With all the different options out there with traditional and alternative investments, I wanted to compare and contrast the similarities and differences between cryptocurrencies and traditional assets that trade on stock exchanges.
A quick note, if you’re looking for a way to put all your alternative investments (real estate, startup investments, cryptocurrencies, etc) into an IRA, take a look at Rocket Dollar. They offer Self-Directed IRA’s that will allow you to do that.
Investing in assets for profit or wealth creation requires one to have a very specific outlook. If you’re interested in investing in shares or other investment options, then you should first carry out a self-assessment to determine what your personal outlook is.
In order to determine your outlook, take a look at your:
- Risk appetite: This refers to your risk attitude. Are you a risk seeker or a risk-averse investor? If you are a risk seeker then you would prefer high stakes trading as compared to a risk-averse investor who would look for stable returns and low risk.
- Holding ability: How much is your holding ability? Can you hold your investment for long periods or are you looking to take advantage of short term fluctuations in the market to reap profits?
- Goal: Are you looking for speculative profits or wealth creation? Your goal will determine the type of assets you invest in, so think properly about your goal before investing as this will determine whether you fail or succeed.
Once you have determined your outlook based on these three points, you can then continue to invest into different investment options. By now you are either moving on with a trading mindset to make profits on speculative trading or with an investor mindset to create wealth by investing in well-performing stocks to generate value over time.
Types of Investment Assets
If you seek the advice of a financial advisor, they will tell you about different types of investment assets. It doesn’t matter if you have a trader’s or an investor’s mindset, your portfolio will need to be constructed carefully keeping in mind the risk profile of every asset you own.
Your risk profile will depend on your risk aptitude but even if you are a risk seeker you will need to have a risk mitigation strategy in order to balance out your portfolio. So let us briefly look at some investment assets
- Bonds: Bonds can be issued by the government or corporations. The bonds that are issued by the government are usually very secure and low-risk assets that carry low-interest rates. Bonds issued by corporations may carry high risk and therefore high interest based on the credit rating of the issuer.
- Shares: Shares are perhaps the most widely known investment assets. Shares represent fractional ownership of the business. Investors can generate a return from shares in the form of dividends and profit on the trading of shares. Shares of high value or blue-chip companies are valuable whereas low-value companies have shares that are not very valuable. Share market is susceptible to crashes and therefore investment in shares requires a certain degree of market awareness.
- Commodities: Commodities are investment assets and they include assets such as precious metals, iron ore, oil, coffee, and grains, etc. Investment in commodities depends on the type of commodity. Perishable commodities have low value whereas commodities like oil and gold have relatively stable values. Gold in particular is seen as a safe haven by investors.
- Real estate: Real estate is also an investment asset, it is, however, a high-value asset, and not every investor can invest into real estate. Investors who want to experience returns of real estate but they cannot afford to invest, can instead invest in “Real estate investment trusts” (REIT). These trusts hold real estate and the rental income is distributed as dividends among the REIT shareholders.
- Collectible assets: Collectible assets are high-value rare assets such as works of art, supercars, or merchandise used by sports stars or celebrities, etc. These are high-value assets that do not have an active market and their value comes from their history of exclusivity.
- Currency: Currency is also a form of an investment asset. Forex is mainly used for hedging the risk of loss. Investors exposed to a weak currency may prefer to keep their investments in a stable currency to prevent loss of value due to devaluation.
- Cryptocurrency: Cryptocurrency is a relatively new form of an investment asset. Technically it functions as a currency and therefore has the same purpose. Investors use cryptocurrencies both for long term value generation and short term profit generation. In recent times crypto is also being seen as a possible safe haven in addition to gold. If you haven’t yet, read the Bitcoin 101 post here to understand more.
This was a brief explanation of the different types of investment assets that investors can invest in. As mentioned earlier the type that you will choose will depend on your risk profile, affordability, and portfolio. Most investors for example invest in shares and mutual funds because these are the most accessible form of assets and also the most liquid assets. If you are investing through an IRA, then your portfolio is going to be very balanced to make sure that you can withstand losses. If however you are a trader then you will prefer to go for stocks that show growth potential in the short term in order to make a profit from short term price movements.
Bonds are usually purchased by more experienced investors. Government bonds are considered the safest investment assets along with gold. Bonds act as a counterweight for high-risk investments. For example, if you have invested in high-value stocks of a company and are skeptical about the gains then in order to balance out your portfolio you should invest in stocks. Because if the stock price falls, the bond price will go up and nullify the effect. Usually bond and stock prices act inversely, that`s why investors balance out their portfolio with both of these assets.
Not all investors look for collectibles. Only enthusiasts go for collectibles and they do this for the exclusivity that comes from such assets. Such assets are priceless and when needed they can fetch a good value but their liquidity is very low. Take the Mona Lisa painting for example, if it was put for auction how many people would be able to buy it? Very few.
Commodities and currencies are mostly used for hedging against potential losses. First, understand that commodities and shares differ from each other. Shares are dependent on the performance of the company they belong to whereas commodities and currencies have intrinsic value. Commodities generate their own value, while the value of the currency comes from the economy it represents.
