What is Bitcoin & How Does it Work?

Bitcoin is a type of digital currency, relying on peer-to-peer technology to operate without a central authority.

The technology relies on several properties different from the standard conventions of currencies, positioning it for unique use cases and investment opportunities.

How Does Bitcoin Work?

Core to Bitcoin is blockchain technology.

The blockchain is a shared public ledger that holds the details of all digital tokens that are being created and distributed.

Each of these transactions is grouped into a chronological group known as a block linked to the previous one using a special code.

This setup ensures that no codes are being tampered with since tampering with one block would also require a change to the other blocks.

As a decentralized database, users can determine exactly where each coin is at a given time.

It is worth noting that because no one person or entity controls the database, the integrity and chronological order are enforceable with cryptography.

Since Bitcoin is a digital currency, nothing physical is being transferred between Bitcoin wallets.

Instead, a transaction refers to the transfer of value between Bitcoin wallets, each included on the blockchain.

Wallets then keep a piece of data known as a private seed, or key, which verifies that the contents belong to a given user.

While the private key is comparable to a password, cryptocurrencies are also given a public key similar to an email which allows users to send their digital assets to and from one another.

When this transaction occurs, the details are broadcasted to the network and confirmed in 10 to 20 minutes through a process more commonly known as mining.

Put simply; mining is a consensus system used to confirm pending transactions by adding them to the blockchain.

This process ensures that these transactions occur in chronological order without the potential for tampering, since users must agree on the blockchain’s state.

Advantages of Investing in Bitcoin

Bitcoin is considered by many as a high-risk investment.

However, like all high-risk investments, there is a potential for significant reward.

Therefore, users can’t necessarily ask if they should invest since this question will depend on a given investor’s risk tolerance and goals.

To understand this investment class and some of the decisions that you must weigh, we will start by listing some of the major advantages Bitcoin offers to investors.

Bitcoin Offers High Earning Potential

It’s true that high volatility may scare some investors off.

However, it is also worth noting that with massive price swings comes the opportunity for significant profits.

Consider the price swings in 2020 alone.

At one point in the year, Bitcoin was trading at $20,000, only to pass $40,000 and later $65,000 a few months later.

With an over 300% price increase in a matter of months, it is no secret that Bitcoin can be profitable with the right investment strategy.

Key Insight

To put these earnings into perspective. If you had bought $1,000 worth of Bitcoin in July 2011, you would have had over $2,700,000, 10 years later, a 270,000% return. In contrast, investing these same amounts in the S&P 500 over the same period would have resulted in a 238% return.

The Markets Never Sleep

In contrast to traditional markets with a specified open and close time, crypto markets are always available.

Therefore, those wanting to make a purchase can do so at any time of the day, even if they are long outside of market hours.

Additionally, cryptocurrency can be a way to generate returns for those looking to earn income outside of their traditional working hours.

Putting Your Eggs in More Baskets

Diversification is a common technique that investors use to reduce their investment risk by allocating funds across various financial instruments and industries.

The intent is that by spreading out one’s investments, users can maximize returns, since an event that may affect one industry negatively may not affect the others.

Therefore, Bitcoin, which represents an entirely new asset class, can be a great way to diversify one’s investments.

Complete Asset Control

One great thing about Bitcoin is that investors retain complete control over Bitcoin, unlike an investment that may be purchased through a broker and stored through a brokerage account.

Since no central party is involved, investors don’t have to worry about their assets being frozen or leaving their life holdings in the hands of someone who isn’t them.

Deflationary by Nature

As the great economic laws of supply and demand state, the more rare an item is, the greater its value.

Traditionally, more money is brought into circulation when central banks choose to print it.

Naturally, this can be detrimental to the value of a given fiat currency.

In contrast, the total amount of Bitcoin is fixed, with coins slowly being released into circulation at an increasing difficulty over time.

Therefore, by investing in these assets, users can have the peace of mind that their assets will only go up in value (in theory).

Lady holding a Bitcoin token looking coin

Disadvantages of Bitcoin

It’s true the potential for profit is incomparable.

However, like other investment opportunities, there is downside that one should be aware of.

Potential for Major Losses

Bitcoin is still considered an emerging asset class.

With its rise in popularity, investors must be ready for prices to swing significantly with headline-making events that may influence buyer beliefs.

Furthermore, since this market is still small compared to traditional asset classes like gold, smaller forces have greater influence.

