The cryptocurrency phenomenon has taken the world by storm over the past year, with several cryptocurrencies -- including Bitcoin (BTC -0.10%), Ethereum (ETH -1.17%), Dogecoin (DOGE -2.61%), and Cardano (ADA -1.31%) -- soaring in value in a relatively short period of time.

The biggest reason why many investors have shied away from cryptocurrency, however, is its extreme volatility. All cryptocurrencies have experienced massive price swings over the past several months, which has made many people wary of this new type of investment.

One alternative investment that is similar to cryptocurrency but offers more stability is the stablecoin. But what are stablecoins, and are they a smart investment? Here's what you need to know.

Several stacks of gold coins

Image source: Getty Images.

What are stablecoins?

While major cryptocurrencies like Bitcoin can be used as a form of payment, their extreme price fluctuations make it difficult for them to be accepted by the general public. The price of Bitcoin has swung by tens of thousands of dollars over a matter of months, and that short-term volatility makes it an unstable form of currency right now.

Stablecoins are different from traditional cryptocurrencies because they're backed by a reserve asset, such as the U.S. dollar or gold. In other words, they're simply tokenized versions of the U.S. dollar, gold, or other reserve assets. This helps keep their prices stable, so they're not subject to the same level of volatility as other cryptocurrencies.

In some ways, stablecoins are designed to be a middle ground between traditional cryptocurrencies and fiat currencies like the U.S. dollar. While they're still a type of cryptocurrency and can be used as a form of payment, they don't experience the rollercoaster of ups and downs.

Are stablecoins a good investment?

If you're eager to get involved with cryptocurrency but can't stomach the waves of volatility, stablecoins may be a good option. However, there are a couple of things to know before you invest.

First, don't expect explosive gains when you invest in stablecoins. They're designed to be, well, stable, and their prices generally don't fluctuate much. For example, the price of Tether (USDT -0.02%), one of the most popular stablecoins, is up by just 0.16% since the beginning of the year, and it's increased by only 0.42% over the past three years. You can earn interest on your stablecoins by holding them for the long term, but this strategy is essentially a riskier version of putting money in a savings account.

Other ways to make money with stablecoins include lending and staking. When you lend stablecoins, you can earn interest payments from borrowers. Staking is the process by which crypto transactions are verified. By putting your own coins at stake, you have the chance to earn rewards. The more coins you pledge, the more you can potentially earn.

While these options can help you make money with stablecoins, they do require more effort than buying and holding your investment.

Also, stablecoins aren't without risk. The crypto industry, in general, is mostly unregulated, and stablecoins have faced their fair share of controversy. Tether, in particular, made headlines earlier this year when its executives were investigated by the U.S. Department of Justice for bank fraud, for example.

Should you invest right now?

If you're on the fence about buying stablecoins, think about your investing goals. If you want to own cryptocurrency to use as a form of payment without the extreme volatility, stablecoins can be a smart choice. Similarly, if you're willing to take a hands-on approach and lend or stake your coins, you could make money with stablecoins.

If you're looking to hold an investment for the long term to build wealth, though, there are better options out there. Investing in traditional cryptocurrencies like Bitcoin or Ethereum could be the right move if you're willing to tolerate higher levels of risk and volatility. Otherwise, you might be better off building a portfolio of stocks and avoiding the crypto market altogether.