Cryptocurrency Investing: High Risk, High Returns?
Cryptocurrencies are an exciting new asset that most people may have come across. On one hand, the technology underpinning cryptocurrencies are seen as a revolutionary innovation that can disrupt the way we do things. On the other, cryptocurrencies have often been in the spotlight as being an extremely risky investment that can make you lose everything. Are cryptocurrencies a worthwhile investment?
Cryptocurrency Market Overview
It is a fact by now that the cryptocurrency market is an erratic environment with tremendous volatility. Perhaps the best representation of the cryptocurrency market’s volatility was more than a year ago in 2018, where prices plummeted by close to 80% in just 8 months. Prior to that, the cryptocurrency market was growing at a rate of over 4,700% in just one year, which is a mind-boggling rate of return that retrospectively, is unsustainable.
The bear market in 2018 is a stark lesson for many in the cryptocurrency market on the intense volatility of cryptocurrencies. Within a short span of two years, cryptocurrency prices have intensely fluctuated. As a result, many have viewed cryptocurrencies to be a highly unstable asset class fuelled by uncertainty and speculation. The largest and most popular cryptocurrency, Bitcoin, experienced tremendous growth in 2017, increasing in price from approximately $700 to a high of almost $20,000! That is an astounding rate of return of over 2700% in just a span of twelve months!
It is therefore, no surprise that a great deal of people jumped on the cryptocurrency bandwagon during the bull run in 2017. However, the exponential growth was fuelled by speculation rather than pure fundamentals, and it was inevitable that a market pulback was on the horizon. In 2018, the market popped and the size of the cryptocurrency market fell from an all-time high of $810 billion to a mere $100 billion, with the general prices of all coins falling close to 90%.
That being said, there are still stories of individuals making a tremendous amount of money through cryptocurrencies. Although many are aware of the disruptive and elegant technology, the allure of investing in a complex and risky asset has– more often than not – overridden the fundamentals of the technology.
Investing vs Trading
When evaluating cryptocurrencies as a possible investment, it is important to first understand the capacity of an individual. Investing and trading are fundamentally different capacities which carry a different set of risk profiles attached to each. Let us explore the finer details between these differences.
There are generally five salient differences between an investor and a trader. An investor has a longer-term approach towards the future expectations of their assets, while a trader has a shorter-term horizon. The frequency of trades made by a trader would be more frequently since they are chasing for short-term price appreciation in the cryptocurrency market.
This makes trading a much riskier proposition in a market which is already inherently risky in the first place. Short-term trading is seen more as a speculative play that can significantly increase the risk profile of an individual. Investing, on the other hand, focuses on the fundamentals of the technology which can take a long while to materialize. It is much easier to bet on the state of the technology five years from now rather than betting if the price of a cryptocurrency would reach a certain price point within a couple of days. The short-term volatility of the market’s price action is viewed as a temporary occurrence and should not bother an investor.
It is therefore recommended that those who are keen to invest in cryptocurrencies should initially take a longer-term approach, since active trading requires a technical skill-set that takes a certain amount of time and experience to embark on. Of course, risk-takers would be inclined to engage in frequent trading in the pursuit of short-term gains. This initial stage of identifying one’s capacity – either as an investor or trader – forms the initial foundation for calibrating one’s risk-return tradeoff.
The risk-return trade-off is perhaps the single most important financial principle that essentially states that the level of risks that one chooses to undertake will directly affect the potential returns that would be generated from the investment. In other words, you need to take a higher degree of risk to gain a higher rate of return.
It is a fact that everyone has different levels of risk tolerance for their investments. For example, a retired pensioner would most likely possess a very low-risk tolerance in order to preserve their wealth at their old age. The types of investments that they would undertake would be in the form of low-risk investments that include highly-rated government bonds, highly-stable blue-chip stocks, pension funds, mutual funds, or that regularly distributes a passive dividend income. Alternatively, a 23-year-old millennial would most likely possess a higher risk tolerance given their relative youth and would, therefore, .0 be more interested in investing in riskier asset classes that include technology stocks and cryptocurrencies.
