Bitcoin Basics: What To Know Before You Buy

Bitcoin Basics: What To Know Before You Buy

Bitcoin—the popular cryptocurrency renowned for turning ordinary investors into millionaires—is making headlines again. The price of Bitcoin continues to reach new all-time highs this week. On Monday, Bitcoin recorded a 20.6% gain over a 24-hour period, fueled in part by Tesla’s decision to hold $1.5 billion of reserve cash in Bitcoin and accept Bitcoin as payment. With Bitcoin on the rise and edging its way into mainstream Corporate America, many investors are wondering if there’s future gains to be made in the crypto market.

It’s natural to experience FOMO when so many Bitcoin investors seem to be getting rich. However, before you pour your hard-earned cash into cryptos or abandon your investment plan, it may be helpful to refresh your memory on a few Bitcoin basics, including the potential risks.

Here are three Bitcoin Basics All New and Renewed Enthusiasts Should Understand:

1. Bitcoin Is the Oldest and Best-Known Cryptocurrency, But Thousands More Exist

The pseudonymous Satoshi Nakamoto introduced cryptocurrency to the world in 2009. Nakamoto described a new kind of money, or currency, which was meant to exist in a secure, stable, and limited supply strengthened by electronic security, or encryption. Pair “encryption” with “currency,” and you’ve got cryptocurrency.

Bitcoin was the first cryptocurrency and is still the most well-known. According to CoinMarketCap, Bitcoin has a market cap of over $867 billion as of February 9, 2021, with its closest competitor Ethereum at just under $200 billion. Although countless coins have been introduced into the crypto market in recent years, their market caps pale in comparison to Bitcoin and Ethereum.

2. Central Regulators and Banks Play No Part in the Crypto Market

One important difference between cryptocurrency and traditional currency is that Bitcoin and other cryptos have no centralized authority to enforce rules. As a result, supply and spending power—both typically managed by central banks—are accounted for differently in the crypto market, with miners and blockchain technology replacing the need for a central regulator.

  • Supply: To maintain their currency’s value, central banks like the U.S. Federal Reserve, Bank of Canada, and Bank of England are tasked with limiting supply—without strangling its demand. On the other hand, Bitcoin was originally designed to have a limited and finite supply of 21 million coins. Once all 21 million coins are mined, the planet’s supply is considered tapped out. However, it’s worth noting that there’s debate as to whether this number will be revisited and amended in the future.
  • Spending Power: In most countries, the nation’s central bank is also in charge of keeping its currency’s spending power relatively stable. For example, only the government can add or subtract from its supply of legal tender. But for cryptocurrency, this stability is maintained by the underlying blockchain.

Mining and Blockchain Technology

  • Mining. Mining is the process by which Bitcoin transactions are recorded and verified and new Bitcoins are created. In addition, mining allows participants to earn Bitcoin without exchanging money for it. Bitcoin miners make transactions possible by competing to solve mathematical puzzles. The miner who finds the solution first is rewarded in Bitcoin.
  • The Blockchain. A decentralized public ledger called the blockchain serves as a shared database of every Bitcoin transaction that has ever occurred, including the creation of new units. This database is stored on a network of thousands of computers called nodes. Information is added to the blockchain if consensus is reached—that is, more than half of the nodes agree that the first miner’s solution is valid and accurate. This consensus is the mechanism that removes the need for third-party verification.

“The blockchain keeps everyone honest, and a whole layer of banking bureaucracy is removed, lowering costs.” -Paul Vigna

3. Bitcoin Is Becoming More Mainstream But Still Has Limitations

Elon Musk’s recent decision to invest Tesla’s cash reserves in Bitcoin and accept the cryptocurrency as payment has no doubt benefited Bitcoin investors. However, less obvious is that investors who hold S&P 500 index funds, as well as some actively managed funds, are now indirectly exposed to the crypto market. (Tesla is currently one of the S&P 500’s biggest members with a weighting of almost 2%.)

While seeing a major company like Tesla put its full support behind Bitcoin is exciting, it also highlights some of the cryptocurrency’s inherent risks. For instance, one of the largest barriers to entry for Bitcoin has long been its price volatility. You may remember when Bitcoin hit its first record high, briefly topping $20,000 on December 17, 2017. Days later, the cryptocurrency lost nearly half its value and continued to decline and trade sideways for the next two years.

The coronavirus pandemic and ensuing economic shutdown renewed interest in Bitcoin, and the price has skyrocketed since March 2020. Though Bitcoin enthusiasts may be tempted to jump on board, it’s important not to lose sight of Bitcoin’s volatile history.

Other Risks

Other ongoing risks include inconvenience and complexity. Though we’ve seen progress more recently, most retailers still don’t accept Bitcoin and other cryptocurrencies as valid forms of payment. Until there’s widespread adoption by merchants, Bitcoin holders run the risk of not being able to spend their coins how they want.

In addition, the complex nature of cryptocurrency means many people—especially older folks—still don’t fully understand Bitcoin and have no interest in educating themselves if they don’t have to. In fact, a recent survey from Grayscale found that of respondents aged 55-64, only 40% were familiar with Bitcoin and just 30% would consider investing.

Still, almost half of the total survey respondents said they believe digital currencies would become mainstream by the end of the decade. So, while there’s reason to be optimistic, we shouldn’t expect Bitcoin to become an integral component of the global economy just yet.

Our Take On Bitcoin

Cryptocurrency is an interesting development with a number of promising possibilities. Indeed, human ingenuity is always a marvel to behold. But like any relatively new, highly volatile pursuit, it entails considerable risk.

If you’d like to try earning and spending cryptocurrency, be sure you’re familiar with the basics first—including potential downsides. And if you’re thinking of trading in it for fun or profit, we advise against putting in any more money than you could afford to lose entirely. 

In our estimation, cryptocurrency remains more of a speculative venture than a long-term investment. However, if you like to discuss these Bitcoin basics (or anything else) in more detail, please get in touch. We’d be happy to help answer your questions.

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