Is crypto too risky an investment?

If you feel like you're surrounded by cryptocurrency talk, you're not alone. Articles and social media posts have flooded our news since 2017, the year Bitcoin went from trading for under $1,000 per coin to over $19,000 per coin. Then, it had what can only be called a roller coaster ride hitting a high mark of over $64,000 per coin in November of 2021, and back down to just under $17,000 per coin in November of this 2022.

Here's a rundown on crypto and some of its risks.

What is cryptocurrency?

Cryptocurrency is a virtual, digital currency. Cryptocurrencies are not currencies in the traditional sense, because they're not issued or backed by a government and not managed by a central bank. The value of a virtual currency is set by market demand rather than tangible assets.

Most cryptocurrencies are backed by blockchain. Blockchain is a digital ledger technology that's managed by a network of computers that encrypt and secure data. Blockchain has many different uses, from tracking supply chains, or the intricate process of getting goods from the originating source to the eventual end user, to providing proof of work.

There are lots of cryptocurrencies: Bitcoin, Ethereum, Binance Coin, Cardano and Tether, to name a few. Some past cryptocurrencies failed from lack of interest, market saturation, poor security or fraud.

6 risks with crypto investment

Let's look at six risks to look out for before adding cryptocurrency to your investment strategy.

Market risk

Cryptocurrencies can fluctuate significantly in short periods of time, so investors risk financial loss.

For example, in the second quarter of 2022, the S&P 500 dropped 16.1%. In the same period Bitcoin had its worst quarter in more than a decade, after losing about 58% of its value. Ethereum was down 69.3%.

Information risk

Most virtual currencies operate publicly and are an open source. Anyone can see, modify and share their data. This means the information available can be highly technical and difficult to understand. As a result, it's challenging to design a strong investment strategy.

Also, information can be unreliable. Anyone with internet access can influence decisions affecting the currency. Consider the messenger as much as the message.

Acceptance risk

There's no law requiring businesses to accept virtual currency. Businesses decide if they're going to accept cryptocurrencies. Because of this, there's a risk that virtual currencies could stop being accepted.

Failure risk

Virtual and real currencies could fail altogether. We saw it in Germany post-WWI when they suspended their currency's convertibility to gold to fund the war. When the war was over, they had debt without the resources to pay it back, their currency was devalued and they experienced severe inflation.

However, Congress has said that Federal Reserve Banks "must hold collateral equal in value to the Federal Reserve notes that the Federal Reserve Bank puts into circulation." This means that the government is protecting the value of our dollar. That protection doesn't exist for virtual currencies.

But, this could change if the Federal Reserve issues a digital currency that's backed by the full faith and credit the U.S. government. If the Federal Reserve Bank extends this ruling to the digital dollar, then risk of failure becomes less of a factor.

Political and regulatory risk

Because there's no central management for different virtual currencies, regulation and oversight varies by country.

In the U.S., the IRS treats virtual currency as property for federal tax purposes. So, changes to the value of your virtual currency investments may be subject to capital gains taxes. Also, exchanging a virtual currency into U.S. dollars is a taxable event. This creates lots of transactions to track and report when it's tax time.

There are also risks connected with crypto exchanges being used in illegal activities like money laundering, selling drugs or weapons, or funding other criminal enterprises.

Virtual currency draws the attention of regulatory and law enforcement agencies. This increases the risk of a shutdown or restricted use of platforms and exchanges, which could limit the ability to use or trade a virtual currency.

Fraud and theft risk

OneCoin, perhaps the most infamous crypto scam, was worthless because it wasn't backed by blockchain. In June 2022, the FBI added OneCoin founder Ruja Ignatova to the 10 most-wanted fugitives list. By then, OneCoin had taken over $4 billion from investors worldwide.

Because virtual currency is based on open-source technology, there's also the risk of cybercriminals. In 2014, Mt. Gox declared bankruptcy, citing that it had lost $473 million worth of its customers' bitcoins due to online theft and hacking. At the time, Mt. Gox was the world's largest crypto-trading platform.

If you invest in virtual currency, be sure you trust the vendor or intermediary.

Crypto versus stock market risks

Neither stocks nor cryptocurrency investments guarantee that you'll be able to make money or even keep your initial investment.

However, unlike cryptocurrency, stocks are usually backed by company profits or tangible assets. Some stocks are riskier than others, but stocks are considered a more stable investment than cryptocurrency. You can analyze a company stock balance sheet or listen to an earnings call. You can even walk into their store to "see how they are doing." You can't do that with a cryptocurrency.

Cryptocurrency and IRAs

If your individual retirement account, or IRA, holds assets like stocks and mutual funds, its value depends on the market. The rules on holding cryptocurrency in an IRA are complex, so do some research. If you still have questions, talk with a qualified retirement planner.

Determining your crypto risk tolerance level

Because of the risks with crypto investment, it shouldn't be a core part of an investment portfolio for most people.

Consider how much of your overall portfolio will be allocated to virtual currency. At USAA, we believe limiting concentration of a portfolio to any specific stock to no more than 10%. And for some people, 10% of a volatile asset like cryptocurrency is even too much.

Don't abandon your retirement plan for risky investments.

During inflation and stock market downturns, people may see their retirement savings stall or drop and wonder if their approach is working.

Unfortunately, most employer-guaranteed pensions are a thing of the past. Now you're on your own to manage your retirement plan. It's tempting to look for a shortcut to grow a retirement balance as fast as possible.

Consider following this tried-and-true retirement savings method:

• Start early. Build and prioritize your savings into your monthly budget.
• Start small if you must. Increase the amount over time as your income grows or expenses decrease.
• Stay committed. Practice patience and discipline.