Cryptocurrencies are a much riskier investment as compared to traditional assets such as bonds and shares, given the sheer volatility of the market. A cryptocurrency can easily fluctuate in value by more than 10% in a single day, which is unheard of in the traditional financial markets.
The varying degrees of risks associated with different investments require you to understand your risk tolerance level and then proceed to assess if the volatility of the asset is aligned to your risk profile. Cryptocurrencies are perhaps the riskiest asset that you can put your hard-earned money on; it is a double-edged sword that can generate a significant rate of returns but conversely, everyone should be prepared for the possibility of a tremendous loss.
In order to understand risks, volatility is used to measure the degrees of risk that the market is currently experiencing. Volatility refers to the degree of chance of an asset price over time. Stable assets such as government bonds and commodities fluctuate minimally and are therefore considered as low-volatile assets. The prices of assets that are extremely volatile include cryptocurrencies, where prices can move up or down in double digits within 24 hours. The volatility of the cryptocurrency market is due to a wide variety of factors that include:
- Relative Infancy: Cryptocurrencies are relatively young as compared to traditional financial assets. Just as the stock of internet companies were volatile during the first few years, cryptocurrency follows a similar life-cycle motion. New technologies take time to be perfected and adopted by the greater public.
- Illiquid: Due to the infancy of the market, there is less trading activity and participation as compared to the traditional markets. A market that lacks liquidity is vulnerable to sudden and sharp fluctuations in prices, since large orders by well-funded individuals can move the markets and directly influence price instantaneously. This is due to the lack of market depth, caused by an insufficient number of market participants and orders in the marketplace to absorb the potentially large orders that can significantly move the markets.
- Speculation: The early stages of a new technology entails a great degree of speculation regarding its future. Currently, it is difficult to quantify the values of any cryptocurrency based on traditional fundamental analysis. For this reason, many engage in speculative bets based on market sentiment, hype and emotions. This creates a market which is extremely volatile and unstable.
- Lack of Regulations: The cryptocurrency market faces a credibility risk due to the absence of uniformed regulations across all countries. Digital assets are largely unregulated due to the complexity and the difficulty in regulating an open-source, distributed technology. With a lack of a regulatory framework, it is inevitable that the market is filled with bad actors that would manipulate the markets since there is no supervision. In fact, it is commonly known that cryptocurrency exchanges themselves engage in manipulative practices to shore up their overall trading volume.
Scams & Hacks Everywhere
The unregulated nature of cryptocurrencies creates a hotbed for numerous scams and shady activities that possess a singular purpose of cheating others. According to a report by CipherTrace, approximately $1.7 billion in cryptocurrency had been obtained through illicit means in 2018. Making matters worse, the total amount of cryptocurrency hacks in 2018 reached $865 million, which is the highest recorded value since the inception of cryptocurrencies. As it stands, a cumulative total of $1.5 billion has been hacked or compromised from cryptocurrency exchanges. These statistics are a staggering indication of the level of risk that the industry faces, especially given the lack of awareness and understanding regarding the finer technical details when it comes to storing one’s coins.
The security risks of owning cryptocurrencies is a tremendous weight for everyone, especially when the complexity of the technology makes it harder for the average Joe to understand the best practices in securing his coins. A great deal of education and awareness is needed to address these security risks.
Investing in cryptocurrencies is a high-risk proposition for most people, given the extreme infancy and complexity of the underlying technology. Not only are there great financial risks related to investing in cryptocurrencies, users must also contend with a great deal of security risks in owning cryptocurrencies. On the bright side, the conception of a new technology and industry entails a great deal of opportunity, especially one that can disrupt the way we do things.
The above content is for informational purposes only and should not be construed as any type of advice. All trading involves risk of capital loss. Digital Assets trading also involves additional special risks not generally shared with official currencies, goods or commodities. For more information on the risks please refer to our Risk Disclaimer
* The information above is not investment advice.