When most people think about investing, their minds typically envision two main asset classes: Stocks and bonds. But these are by no means the only available asset classes that someone can invest in. Precious metals, real estate, and commodities have all also served as important investment vehicles for hundreds of years.
But there’s one asset class in particular that is much younger than these more established options. We are, of course, talking about digital assets.
As an asset class that has yet to fully mature, there’s a lot of buzz and excitement around digital assets and the potential opportunities that they present to investors. But there’s also a lot of confusion as to what exactly digital assets are, what they aren’t, and the risks inherent in investing in them.
Below, we answer these and other questions so that you will be able to make a more informed decision about whether or not these assets belong in your investment portfolio.
What is a digital asset?
To understand what a digital asset is, it’s first important to understand the technology that makes them possible: Blockchain.
Simply put, a blockchain is a ledger containing entries recording transactions. The primary difference between blockchain and other databases is that it’s distributed. This means that instead of being held in one central location—where data could theoretically become corrupted, manipulated, or otherwise adulterated—blockchain is shared amongst multiple nodes of a computer network. This network is continuously verifying the accuracy of the data, and once a "block" of data is authenticated, time stamped, and added to the chain, its data can never be changed.
This is what allows digital assets to exist. The fact that data in a blockchain cannot be manipulated or adulterated essentially serves as a way of proving who owns what digital asset. For this reason, blockchains are also sometimes called distributed ledger technology (DLT). Because blockchains are not centralized in the same way as fiat currency, the technology has become known as "decentralized finance” or DeFi.
With all of this in mind, a digital asset (in investing) is exactly what it sounds like: An asset that exists virtually on the blockchain. This could be a digital representation of a real-world item, such as a home or piece of art, or it could be an asset which exists only virtually.
Types of Digital Assets
Cryptocurrencies are a form of digital asset that are essentially meant to act as virtual currencies. This means that they are designed to be used in transactions, for example to buy a good or service. They are secured by a technology known as cryptography, which is the study of secure communications techniques that allow only the sender and intended recipient of a message to view its contents. This is where the “crypto” portion of the name comes from.
True cryptocurrencies by definition must exist on their own native blockchain. Bitcoin (BTC), Ethereum (ETH), and Ripple (XRP) are some of the largest cryptocurrencies, which you may have heard of.
Tokens are often referred to as cryptocurrencies, but there’s an important difference between the two. Whereas cryptocurrencies exist on their own native blockchain, tokens do not. Instead, they exist as an additional layer, or application, on top of an existing blockchain.
Ethereum, for example, is a very popular base layer that many DeFi protocols (and their respective tokens) are built on top of. In this scenario, you might think of Ethereum as the operating system for a smartphone, with various secondary protocols and tokens acting in the same capacity as apps.
A stablecoin is a type of digital currency that pegs its value to an external reserve asset in an attempt to eliminate (or dramatically reduce) price volatility. This reduction in volatility creates confidence in the system so that holders of stablecoins will actually be comfortable using them for transactions. The US dollar and gold are two common reserve assets for stablecoins.
Tether (USDT), USD Coin (USDC), Dai (DAI), and Binance USD (BUSD) are some of the better-known stablecoins, though there are many others.
4. Non-Fungible Tokens (NFTs)
A non-fungible token (NFT) is a type of token that is capable of representing an asset on the blockchain. Because they can only be owned by a single person at any time, and because they’re secured by the cryptography of the underlying blockchain, they can be an excellent means of communicating ownership records.
What kind of assets can be represented by an NFT? Literally anything. Art, music, real estate, collectibles—even jpegs of apes—can be converted into NFTs, and then bought, sold, and traded based on demand.
Most NFTs exist on the Ethereum blockchain, but other protocols also support them.
Challenges for Digital Assets
While digital assets have many champions, the asset class also faces a number of challenges which you should be aware of before deciding to invest.
Perhaps the most important of these challenges is the fact that digital assets are largely unregulated at the moment. Without regulations in place, investing in digital assets is risky, and risk begets volatility. First, it means that there are fewer protections for investors, especially when you get into the realm of tokens and their various projects.
But beyond that, there’s no way of really knowing how governments might choose to regulate digital assets in the future. While it seems increasingly likely that digital assets will eventually be regulated in a similar way to stocks and bonds, doing so may cause volatility in their value. Additionally, it’s entirely possible that governments might take the step of banning digital assets altogether or of making them illegal, as China and other countries have already done.
Without a regulatory framework in place, it’s impossible to truly know what the future of digital assets will look like, and this makes them particularly risky.
It’s also worth pointing out that the rise of digital assets has had a negative environmental impact as well. The processes of transferring NFTs and of mining various cryptocurrencies, for example, currently require an exorbitant amount of energy, which may have a non-trivial impact on greenhouse gas emissions and other environmental concerns.
Should digital assets be in your investment portfolio?
While risk-averse investors might look at the discussion above and decide that digital assets aren’t for them, investors who can stomach a bit more volatility in their portfolios might turn to these assets as an opportunity. In fact, the very fact that digital assets are risky is precisely why it can be smart to include them in your investment portfolio, because that risk has the potential to translate into yield. Of course, that doesn’t mean that they’re for every investor, either.
In order to understand whether or not you should include digital assets in your portfolio, you should first ask yourself the following questions:
What is your risk tolerance?
What is your investment timeline?
What are your financial goals?
How much am I willing to lose on this investment if it goes to $0?
By answering these questions, it’ll be easier to determine what percentage of your portfolio is wise to allocate to digital assets—as well as to other alternative asset classes, such as commodities and real estate.
Here at Allio, we believe that cryptocurrency has exciting potential to help build the infrastructure of tomorrow’s technological and financial ecosystem but currently as an asset, doesn’t have the regime in place to drive its price up. Bitcoin, due to its limited supply could come into high demand if the global financial system ever experienced hyperinflation. Rather than have our clients purchase a wallet or trade on a messy exchange with hidden fees to purchase coins, we prefer to seek this upside via the use of an ETF which includes the added benefit of not being directly exposed to the speculative underlying asset. That said, they are still volatile and investors should only purchase them if they’re willing to lose that entire portion of their portfolio. For that reason, we offer our clients the choice for whether they’d prefer to have crypto exposure, alongside traditional asset classes—like stocks, bonds, commodities, and real estate— for a truly diversified macro investment strategy.