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Six Things Investors Need to Know Before Investing in Cryptocurrencies

By Namrata Sen Chanda - Jun 23, 2021 at 3:36PM

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Cryptocurrency investing can be confusing for newbies. Here are the factors you must consider as you get started.

Cryptocurrency investing is seen as one of the most lucrative strategies in 2021. As institutional investors and famous personalities have expressed their love for cryptos, demand for these digital currencies is skyrocketing, and so are their prices. The crypto bull run in the past year has tempted many new investors. However, cryptocurrencies are highly volatile assets with a fair share of risks. 

Here are the six things you should understand as a new investor before investing your hard-earned money into these digital assets.

Bitcoin logo over a stock chart.

Image Source: Getty Images.

1. Don't take large bets.

I agree that the spectacular returns generated by some cryptos are too enticing. You may want to invest all your money to earn maximum profit in this winning phase. But hold on because crypto markets are no less than a roller-coaster ride. No one knows if -- or when -- the market will crash. Unlike stock investing, there is no Securities Investor Protection Corporation (SPIC) or Federal Deposit Insurance Corporation (FDIC) coverage that comes as a savior. Hence, the gyrations of the crypto markets can be damaging if you take large bets. It's wise only to invest a portion that you can afford to lose. 

2. Research well at the outset

With a new altcoin seemingly launched every other day, you must know to separate the quality investments from the equivalent to penny stocks. It's crucial to invest in projects that have been around for a while and have credible backing. Research the authenticity of the developers or teams backing them. Examine initial coin offering (ICO) whitepapers or prospectuses. And watch out for scammers that most certainly abound during the peak periods. If a proposition is too good to be true, it probably is.

Due diligence is critical here. Whenever you plan to invest in crypto in an initial coin offering, you must read the prospectus thoroughly. It's an uphill task for sure, but something worth the effort. In addition to the coins, choosing crypto exchanges also require judgment, especially the ones that offer over 100x leverage. All's well if a currency gains value, but you could end up losing all your money if it sees a correction. 

3. Invest time in learning about value proposition

Investors buying a particular cryptocurrency for its rising price doesn't necessarily make a good argument for its its value proposition. Unlike equities, the value of cryptos isn't determined by metrics, cash flows, or profits. Instead, you need to understand the primary objective of each cryptocurrency. Identify the gap they aim to address and the factors that make them unique.

For instance, replacing gold as the store of value and a hedge against inflation is the best use case for Bitcoin. Ethereum blockchain serves as the base for the majority of the DeFi (decentralized finance) projects. Similarly, Cardano aims to create an open financial system for inclusive banking. Researching the use cases of each coin is the best way to understand what the future holds for them.

4. Diversify your crypto portfolio

Bitcoin is the most-talked-about cryptocurrency. It has had a bull-run for a long time but has plummeted since April. So never put all your trust in one single crypto. Instead, you need to diversify your crypto basket to spread the risks evenly. A smart diversification across multiple coins ensures that if one coin goes through a rough patch, the other coins can help you to recover the losses. For example, some crypto investors like to follow a 6:3:1 strategy which implies investing 60% in Bitcoin, 30% in Ether, and 10% in other altcoins. This ratio varies across investors, though. 

5. Don't get swayed by emotions

Investing in cryptos should be based on research and not gut feeling. If fear of missing out is driving your crypto investments, you could miss out on safeguarding your wealth. I understand that the hype around crypto, the constant barrage of news, and the social media sentiments can be overwhelming. You may just want to follow every trend out there. However, this can be extremely dangerous, and you could fall prey to fly by-the-night scams. Don't just go by what others tell you, whether they are promoters or detractors. Evaluate the merits of the investment case yourself and plan your moves based on the research. 

6. Don't ignore other expenses

Seeing multiple price changes in cryptocurrency prices within a single day or an hour is not uncommon. Naturally, you may want to take advantage of these changes, but you must consider the transaction fees for that. Another factor you need to check is your taxes. In the U.S. and Canada, you need to pay capital gains taxes on each transaction. So if you are involved in excessive trading, a significant portion of your gains can get wiped off if you don't do the math for fees and taxes.

Be prepared for the risk and volatility.

Investing in cryptocurrency is exciting and rewarding. But these profit opportunities come with high risks. You could end up making losses if you aren't sure of what you're doing and why you're doing it. Before you take the plunge into cryptocurrency, you must have a high-risk tolerance because volatility is a permanent element here.

Namrata Sen does not own any of the stocks mentioned. The Motley Fool owns shares of and recommends Bitcoin. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Bitcoin Stock Quote
$23,435.45 (-1.50%) $-356.29
Ethereum Stock Quote
$1,845.89 (-2.30%) $-43.50
Cardano Stock Quote
$0.54 (-3.07%) $0.02

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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