10 Things to Know Before Investing in Crypto

The cryptocurrency economy is exciting, in a thrill ride kind of way. Digital currencies rise and fall dramatically in short order, creating fortunes and losses practically overnight. It's tempting to jump in and try your hand at timing those fluctuations. With some luck, you could bank some profits, right?

Luck is a great thing in investing, but so is knowledge. The crypto economy is complicated. As an investor, understanding some working basics about cryptocurrency can guide you to better decisions and less risk. So here's your crash course in 10 must-know basics every crypto investor should know.

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Cryptocurrencies are not issued or controlled by a bank or government treasury. Instead, these digital assets exist in, and are governed by, code. That code is an encrypted ledger of transactions documenting who owns what.

Most cryptocurrencies rely on a system called blockchain. Blockchain records, protects, and publishes the history of digital assets. Think of it as a shared database -- one that can accept new transactions but doesn't allow edits to historic ones.

The data protection is blockchain's shining capability. It prevents fraud, and this allows cryptocurrencies to operate without a governing authority. Assets can transfer directly between peers globally, rather than going through a bank or clearinghouse.

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Bitcoin is the oldest and best-known cryptocurrency, but it's not the only one. Other popular digital currencies include Ether, Tether, Binance Coin, and Cardano. There are thousands more that are less popular.

Like stocks, cryptocurrencies can range widely in quality. Some, like Bitcoin and Ether, are well established and supported by a growing community of investors. They enjoy strong trading volume and offer a reasonable level of liquidity.

A lower-quality option would be a new crypto launched by an unknown development team with an unclear mission. The latter is the penny stock of the crypto economy. Like penny stocks, these obscure cryptos can be used for pump-and-dump scams. Investing there would be very risky.

For a novice crypto investor, established currencies are a logical starting point. You can take your chances on newer currencies later, when you're confident you can differentiate the good from the bad.

You use an exchange to buy cryptocurrencies with dollars. Exchanges also allow you to convert crypto back to dollars or to trade one crypto for another supported crypto.

There are two main types of crypto exchanges -- centralized and decentralized. A centralized exchange is a third-party mediator that facilitates transactions. Centralized exchanges are easier to use but can be more susceptible to security failures.

A decentralized exchange has no third party; the transactions occur directly on the blockchain. Decentralized exchanges cannot be hacked, but they can be intimidating for new users.

The user experience you want is an important factor in choosing an exchange. But also evaluate an exchange's reputation, security record, and fee structure.

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Crypto wallets don't hold actual funds or coins. They hold your access keys, which you need to make transactions on the blockchain. Secure storage of those keys is critical because anyone who has your access keys can transact with your funds.

You can store your keys online or offline. Online storage, called a hot wallet, is convenient but less secure. Offline storage, or the cold wallet, is more secure but harder to use. Some cold storage methods can feel archaic in this digital age. You might print your keys out on paper or download them to a thumb drive, for example.

An in-between option is cold storage you can access online. An example is the vault feature offered by popular crypto exchange Coinbase.

Cryptocurrencies can be extremely volatile. A look at Bitcoin's price performance over the past 12 months demonstrates this. In April 2021, Bitcoin eclipsed $64,000. Four months later, the coin's value had fallen more than 50% to about $29,000. Since then, Bitcoin has risen to the mid-$60,000s and dropped to the mid-$30,000s. It's currently trading at about $44,000.

For most people, it's not realistic to time these cycles for a quick profit. A smarter approach is to invest in Bitcoin or another crypto because you believe an open, decentralized currency can drive opportunity and wealth over a longer period. If you're in it for the long term, the volatility right now will be easier to tolerate.

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Bitcoin, the first cryptocurrency, was created in 2009. Its entire history spans 11 years. The U.S. stock market, on the other hand, has been around since the late 1700s.

History does not predict the future, but it can be instructive. For example, the history of the U.S. stock market gives investors confidence that downturns are temporary.

Crypto investors, on the other hand, are learning and accepting how the asset behaves as they go. They accept the uncertainties because they see massive upside potential. (Famous investor Cathie Wood believes Bitcoin could hit $1 million by 2030.)

But where there's upside, there's also risk. The entire crypto economy could collapse based on factors investors didn't see coming. Without much history to analyze, it's hard to predict which outcome is more realistic.

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According to Digiconomist, a single Bitcoin transaction uses 2,205 kilowatt hours of electricity. For context, that amount of electricity would power the average U.S. household for 75 days.

Many countries generate much of their electricity from fossil fuels. In the U.S., for example, fossil fuels produce 60% of the country's electricity. That means Bitcoin has a sizable carbon footprint. Digiconomist estimates annualized emissions from the Bitcoin economy at 97 million metric tons of CO2e, which is on par with the country of Kuwait.

One factor in a crypto's energy consumption is the method it uses for validating transactions. The two main methods are proof of work (PoW) and proof of stake (PoS).

Bitcoin, Ether, and others use PoW, and it is resource intensive.

PoS is the more efficient method, used by Solana, Cardana, Polkadot, and others. These cryptos have lower carbon footprints than Bitcoin, in part because they're more efficient per transaction. The other factor is how popular the currency is, which contributes to overall energy consumption.

You can benefit from the growth in crypto without owning any digital currencies. To do that, you'd buy stock in companies that generate revenue and profits as crypto adoption rises. Payment processors that accept crypto fall into that group, as do crypto miners and crypto exchanges. Semiconductor manufacturers are also a sector to watch since crypto networks require so much computing power.

Companies like PayPal Holdings, Block, and Nvidia have exposure to crypto but don't live and die by the crypto economy. These companies could be an easy entry point to crypto investing with less volatility than digital currencies.

ALSO READ: Investing in Cryptocurrency Stocks

Cryptocurrencies don't behave like stock, but you can still use traditional investing strategies to manage your risk. Two strategies to consider are diversification and dollar-cost averaging (DCA).

You'll want to diversify across crypto and noncrypto assets. You can also diversify within your crypto holdings. That could mean positions in multiple currencies or positions in currencies and crypto stocks.

DCA is the practice of investing small amounts regularly -- say, $50 a month instead of $600 once a year. DCA's main benefit is that it insulates you from big losses if the asset loses value immediately after you buy it.

If you're investing $50 a month using DCA, your cost basis after a year is the average of multiple transactions. If you invest $600 once a year, your cost basis is what you paid on that day. Given crypto's volatility, it takes some luck for the latter strategy to work in your favor.

The IRS taxes cryptocurrency gains, just as it taxes realized gains on stocks. The amount of taxes you'll pay depends on how long you owned the crypto, your tax filing status, and, sometimes, your income.

If you realized a gain on crypto you owned for less than a year, the IRS taxes that gain as ordinary income. If you owned the crypto for more than a year, the IRS taxes your profit as capital gains. The capital gains rate is usually lower, so you'll want to be strategic about selling older coins first.

To avoid any trouble at tax time, document your transactions carefully. You'll need that history to report your gains and losses accurately to the IRS.

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Crypto is a young asset with an uncertain future. Now's the time to learn how it works, what the risks are, and why it's gaining momentum.

The next step is to turn that knowledge into savvy investment decisions. You might do nothing and stay out of crypto for now. Alternatively, you might invest in crypto stocks or even build out a portfolio of cryptocurrencies to complement your traditional portfolio. The right approach is the one that aligns with your risk tolerance and your view on crypto's long-term viability.

Catherine Brock has no position in any of the stocks mentioned. The Motley Fool owns and recommends Bitcoin, Block, Inc., Coinbase Global, Inc., Ethereum, Nvidia, and PayPal Holdings. The Motley Fool has a disclosure policy.