Investors use derivatives to hedge on the value of commodities and currencies. Futures and options are common forms of derivatives. For instance, if a barrel of oil costs $6 today then an investor can enter into a futures contract to buy 100 barrels in a month at the price agreed upon today. In this manner the investor will be able to limit the exposure to drastic price movements. A month later if the price of oil has increased the investor will benefit and if it has fallen (which is unlikely) the investor will lose out.
These are more or less traditional assets but what about Cryptocurrency? Many investors consider it a non-traditional/alternative asset. Perhaps rightly so because cryptocurrencies were introduced in 200 from this perspective crypto currencies have only been around for a little over a decade, they are perhaps the newest form of assets.
What is Cryptocurrency?
A cryptocurrency is a currency that is based on the blockchain platform. This allows the currency to be a non-regulated currency, that is not controlled by any government or regulatory authority. Blockchain technology helps to prevent fraud. Read the Blockchain 101 article to see how blockchain technology helps to prevent fraud.
Since monetary authorities cannot control crypto, the value and quantity of cryptocurrencies cannot be increased or decreased like fiat currency. This allows cryptocurrencies to remain in a fixed quantity and it is this scarcity that makes cryptocurrencies like Bitcoin similar to gold.
Gold is also limited in supply and can act as a medium of exchange. Both of those properties apply to cryptocurrencies as well. At present there are two uses of cryptocurrencies. People can use them as real currency to buy and sell goods and services, thus allowing them to be used like any normal currency.
Investors can also use bitcoins for speculative and wealth creation purposes. Interestingly this is also how commodities especially gold is used. Does this mean that cryptocurrency has become a safe haven for investors? Well it may take some time for investors to say this because this is the first real litmus test for cryptocurrencies. Gold has been here since time immemorial and has gone through countless tests but cryptocurrencies were introduced in 2009 and therefore this is their first real-world financial crisis and they seem to be holding on very well.
Figure 1 shown above shows the value of bitcoins over the last three months. The dip in March is similar to the global stock market crash due to COVID-19. It can be seen that since then the value of bitcoin has recovered quite well and is now trading close to $10,000. This is despite the fact that many companies are in a financial crisis. To get a clearer picture let us contrast this with the value of gold over the same time period.
Figure 2 shows the value of gold over the same three-month period. The dip came in mid-March and even gold lost its value because investors at that point were in total panic. However, with both bitcoin and gold, you can see that they didn’t go below key points of technical support.
For fairness let us now also look at Dow Jones index, just to see how these two safe haven assets performed in contrast with shares that are more traditional form of assets.
This figure clearly shows that while Bitcoin and Gold have not only recovered their lost value but are now set to trade higher than they were before the market crash. The Dow Jones index has hardly recovered almost 50% of its lost value and it is struggling to stay at this level. Any external shock can send the value down once again.
This means that in terms of value preservation, Bitcoin is behaving similarly to gold as compared to traditional stocks. Their volatility allows traders to speculate in the short run as their ability to recover value quickly after such large moves make them ideal for investors with a more long term outlook.
Investing in Equity vs Crypto Differences
Investors seek returns whenever they invest into any asset. The assets that we have covered in this article so far, have different ways to generate returns. If we look at shares for example, then shares generate returns in two main ways.
- Dividend Income: Shares carry annual dividends and for most investors, these shares are the only form of return they look for. Long term investors reinvest thee dividends to increase their investment and thus increase dividend income in return.
- Capital gains: The second form of income through shares comes through capital appreciation in the value of shares. If you bought a share for $10 and then it increased to $100 in value and you sold it, you’d have a capital gain of $90. A lot of investors trade to take advantage of capital gains.
When you look at cryptocurrencies, you can see that cryptocurrencies are a form of digital currency and therefore they do not carry period returns like dividends or interest payments. So those who invest in crypto won’t get periodic dividend income. Crypto however offers the opportunity to gain through capital appreciation in a manner similar to gold. The value of cryptocurrencies, as shown in the Bitcoin price chart above, goes in an upward trajectory when their demand increases and this means that investors can experience capital appreciation or capital gains by investing in crypto currencies.
The Risk Factors
Risk is an inherent part of investing in any asset. Even the lowest risk of carrying bonds still carry a risk. Equity investment carries the risk that the company may fail to create shareholder value and then equity investments are susceptible to systematic risk. Systematic risk is the risk that cannot be diversified, like what happened in March 2020 when markets crashed. The stock market crash affected every asset class – shares, bonds, currency, or gold. Cryptocurrencies therefore too are not free from systematic risk. Apart from systematic risk, cryptocurrencies have the major drawback of being too volatile. Perhaps this volatility comes from the fact that crypto is still a new class of assets and the market hasn`t yet fully embraced it.
Before you decide to invest in any asset, make sure you get your fundamentals right. Determine why you want to invest; what are your long term and short term goals and how much risk are you willing to take. These questions will help you clearly define your path and prevent you from making amateur mistakes.
If you have an IRA for traditional investments like stocks, did you know that you can also do put alternative investments in an IRA? Rocket Dollar allows you to create and manage your Self-Directed IRA, so check that out if you invest in real estate, startups, crowdfunds, cryptocurrencies, and other non-traditional assets.