The market size makes for higher highs and lower lows to occur within a short period, adding to the risk level that an investor must account for.

Limited Regulations

In comparison to the traditional market, investing in Bitcoin offers little oversight since cryptocurrency laws and taxes are still in the process of being set, leaving some ambiguity.

Unfortunately, with a lack of regulation, this leaves the door open to fraud and scams, adding to the uncertainty vs a traditional market.

The Risk of Missing Assets

Another disadvantage worth considering is the risk of loss.

Bitcoin users typically keep their assets in what is known as a cryptocurrency wallet.

Since many of these wallets require an investor to hold onto their own key (or password), they risk losing their investments if they forget where it is written down or misplace their physical key.

Alternatively, devices aren’t perfect, so if a hard drive crashes or a virus corrupts a device, funds may disappear with no support in sight.

Cyberattacks and Hackers

Bitcoin faces another risk when it comes to storage.

Hackers, recognizing the increased value of Bitcoin, often turn to cryptocurrency exchanges as a jackpot.

Unfortunately, those storing their assets in this manner have often found themselves out of luck when significant amounts of funds have vanished with no solution for return.

Fortunately, proper storage eliminates this otherwise disadvantage.

What Can Bitcoin Be Used For?

Bitcoin was designed as an alternative form of payment in everyday transactions, with the opportunity to use it online in place of a credit card.

Many well-known companies are already accepting Bitcoin as a form of payment, including Microsoft, PayPal and the American retailer Overstock.

The advantage is that Bitcoins can be used to buy merchandise anonymously, without putting personal details like credit card details on the line.

Small businesses also benefit by skipping the high fees to accept credit cards, increasing their margin.

Purchases are only one of the potential uses for Bitcoin.

Another benefit comes from the ability of Bitcoin to operate despite borders.

Since these assets aren’t tied to a country, Bitcoin provides use for remittance and other international payments.

Furthermore, because cryptocurrencies can be accessed with a mobile device, they allow those considered unbanked to receive funds directly.

Lastly, others still look to Bitcoin’s rising prices as a popular investment, hoping that they will go up in value.

Even if they don’t, the deflationary value of the asset presents itself as a hedge against inflation.

Is Bitcoin a Scam?

Many believe Bitcoin is a scam, often associating the cryptocurrency with a pump-and-dump scheme.

In this situation, a person or given set of people artificially drives the price of an asset up to dump their holdings for a profit later.

Other negative opinions come from the anonymity of the asset, which makes it a strong contender for supporting crime.

However, despite these claims, Bitcoin is not a scam.

Instead, it is widely recognized as a legitimate digital currency that offers several advantages over traditional fiat currency, including user autonomy.

This feature ensures any user can send or receive payments without requiring approval from traditional authorities or the bank.

Despite these benefits, many still have a negative association with Bitcoin out of fear.

Since the technology is complex, many do not understand the new system and its intricacies, especially since it is substantially different from the traditional system they are familiar with.

Alongside the unknown is the fear of change, which leads many to question what a new system will mean for them.

Should I Invest in Bitcoin?

Determining if investing in Bitcoin is right for you will come down to understanding your personal goals.

If you decide to diversify your holdings or seek an alternative investment strategy, then Bitcoin is likely a good asset to add.

However, if your motive is to invest out of the fear of missing out (FOMO), you’re encouraged to reconsider your ‘why’ before putting a significant amount of your holdings on the line.

If, as an investor, you decide to proceed to the next step in your journey, it is worth noting that your holdings in Bitcoin should never be more than you are willing to lose.

Frequently Asked Questions

  • Can Bitcoin be converted to cash?
  • Who is Satoshi Nakamoto?
  • How Many Bitcoins Exist?

Sarah Jansen is a passionate cryptocurrency investor, copywriter and marketing professional who has been working in the field since 2017. Sarah graduated from the University of Calgary in Canada with a degree in business, where she quickly found her passion in helping people.

She has worked for several major cryptocurrency exchanges, news outlets, and in the content marketing department of a local bank. Starting as a marketing assistant, Sarah quickly specialized in long-form content creation and technical writing. Here, she discovered her place in lowering the barriers to entry for personal investors looking to secure their financial future.

When she’s not staying on top of industry trends, you can find Sarah in the mountains hiking or across the world chasing another bucket list item.