you’re OK with it, proceed!
Deeper Down the Rabbit Hole:
- Original Bitcoin Whitepaper https://bitcoin.org/bitcoin.pdf
- Nick Szabo, Naval Ravikant, Tim Ferris Podcast on Crypto – https://tim.blog/2017/06/04/nick-szabo/
- Bitcoin vs. Etherium – https://learn.onemonth.com/bitcoin-vs-ethereum/
- Getting Started with Bitcoin – https://bitcoin.org/en/getting-started