Trading and Investing

5 Things to Do Before Investing in Cryptocurrencies

Published
January 13, 2020
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Bitcoin prices are moving quick and it's tempting to jump into the market head-first, but so-called FOMO (fear of missing out) can be disastrous for your portfolio. You should understand how to analyze cryptocurrencies, how they fit within your portfolio, what tools you need to succeed, and how to protect your holdings from loss or theft.

Let's take a look at five things that you should do before investing in cryptocurrencies to avoid common pitfalls and maximize your odds of success.

#1. Get Knowledgeable About Crypto

Most investors don't know much about order flow or market makers. In the same way, you don't need to know the ins and outs of AES256 encryption algorithms to buy and sell cryptocurrencies. That said, it helps to know what cryptocurrency projects aim to achieve and quantify their risk compared to conventional investments.

For example, Bitcoin is a digital currency that aims to cut out the middleman in online transactions. Its value is a function of supply and demand at any given point in time. However, Ethereum is a platform for DApps — or decentralized applications. The value of ether is dependent on the demand for underlying Ethereum-based applications.

There are also many different strategies for quantifying risk. The beta coefficient measures volatility relative to a benchmark, such as the S&P 500 index, but it doesn't account for return potential. The Sharpe ratio is a measure of return that makes an adjustment for risk, making it easier to compare the risk-adjusted returns of different asset classes.

#2. Know How It Fits into Your Portfolio

Cryptocurrencies have a mixed reputation among traders and investors. They provide traders with ample volatility to generate quick profits and investors with an uncorrelated asset class for diversification. However, they don't have any intrinsic value (e.g. physical assets or revenue) and don't offer any yield (e.g. interest payments like bonds).

Traders and investors should carefully assess how they fit into their portfolio or trading strategy before committing any capital.

Here's how crypto may fit into various portfolios or strategies:

  • Speculators should only invest money that they can afford to lose — don't put your life savings on the line and don't take out a consumer loan for investment funds.
  • Investors should ensure that cryptocurrencies account for an appropriate portion of their portfolio based on their investment goals and risk tolerance. For example, they may only allocate 1% to 5% of their portfolio to crypto and invest the remainder in traditional assets, such as stocks, bonds, or real estate.
  • Traders should carefully assess the cryptocurrencies that they plan on trading to determine if the volatility, liquidity and other factors meet their trading needs. For example, traders should ensure that smaller ICOs have enough liquidity to support the frequency and volume that they want to trade.

It's equally important to consider the tax consequences of each choice. For instance, short-term traders and speculators will owe short-term capital gains tax on trades closed within a year, whereas long-term investors could benefit from the lower long-term capital gains tax rate. Options and futures may be other options to consider for exposure.

#3. Setup the Right Tools to Help You Trade

Most traders and investors buy and sell cryptocurrency through online exchanges that provide trading and research tools. For instance, Coinbase Pro offers active traders technical analysis tools to assist them in identifying and executing trades. Traders may also look toward third-party platforms like TradingView where traders can share trade ideas.

Before Cryptocurrency Investing

ZenLedger Screenshot - Source: ZenLedger

ZenLedger makes it easy to prepare for tax time by automatically aggregating transactions and calculating the overall cost basis. In addition to simplifying tax time, the platform quickly identifies opportunities to take advantage of tax loss harvesting where losing positions are sold to realize a loss and then re established to maintain the portfolio.

#4. Secure Your Cryptocurrency from Loss

Cryptocurrency thefts reached $1.7 million in 2018, according to the U.S.-based cybersecurity firm CipherTrace, which was up more than 400% from the prior year. Since cryptocurrencies aren't protected by federal insurance and the transactions cannot be reversed like conventional bank transfers, most people will never recover the funds that they've lost.

If you're using a crypto exchange, you should ensure that you have the proper account protections in place. Strong unique passwords and two-factor authentication go a long way in preventing account takeovers. SIM swap attacks make two-factor authentication somewhat vulnerable, but hardware security keys can make break-ins nearly impossible.

It's also a good idea to move any cryptocurrency that you aren't regularly trading into cold, or offline, storage. There are many different devices that make it easy to move cryptocurrencies offline, such as Trezor or Ledger Nano, but losing the devices can be catastrophic, so it's important to keep them in a safe place.

#5. Know How to Spot and Avoid Scams

The best cryptocurrency security tools won't save you from a clever scam. From pyramid schemes to fake tweets, there are many strategies that criminals use to separate people from their cryptocurrencies. The best way to avoid becoming a victim is to be aware of the different techniques and use some common sense advice along the way.

The most common sign of a scam is the promise of abnormally high returns and/or abnormally low risk. For example, an opportunity that promises a 1% daily return may seem modest, but after compounding, translates to billions of dollars in a short period of time. If these returns were possible, the individuals running it would not share the strategy.

Many other scams come in the form of initial coin offerings, or ICOs, that are similar to an unregulated securities offering. While some of these ICOs may be legitimate, there are many others that promise ambitious growth and outlandish returns. It's important to conduct due diligence and use common sense before investing in these opportunities.

The Bottom Line

Cryptocurrency traders and investors should ensure that they are fully-prepared before committing any capital to the market. With the right knowledge and tools, you can maximize your odds of success and ensure that your holdings are secure from theft.

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