Cryptocurrency has risen rapidly in recent years, sparking growing interest and curiosity. It’s no wonder investors want to understand how it works and what it offers. This article aims to explain cryptocurrency, its underlying technology, and how it compares to traditional share investing.

At Pearler, we believe in long-term, sensible investing. At present, this approach doesn't align with the speculative nature of cryptocurrency investing. However, understanding different parts of the investing world is essential. Our goal is to help you understand how cryptocurrency works and equip you with knowledge to inform your investing journey.

Let's explore the basics of cryptocurrency as an investment.

What is cryptocurrency?

Cryptocurrency is a type of digital currency. Unlike traditional money, it exists only online. Two of the most well-known examples are the currencies Bitcoin and Ethereum. One key feature of cryptocurrencies is their limited supply. For example, as of publication, only 21 million Bitcoins will ever exist. This scarcity aims to drive demand and therefore drive up the price.

People use crypto for various reasons. Some see them as an investment. Others use them for online purchases. In some countries, like Jamaica and Nigeria, they have grown in popularity as an alternative to unstable national currencies. This is known as a central bank digital currency (CBDC). In Australia, the Reserve Bank of Australia (RBA) is researching CBDC to complement existing forms of money.

Despite their popularity, crypto is highly volatile. Their value can change quickly and unpredictably. This can make them a particularly risky investment choice for many.

Understanding these basics is key as we dive deeper into how cryptocurrencies work and how they compare to other traditional investments.

The role of blockchain in cryptocurrency

Blockchain is the technology behind cryptocurrencies. It is a type of digital ledger. This public ledger exists to record all cryptocurrency transactions across a network of computers.

Structure of blockchain

A blockchain is made up of – you guessed it – blocks. Each block contains a list of recent transactions. Once a block is complete, it’s added to the chain of previous blocks. This creates a continuous and unchangeable record of all transactions.

How blockchain works

When someone makes a cryptocurrency transaction, it is broadcast to the network and verified by the parties involved through a smart contract. A smart contract is a digital contract that automates the execution of a transaction. This happens when pre-determined terms and conditions are met.

Once verified, the transaction is added to a new block, stored as a smart contract. This block is then linked to the previous block, forming a chain. This linking process ensures the security and integrity of the blockchain.

Decentralisation

Blockchain is decentralised. This means no single entity, like a bank or government, controls it. Instead, it operates across a network of computers. This decentralisation aims to make blockchain secure. It’s difficult for any person or group to alter the transaction history, thereby making it theoretically resilient against attacks.

Transparency

Every transaction on the blockchain is transparent. Anyone can view the transaction history. However, the identities of the users remain private.

How cryptocurrencies work

Cryptocurrencies operate through a network of computers. As mentioned above, these networks use a technology called blockchain. Here’s a step-by-step look at how crypto works:

1. Creation (mining)

Cryptocurrencies like Bitcoin are created through a process called mining. Bitcoin miners are people who use powerful computers to solve complex mathematical problems. When they solve these problems, they add a new block to the blockchain. As a reward, miners receive new cryptocurrency units – they accept crypto to add to their wallet (more on that below).

2. Transactions

Transactions with crypto happen directly between users – known as peer-to-peer transactions. The transactions are completed by those aforementioned smart contracts. To make a transaction, a user needs a cryptocurrency wallet. This wallet holds the user's public and private keys. The public key is like an address where others can send cryptocurrency. The private key is a secret code that allows the user to access and send their cryptocurrency.

3. Verification

As mentioned, when a transaction is made, it is broadcast to the network participants. Miners then verify the transaction by confirming the details and ensuring the sender has enough balance. Once verified, the transaction is added to a block on the blockchain. The purpose of this process is to be secure and transparent. It ensures that transactions can’t be altered once they are recorded.

4. Storage

Cryptocurrencies are stored in digital wallets rather than a bank account. These wallets can be online (hot wallets) or offline (cold wallets). Online wallets are convenient for frequent transactions. Offline wallets are generally perceived as being more secure against hacking.

5. Security

In addition to the decentralised nature of blockchain, cryptocurrencies rely on cryptography for security. Cryptography is a method used to secure information and communications. It involves encrypting each transaction – converting data into a code to prevent unauthorised access. This makes cryptocurrencies hard to counterfeit or double-spend.

