What Is Bitcoin and How Does It Work? | Personal Capital

A couple months ago, I received a question from a podcast listener about my thoughts on Bitcoin and if it was worthwhile. At the time, I really didn’t think much of it and considered cryptocurrency a distraction to my plan of long term buy-and-hold stock market investing.

That being said, innovations and industry disruptions happen quite often. And we find ourselves looking back and wishing we would have jumped in earlier.

I’m thinking of when I ordered my first physical Netflix subscription after years of going to Blockbuster. I remember saying, “This is going to be big.”

Did I buy a share of Netflix though when they went public? Nah, I was too busy catching up on The Sopranos.

So is Bitcoin this decade’s Netflix? Or is it some wild made up currency that has no real value?

When I don’t know a lot about a subject, I do my research and I ask people I trust. I scoured the interwebs and found some excellent resources. Also, I decided to reach out to 13 friends, colleagues and money experts for their gut check on Bitcoin. Here’s what I learned.

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What is Bitcoin and How Does it Work?

When you think about it, digital currency isn’t all that far fetched. Currently, we spend “our physical money” with credit cards, bank transfers, Venmo or taps from our iPhones.

Yes, cash ($USD) is still our main form of currency, but I could count on my hand how many times I’ve used cash this month. I think that trend will continue: less physical and more digital.

But will Bitcoin be the digital currency of the future? Let’s learn more about what it is first.

What is Bitcoin?

Bitcoin is a type of cryptocurrency (or digital currency) that has been around for over 10 years. One major advantage of Bitcoin is that it eliminates the need for a third-party intermediary in financial transactions. No banks, clearing houses, or governments need to be in the middle of a transfer between one party and the other.

As opposed to fiat currency (cash in your bank), it is not currently backed or regulated by the government that issues it. Given that, its use as a currency is limited at the present time.

How Does Bitcoin Work?

Bitcoin was born from and continues to be created through blockchain — a revolutionary technology that decentralizes information to promote transparency and accuracy. Given blockchain’s scope of use, it is a technology that has been adopted by various industries outside of the financial world.

Even though Bitcoin is created digitally through a process called “Bitcoin mining,” there is a planned end to its development. There will only ever be 21 million bitcoins mined into existence.

Buying and Storing Bitcoin

If you’re interested in buying Bitcoin, it’s important to recognize that this is a speculative and highly volatile asset class.

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For example, when I bought my first fraction of a Bitcoin in May 2021 the price was around $56,000 per coin. Just two short weeks later, the price was closer to $36,000. That’s a $20,000 drop in two weeks!

Someone else who purchased Bitcoin much earlier than I did may be singing a different tune. In mid 2020, the price per coin was around only $10,000.

My point is that Bitcoin and other cryptocurrencies come with risk and not a lot rhyme or reason to the rise or fall in price. So I don’t see it as an investment per se. It’s more of a speculative bet.

If you’re a betting person, here’s how to buy your first Bitcoin.

Buying Bitcoin

Today, there are quite a few cryptocurrency exchanges available to choose from. Given the under regulated nature of cryptocurrency, be sure to do your research before purchasing your first Bitcoin. There are a lot of exchanges but not a lot of oversight.

One of the more well known (and now publicly traded) exchanges is Coinbase.

If you’re tech-savvy and have the bandwidth, you can also “mine” Bitcoin yourself and skip the exchanges. This is not typically an option the everyday person goes for given the technology, time and experience required.

Storing Bitcoin

After you purchase your Bitcoin, it needs to be stored somewhere. Think of it as your digital wallet.

There are two types of wallets you can choose from:

• Hot Wallet:  Also called an online wallet, a “Hot Wallet” is stored in the cloud.
• Cold Wallet:  This is when your crypto is stored offline in some sort of encrypted device like a thumb drive.

If you work with a trusted exchange, you’ll be storing your Bitcoin (or other cryptocurrency) in a Hot Wallet. Since I’m a crypto newbie, my personal preference is allowing the trusted exchange to store my digital funny money.

Should You Invest in Bitcoin?

As I mentioned earlier, I don’t think of Bitcoin as an investment. I see it as a speculative bet.

There may be some major upside to this Bitcoin bet down the road though. If Bitcoin becomes a recognized and legal currency in the US and other countries (as it has already in El Salvador), the price could continue to rise. But again, that’s me speculating!

Like any bet, having all of your eggs in one basket can be a risky move. The general sentiment that I’ve heard through my interviews is to put Bitcoin and cryptocurrency in the same camp as single stock purchases. Consider limiting your purchases of these riskier bets to between 1-10% of your overall portfolio. That way, even if it all crashes and burns, 90% of your portfolio is still invested in well-diversified assets across sectors, size, and style.

For me, 1% will be max. While Bitcoin and cryptocurrency are interesting and feel like the future to me, I’m a conservative guy and I like having more control and history around my investments.

But to each their own. Investing is personal and should be executed according to your beliefs and future goals.

That all being said, I don’t believe purchasing Bitcoin falls under the category of investing. So if you do decide to take a risk and place your bets, I hope you win big.

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Personal Capital compensates Andy Hill (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.