Ever since their invention, Bitcoin and cryptocurrencies in general have been characterized by very sharp and amplified price movements.
Both in the upward and the downward direction. This makes them extremely volatile assets.
In this article I take a look at the downsides to Bitcoin and cryptocurrency investing.
Let me say first of all that I’m a Bitcoin and cryptocurrency enthusiast, both from the tech and innovation side, as well as from the investment perspective.
But like all investment assets, cryptocurrencies are not without their risks. And it’s important to be aware of them and to know how to handle them.
Bitcoin and other cryptocurrencies have seen enormous value appreciation in recent years.
From 2011 to 2016 the value of Bitcoin increased by an incredible 14,600%. No, that’s not a typo. 14 thousand 600 percent.
In just one year 2015 to 2016, it appreciated by around 1,000%. And from 2016 to 2017 by over 500%.
But there have also been very severe and substantial falls in the Bitcoin price.
The latest of which in 2018 saw the Bitcoin price fall from a brief peak at around $19,000 to around $3500 by early 2019. That’s a fall of over 80% in just over 12 months. So it isn’t all sweetness and light with Bitcoin by a long way.
One characteristic of cryptocurrencies that becomes clear right away is that they don’t behave like typical forex currencies. Fiat currencies experience price fluctuations are usually only within several percent or so in the medium-term, and 10, 20, or 30 percent or so in the longer term at most.
And in the short term, most forex currencies move at a snail’s pace compared to crypto.
Nor do cryptocurrency price movements behave like typical stock market shares. Crypto is far more volatile than even the most volatile of quoted stock market values.
So if you invest in crypto, you are by definition investing in something which is extremely high risk.
This has consequences for portfolio planning.
Risk and Reward Are In Inverse Relationship
Risk and reward in investing are generally in an inverse relationship. The more profit potential, the greater the risk. It’s hard to avoid this fact as it seems to be pretty well a tautology right across investment asset classes.
And Bitcoin and crypto are no exception here.
Crypto is like a crazy high-performance roller-coaster. It can be an exciting and exhilarating ride up – and a terrifying ride down again.
And it can happen extremely fast. The massive sudden price appreciation Bitcoin experienced in late 2017/early 2018 came very suddenly. For much of 2017 the Bitcoin price movement was relatively lacklustre. Then it suddenly took off and went “bananas”.
I’ve experienced at least two such sudden massive price increases in Bitcoin. These sudden movements are dangerous, make no mistake. People get sucked in, euphoria takes hold.
What I should have done when this happened in 2018 – but didn’t – should have been to move much of my crypto holdings out of the sector and into stocks and other asset classes.
Instead I, like most other people at the time, was looking forward to higher and higher gains and price appreciation. And I was also heavily geared in altcoins as well, denominated in Bitcoin.
Then the market began its slow but sure trek downwards. Fortunately I had moved out of some altcoin positions, but my exposure was still too great. Lessons learned and all that.
Cryptocurrencies Are Not Like Traditional Assets
Cryptocurrencies are relatively new forms of assets. And they have different characteristics to traditional assets. As a result, some investors, notably Warren Buffet, tend to scoff at them.
And I can see their point. Compared to stocks, cryptos have little if any physical assets behind them to back them up and support their price. There are some few exceptions, but most cryptocurrencies are not backed by physical redeemable assets.
Nor do many of them provide any form of dividend or interest payment. There are exceptions here – most notably the Proof of Stake altcoins. But they are exceptions. Proof of Stake is becoming more popular, but it is not standard across cryptos by any means.
The position of cryptocurrencies is for this reason more akin to commodities such as gold or silver. Like gold, cryptos rely to a large extent on market sentiment.
There are some cryptos which serve specific functions and which do have a specific utility in themselves – and these can be worth looking at. But for many cryptocurrencies – perhaps the majority, the motto has to be “buyer beware”.
Now I’m a crypto and blockchain tech enthusiast. As an IT professional I’ve had close technical involvement at the sharp end.
But I’m also aware of the shortcomings and limitations of the crypto sector. And I think there is more hype and hot air in the crypto field than in practically any other industry or startup sector.
So don’t fall for it. Treat all promises and grandiose “changing the world” schemes with a substantial pinch of salt.
Also beware especially of ICOs or “initial coin offerings”. These are especially dangerous. When I started investing in altcoins a few years back I was enthusiastic about ICOs.
I’ve since become far more skeptical. Most ICOs I won’t even consider nowadays. An ICO has to have a very solid value proposition for me to even go near it. Most of them just don’t make the grade.
Tech startups are by their nature high risk ventures. And a tech startup which offers you a coin instead of a share or company stock is the riskiest of all.
ICOs are a way for startups to get their hands on your hard fiat currency and give you unproven, unbacked, toytown crypto currency in return. They are the riskiest of riskiest crypto investments.
Blockchain Hype Is A Constant In Crypto
There is a great deal of hype and optimism in the blockchain tech industry. Optimism is no bad thing – nothing happens without taking a positive view of the future. But with optimism in such a new sector also comes hype and inflated expectations.
We saw a great deal of this in the altcoin sector in 2017 especially.
We experienced something rather like the 19th century railway mania in Britain and US when railways were suddenly being constructed all over the country.
Lines were built even extending to the smallest hamlet towns and villages and large terminus stations were constructed and duplicated in big cities. It was assumed there would be a never-ending stream of passengers with no limit in sight.
