It is now allowed to add cryptocurrencies to your retirement portfolio. But should you? Bitcoin is the most well-known cryptocurrency, and Ethereum is in second place. The cryptocurrency, which only exists digitally, works by using an encrypted algorithm to send payments, making it more secure and without the need for a third party such as a bank or financial institution.
It is important to understand cryptocurrencies and the pros and cons of using them for investing, and especially for retirement planning. For the sake of simplicity, I will use Bitcoin as an example throughout this article. The question is whether a retirement portfolio is a good place to invest in cryptocurrencies.
To begin with, it is important to understand what a cryptocurrency is and how it is valued. Each Bitcoin has a designated value, which rises and falls similar to how the value of a dollar rises and falls. This value is based on the seller’s willingness to accept it for the goods sold or how much investors are willing to pay for a Bitcoin.
A single Bitcoin can be worth $39,000 and can be subdivided, depending on the value of the transaction, up to one trillionth of its value. That’s different from the dollar, which can only be subdivided by a hundredth of its value (a penny) at most.
Bitcoins are handled digitally and the management of bitcoin transactions is almost impossible to counterfeit. Accounts (called wallets) that use Bitcoin are private. All cryptocurrencies use blockchain technology, which is a digital system that has the total history of all past transactions from the beginning to the present. As such, cryptocurrency accounts are not part of a bank. The user maintains the transaction. There is no government, corporation or central bank that has access to a person’s funds or personal information.
There are some downsides with cryptocurrencies. Due to the privacy of the cryptocurrency transaction, money laundering and tax evasion are possible, although previous attempts have been discovered and prosecuted.
Because cryptocurrency is digital, there is no physical cash that can be accessed. And if a computer crashes, the balance of a cryptocurrency could be erased unless the holdings have been backed up.
Also, the value of the cryptocurrency can vary greatly. It is important to note that cryptocurrencies have seen historically high returns in recent years. Additionally, cryptocurrencies are uncorrelated to the stock market, meaning they can help offset a stock market decline while providing a risk-adjusted return. Although cryptos are currently doing well, they may drop precipitously and cause a panic sell-off. If you want to learn more about cryptocurrencies, you can refer to this website: corporatefinanceinstitute.com/resources/knowledge/other/cryptocurrency.
If you plan to add crypto to your retirement plan, knowing your risk tolerance is especially important. If you are retiring in 15-20 years, then cryptocurrencies (as a small percentage, say 1%-5%) may be a good option if you can manage the downside risk. However, due to the volatility of the value of cryptocurrencies, it may not be suitable for someone who will be retiring in five to ten years.
It may be better to think of cryptocurrencies as dessert after a good meal. A small bite goes a long way. If you have a financial planner, he or she can better determine the right portfolio mix for your retirement. As a final word of caution, do not plunge into the unknown with cryptocurrencies unless you have done your homework and understand the risks.
Mary Fox Luquette, MBA, CLU, ChFC is a finance instructor at the BI Moody III School of Business at the University of Louisiana at Lafayette.