Many investors are considering adding cryptocurrency to their investment portfolios if they haven't already. But investors shouldn't conflate holding cryptocurrency with holding a stock. The two asset classes are very different and behave very differently.
The differences between cryptocurrency and stocks are actually a good thing. It'll make your portfolio truly diversified. But it's important to understand what you're buying and how it might affect your portfolio's risk profile and returns.
What is a stock?
A stock represents equity in a company. When you buy a share of Apple stock, for example, you're essentially buying a tiny fraction of the company's operations and assets.
You are an owner of the company. You don't have control over the operations, but you get to vote on key aspects of the company like who sits on the board of directors and how much executives get paid. You're entitled to a portion of the assets of the company. And anytime someone buys a new iPhone or Mac, you technically earn a few fractions of a penny.
A corporation will sell stock and give up some control of the company in order to raise funds to grow the business. Early employees may receive shares of the company as compensation instead of cash because start-ups may be devoting all of their cash to growing the business. A company may make a public stock offering to raise more funds or list its stock directly on an exchange to allow early investors to sell some of their shares and cash out.
What is cryptocurrency?
Cryptocurrency is a term used for various digital currencies that rely on blockchain technology to provide a secure payment network and eliminate double-spending. Instead of relying on a central bank, cryptocurrencies use a network of computers to confirm transactions.
A cryptocurrency is issued directly by the blockchain it uses. For example, the Bitcoin (CRYPTO: BTC) blockchain will issue a certain number of coins for the network node that confirms the next block in the blockchain. Cryptocurrencies are also used to pay the fees to process transactions on the blockchain.
Similarly, Ether (CRYPTO: ETH) is the cryptocurrency associated with the Ethereum blockchain. But many crypto tokens use the Ethereum blockchain to run decentralized finance applications. A project like Uniswap (CRYPTO: UNI) uses the Ethereum blockchain to run its exchange, which means Uniswap users need to use Ether to perform transactions. So, buying Ether is a bet that the Ethereum blockchain will continue to expand in functionality as more decentralized applications gain adoption.
You could also buy tokens directly. Tokens for DeFi projects like Uniswap may be utility tokens or governance tokens.
Utility tokens like Binance Coin (CRYPTO: BNB) enable people to use a decentralized finance app. Binance, for example, uses Binance Coin to pay for transaction fees on its exchange. Users can also use Binance Coin to buy new tokens launched on its platform. Users can hold the token to get better rewards for using its debit card. And they have to use Binance Coin to pay for games and applications that run on the Binance blockchain.
Governance tokens are similar to utility tokens, but add the ability to vote on the future of a blockchain project. (Uniswap is a governance token.)
Owning a utility token like Binance Coin imparts zero ownership interest of the underlying company. So, when Binance earned about $750 million in profits in the first quarter of 2021, that all went to the owners. (There are mechanisms allowing owners to share profits with token holders, but that's at their discretion.) Governance tokens and many corporate stocks both offer voting rights, but that's about where the similarities end.
The most important factor for diversification
Understanding what you're buying when you buy shares of a stock or a few cryptocurrency coins or tokens is important. If you're buying cryptocurrency to diversify your portfolio, you need to know if the investments behave similarly.
Historically, Bitcoin and the S&P 500 Index (SNPINDEX: ^GSPC) have practically no correlation. That means the direction of their value changes aren't related. That's good for diversification, but negative correlation — where one asset appreciates in value while the other declines in value — is usually better for managing risk.
It's also important to note cryptocurrencies are historically much more volatile than stocks. So, when they go up in price, they go way up, and when they go down, they go way down. And since there's no correlation between cryptocurrency prices and stock prices, that means adding cryptocurrency to your portfolio alongside stocks will increase the risk profile of your portfolio.
Owning cryptocurrency is definitively not the same as owning stock. The crypto asset class may be attractive to investors looking to take on additional risk in exchange for greater potential returns. But crypto investors should understand what they're buying and the role it plays in their portfolio.
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Adam Levy owns shares of Apple and Bitcoin. The Motley Fool owns shares of and recommends Apple and Bitcoin. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.