Within a short space of time the country was over-provisioned with railway capacity.
Then suddenly the railway mania collapsed. Railway companies went into liquidation or were taken over. A rationalization and merger phase took over. Then eventually, some decades later, the entire sector was nationalized.
In the crypto sector, the “railway mania” of 2016 and 2017 has since quietened down somewhat, but the hype and overly inflated expectations are still present. Investors should beware.
Blockchain tech is touted as a cure-all and a “disruptor” for all manner of industries, services, and sectors. And blockchain does indeed have something to offer some industries. But hype is still hype. Blockchain is not a wonder-technology.
Because sentiment plays such a major role in cryptocurrency valuations, given the lack of underlying physical assets, it means that these currencies are highly susceptible to hype and opinion, as well as herd investor movements.
And over-valued assets can still crash, blockchain or no blockchain. They will be found out. So it’s important to be aware of the dangers.
How to Manage Risk in the Crypto Sector
So what does this mean for do it yourself investors? Is crypto too risky? Should we just stick with the stock market?
I think cryptocurrencies and blockchain have great future potential both as a technology as well as for investing, trading and holding.
But you have to understand and accept that these are the most riskiest of asset classes of all.
I should know – I have played with them. I’ve made handsome profits. But I’ve also experienced substantial losses – as have many people. So caution is advised.
Here are some things to watch.
Limit crypto exposure
The important thing to do is to limit your fund’s exposure to the crypto sector. Watch your portfolio asset class ratios. Set your risk exposure ratio that you are most comfortable with, bearing in mind the market situation in the different asset classes that you are invested in and the level of risk you are prepared to accept.
Diversify your crypto holdings
It’s important to hold a diversified altcoin portfolio. Don’t just be invested in 4 or 5 different coins. And don’t invest in just one or two types of coin. Spread your crypto portfolio across a range of different types of token – money tokens, utility tokens – of which there are many different sectors, and security tokens which are backed by physical assets. The trading market in security tokens is limited at present, but the number and range on offer is increasing all the time.
Take the time and trouble to research different crypto sectors and tokens and make a list of those which have solid characteristics in terms of development teams, capital backing, technical and market viability, strong market valuation and sound future prospects.
Remember that most of the crypto coins on the market do not make the grade. So the process involves a shake-out analysis.
Avoid swing-trading in trash coins
Don’t be tempted to buy into trash coins just because of a sudden sharp upward price movement. Small low value coins can very suddenly shoot up by large percentage amounts which tempts some traders into jumping onto the bus.
Unless you get in really early, the chances are you will end up regretting it. These sudden price movements out of the blue for small value coins are almost always short-lived. I should know – I’ve tried myself to jump on enough of these swing-trade crypto buses in the past and have lost out. They’re a classic example of the worst aspect of crypto volatility. Unless you have money to risk burning, you should steer clear.
Swing trading on high value coins in the top 40 or 50 is another matter. Swings can also be volatile for these coins, but they are less likely to be as extreme as for the lesser-known tokens at the bottom of the hierarchy and they are less likely to crash to nothing or near nothing. But again – it’s still a risky strategy, so only do it if you feel the risk-reward ratio is in your favour.
Move out of crypto on a downturn
Move money out of crypto quickly on a downturn. When the market looks like it is entering a bear phase and turning sour, don’t stick around to wait and find out. That way you protect your capital. Don’t sit around and wait. It’s far too risky.
So how do you know when the crypto market is turning?
Well, for one thing the moving averages are important. Keep an eye on the 60, 90, and 200 day averages. If you see a downward cross looming, then that’s a strong sign.
Secondly, parabolic fast upward moves are almost always followed by a fallback. If there”s been consistent and very strong sudden upward movement, then it’s likely it will be followed by a downturn.
Always prioritize capital protection and risk reduction. Don’t push your luck and your risk too far.
Risk reduction means keeping your crypto exposure under control.
Watch your margin trading very carefully
Monitor your margin maintenance reserve at all times. And know 24×7 what the market is doing and where it is going. If things look like they are turning sour, close your position.
Shorting can leave you short
Likewise with shorting. Shorting can be a profitable response to a market downturn and all professional traders have shorting strategies. But as with long trading on margin, shorting can also be high risk, especially in such a volatile market as crypto.
The watchword as always is “watch the market all the time”. And be ready to close your short position/s when the trend turns.
It should also go without saying that you should always set stop levels for all margin trades whether short or long. Crypto however is much more volatile than the average stock market position. So you will in most cases want to allow a little more slack in setting the stop levels than you would for a traditional stock.
Just make sure your margin maintenance reserves are adequate to cover the increased volatility amplitude to avoid the position being called and closed automatically before you reach your set level.
Watch your altcoin/Bitcoin gearing
Also don’t go too heavily into altcoin/Bitcoin pairs. When the market is doing well and going up up up, everyone is feeling great and you’re enjoying the ride. I’ve done it often enough.
But it can quickly turn the other way, and then your altcoin-Bitcoin gearing very suddenly becomes a curse. Get out of altcoins quickly or at least substantially reduce your exposure. I always watch my gearing ratio here.
Also, remember you can hold some altcoins directly paired with fiat, rather than always having to use Bitcoin, unlike what used to be the case a few years back. This helps to reduce the risks of gearing.
So those are some tips for reducing your risk in the crypto sector. Good luck and safe trading!