It's easy to understand why someone would want to invest in cryptocurrencies. Some of them have historically produced incredible returns. And other cryptocurrencies are tackling some interesting, real-world problems in novel ways.
However, the cryptocurrency space can be risky. Here are three of the biggest risks that I believe can hinder your chances of positive returns.
Risk 1: Terrible tokenomics
Crypto values rise when demand for the currency or token is greater than its supply. When cryptocurrencies are developed, their developers create ways to incentivize demand and regulate supply. This is referred to as "tokenomics," and it differs from project to project. Some designs are very good. But in other cases, the tokenomics don't support long-term price appreciation.
For example, I believe that the fitness lifestyle app STEPN (GMT 0.35%) didn't design its Green Satoshi Token (GST) to sustainably increase in price. GST is earned for using the app to exercise and is used in the app to play and level up. GST is burned when it's used -- taken out of circulation. However, there's an unlimited supply of GST. The more people play and use the app, the more GST can be created.
An unlimited supply of tokens isn't good for values. But it's more than this. You could swap GST for USD Coin and exchange USD Coin for any other cryptocurrency on a crypto exchange. But logically, the only people interested in purchasing GST tokens would be people looking to level up faster in the STEPN app.
The irony here is that people joining the STEPN platform theoretically provide a short-term boost to GST values. However, as these new users come online, GST is minted faster, increasing the supply and diluting the long-term value.
STEPN seems like a fun fitness app and it should probably be treated as such. But I doubt it's a good long-term income opportunity.
Many bad investments won't be quite as obvious as this extreme example. But investors should always know what's driving token demand and what is regulating its supply. To summarize, researching tokenomics helps you avoid poorly designed systems.
Risk 2: Unsustainable yields
Like depositing fiat currencies in a savings account at a traditional bank, it's possible to earn yield on your crypto. Often, the interest rate for digital currency is much higher than what you'd get elsewhere, which is why it's so tempting. But high-yield crypto products are the second huge risk for cryptocurrency investors.
High-yield financial products are frequently unsustainable. For example, consider Anchor Protocol. At one point, users could earn 19.5% yield on their TerraClassicUSD through Anchor. This incredible yield was driving people to TerraClassicUSD and Terra Classic, causing the market capitalization of TerraClassicUSD to increase and sending the price of Terra Classic soaring.
However, the yield was unsustainable. Anchor's reserves were getting drained. And perhaps this is why users suddenly started withdrawing TerraClassicUSD in large numbers -- the initial catalyst that caused Terra Classic to start collapsing.
Many other risky cryptocurrencies offer high-yield returns simply by holding. Mitigate this risk by researching where the money for paying the yield is coming from. This way you can analyze whether the return is sustainable. Avoid anything that looks unsustainable.
Risk 3: FOMO
Fear of missing out (FOMO) is perhaps the greatest risk for crypto investors. Even with their recent declines, cryptocurrencies like Bitcoin and Ethereum (ETH -0.78%) have greatly outperformed most stocks over their histories. And the allure of ultra-high returns like these can cause investors to invest in cryptocurrencies before they're ready and before they've thoroughly grasped what they're investing in.
FOMO is an emotional response to a bullish thesis. We believe something is poised to go up in a hurry. One of the best ways to combat this, therefore, is to spend time developing a bearish thesis -- an explanation of what could go wrong.
Take Ethereum as an example. I believe the Ethereum blockchain offers a lot of potential in the world of smart contracts and decentralized applications. With its Ether token trading at its lowest level since 2020, it would be easy to get FOMO right now with Ether, hoping for a quick rebound.
However, there's a big risk right now with Ethereum. This blockchain is transitioning from a proof-of-work blockchain to a proof-of-stake blockchain. Without diving into the weeds, let's just say that the tokenomics are changing. Rather than mining Ether by using lots of computers to solve complex math problems, nodes will stake Ether to process transactions. Ether is being locked up for long time periods and holders are joining staking pools to participate and earn yield. This move to proof-of-stake really changes the entire Ethereum playing field and it's impossible to know for sure what the long-term impact could be.
Investors in Ethereum today need to recognize that it's not entirely the same Ethereum of the past. And this could have an impact on future returns.
Simply asking what can go wrong is a powerful deterrent to FOMO.
Avoid risks when investing in crypto
As we've seen, poorly designed tokenomics, unsustainable yields, and FOMO are three big risks when it comes to crypto. The first two risks are token-specific and can be mitigated by being sure you understand exactly how the cryptocurrency you want to buy works. The last risk is personal and is mitigated by developing an investment thesis of what can go right and what can go wrong when buying cryptocurrencies.