Risks of investing in cryptocurrency

As we highlighted earlier in this article, the cryptocurrency market is known for its volatility. Prices can rise and fall dramatically in a short period. This unpredictability can make it challenging for investors to figure out the right time to buy or sell. Here are some of the risks associated with crypto investing:

• Market manipulation : The crypto market is less regulated than traditional investment markets. This lack of oversight can lead to large investors manipulating prices.
• Security threats : Digital wallets and exchanges can be vulnerable to hacking. Losing access to your wallet can mean losing your investment.
• Regulatory uncertainty : Governments around the world are still figuring out how to regulate cryptocurrencies. Future regulations could have policy implications on their value and legality.
• Scams and fraud : The rise of cryptocurrencies has also led to an increase in scams. Investors need to be cautious and do thorough research before investing.
• Lack of intrinsic value : Unlike shares, which represent ownership in a company, cryptocurrencies have no underlying asset. Their value is based on what people are willing to pay for them, adding to their volatility.

Understanding these risks is essential for making informed investment decisions. While some investors have made significant profits, the potential for loss is also very high. Always consider the volatility and risks before you think about investing in cryptocurrencies (or any investment).

How crypto investing compares to share investing

Understanding the differences and similarities between cryptocurrency and traditional share investing is crucial. These factors impact long-term investors' portfolios differently. While both have the potential for returns, they also come with unique risks. Let's explore the key characteristics of each and how they compare.

Key characteristics of share investing

• Ownership and dividends : When you buy shares, you own part of a company. This ownership can earn you dividends, which are a share of the company’s profits.
• Regulatory oversight : Share markets are regulated by government bodies. Compared to crypto, this regulation provides some protection for investors.
• Historical performance : Shares have a long history to which investors can refer when making investment decisions. Though past performance isn’t a reliable indicator of future performance, they’re seen as a potentially reliable way to build wealth over time.

Key characteristics of cryptocurrency investing

• Lack of intrinsic value : When you buy crypto, you don’t own an asset. The value of cryptocurrencies is also based on what people are willing to pay.
• Absence of regulatory oversight : The crypto market is largely unregulated. This lack of oversight can lead to higher risks for investors.
• Speculative nature : Crypto is highly speculative. Their prices can be very volatile and influenced by market sentiment.

Here’s a snapshot of the key differences between crypto investing and traditional share investing:

Feature	Crypto	Shares
Physical ownership	No	Yes
Dividends	No	Yes
Regulatory oversight	Minimal	Extensive
Historical performance	Short, volatile history	Long, comparatively steady history (although still volatile at times)
Market manipulation risk	High	Lower (but still present)
Security risks	High (hacking, scams)	Lower (regulated transactions)
Value basis	Market demand	Market demand and company performance

These differences influence how crypto and shares fit into various investing strategies. For example, you may be deciding whether to invest in Bitcoin ETFs or technology ETFs, made up of shares of technology companies.

With their regulatory oversight and historical performance, shares may potentially offer more stability. Cryptocurrencies, while potentially lucrative, come with higher volatility and risk. Understanding these factors can help you make informed decisions about including them in your portfolio. However, in either case, you always assume risk when buying an investment.

Pearler’s long-term investing philosophy

At Pearler, we understand that investing can be overwhelming. Our philosophy focuses on simple, long-term investing. We believe in strategies that offer steady growth over time and seek to minimise risk – even if it seems boring. Though all investing comes with some level of risk , the long-term approach is different from the speculative nature of cryptocurrency investing.

We recognise that cryptocurrencies are becoming increasingly popular and can seem exciting. However, their prices can be extremely volatile and influenced by market sentiment. This unpredictability can make them a risky choice for long-term investors. While some may see high returns, others can face significant losses. And it’s hard to guess which of these groups you’ll fall into.

Key takeaways – cryptocurrency basics

Knowing how cryptocurrency works can be useful information to help guide your investing journey. Investing in cryptocurrencies offers a different path to long-term investing. Cryptocurrencies bring innovation and potential high returns but can come with significant risks and volatility. Their decentralised nature and lack of regulatory oversight make them a unique but unpredictable investment option.

Understanding the differences between options helps you make informed decisions that align with your investment goals. Remember to consider your risk tolerance and investment strategy carefully. The choice between cryptocurrencies and other investments depends on what aligns best with your financial objectives and comfort with risk. It helps to read independent, credible sources to learn more about the types of investments appropriate for your investing philosophy. It's also worth seeking out a financial adviser if you need more support in figuring out the best strategy for your investment journey.

Whatever decision you make, always ensure it's the right one for your preferences and goals.

Happy investing!