I lost the first bitcoin I had, shortly after the first Mt. Gox compromise. If you haven't lost coin yourself, I'm sure you've heard of those who have. The reasons vary, but all come down in the end to a lack of experience and education.
As we go about bringing bitcoin more into use in our day-to-day lives, it becomes important to have a basic understanding of what bitcoin is, how it works, and how we can use it without putting our value at unnecessary risk.
A very short primer on Bitcoin and the Blockchain
Firstly, Bitcoin is a layer on top of an accounting abstraction implemented in software called 'the blockchain'. Think of the blockchain as the network, and bitcoin as a protocol running on that network. Some have called the blockchain a 'peer-to-peer ledger', and they have the peer-to-peer part right, but it is very much more journal than ledger. It 'contains' a large list of transactions. The people who run the programs or 'nodes' that record the transactions are paid in bitcoin, and the 'records' they create are called 'blocks'.
It's important to note that bitcoin transactions are stored cryptographically. No one actually 'holds' the coin; they hold cryptographic keys to the coin. These keys come in pairs, one public and one private. The public key is used to check the balance and make deposits; the private is used to 'sweep’ or collect the coin from the key pair. Every transaction represents a movement of some value, and so that value is always finally 'stored' in some key pair. The point is, the key pair is the wallet; not the paper it's printed on, not the website holding your coin, not the software in your mobile phone.
The disposition of your coin is under the control of whoever has the private keys.
People like to say that bitcoin is a 'digital currency'. That's not quite right, for all that it is wed to networks and the Internet; it is more accurately described as a 'cryptographic currency', or 'cryptocurrency'. In either case, the same sort of common sense rules apply as if you were using cash or a line of credit through a bank.
It is good to form a habit of asking yourself what you are doing with bitcoin today. Investing? Buying a product or service online? Selling some bitcoin in person? There are many things you might be doing with bitcoin; being very aware of what you are doing and what you hope to accomplish helps avoid missteps and losses. The key is, do one thing at the time, and only keep coin on your person (or accessible on the Internet) that you intend to dispose of in the near term. If you are sweeping your cold storage to your mobile to have funds for coffee and donuts for your office, you should probably be a little more careful.
There are many companies offering many services in the marketplace. Before signing up for a service, make certain you understand the services provided and how those services solve problems for you. For instance, if you aren't going to be actively trading, you probably don't need to go through the hassles of signing up for a full exchange account.
In it's finest essence, the 'wallet' is the public/private key pair. However, the way in which the wallet is implemented in the physical world is of considerable importance.
Let us suppose for a moment that we can all memorize our key pairs with complete accuracy, and as many of them as we will need. We could safely store bitcoin in these wallets without any problem at all. However, we can't do that, so we need ways of recording the keys, and retrieving them as needed; and some ways are more convenient for some purposes than others.
Types of Wallet
Let us briefly break down the various types of wallets. Firstly, there are web-based wallets. These might be associated with a service. If so, they are likely to be attached to the service via a sidechain for purposes of paying for the service or perhaps trading. Then there are web wallets as such as a service; the primary usefulness of which is convenience. There are also the hardware wallets, which generally provide some electronic security and some key storage. Lastly, the so called 'paper wallet', which can take many physical forms. The important thing to remember is that the key pair is the wallet; these physical implements simply encode and store key pairs.
Each type of wallet is useful for different reasons, and each has unique security strengths and weaknesses.
Web wallets attached to services are very useful; they facilitate rapid payment for the attached services. Are such wallets good for long term asset storage? It depends on your level of trust in the service provider. Probably not. Are they useful in other respects? Yes, they are indisposable for trading, purchasing coin, or cashing out to fiat currency.
General Purpose Web Wallets
More generic web wallet services are useful in a variety of ways, most of which involve using them temporarily on an as-needed basis. Paper wallets are really any reasonably durable material that has a key pair encoded on or in it. Literal paper wallets are useful for private retention of key pairs according to conventional security practices; e.g., in a safe or safe deposit box. They can also be a convenient means to deliver coin to another party, without using devices.
Mobile and PC wallets are software systems for phones and computers that implement wallets. Wallets on such devices are only as secure as the device. Your level of comfort should vary with the amount of bitcoin on the device at any given time.
Finally, hardware wallets provide the security features of a paper wallet, but typically with an additional layer of security provided by hardware level cryptography.
Security and Utility: Two Sides of the Same Coin
Bitcoin is like any other currency in many respects; if you leave it laying around, someone will pick it up. If you leave it in someone else's care and they get lost, so does your coin. That being said, strategic use of wallets can go a long way to keeping your coin safe and in your control.
Using Service Wallets
Use service wallets only in conjunction with services. Never deposit more than you will spend with the service in the near term, and always sweep such wallets of any coin that will not be used there. Use web wallets only for moving coin; always keep them as near empty as possible otherwise. If the service provider fails, nothing is lost. This is also why we keep service-attached wallets as near empty as possible.
Using Mobile or PC Wallets
Mobile and PC wallets should also be 'normally empty'. This means you should only send as much value to such wallets as you need in order to complete some anticipated transaction, and only for as long as it takes to do so.
Using Paper Wallets
Paper and hardware wallets implement 'cold' or 'offline' storage. This is the safest means of storing coin for longer terms, as it is inaccessible to the network until the 'paper' is swept to a connected device. Be careful with hardware wallets; they often incorporate a second set of keys to protect the first. If you lose these...
By using a little common sense and these best practices with respect to wallets, you should be able to take your place in the cryptocurrency revolution with the confidence that you will neither lose your coin nor fall victim to digital theft.