By Alex White, Head of ALM Research, Redington
Cryptocurrencies have also fed off a positive feedback loop. More successful coins are accepted on more platforms, become more liquid and available to more investors, and rise in value.
That said, with crypto ETFs now in the market, should investors buy into the craze?
From a purely mathematical standpoint, the answer is probably ‘yes’. Because the volatility is so high, a very small investment (and therefore very small risk) has a chance of spectacular outperformance. A pension fund with a 90% funding level, for example, could have invested 1% in Ethereum and halved its deficit over the year. A 99% cash, 1% cryptocurrency investment would also have had a worst-case loss of 1%, making it a pretty safe portfolio.
So, why might investors still be wary?
The most obvious answer is the volatility – but this is actually something of a red herring. Crypto vols are extraordinarily high. Bitcoin’s 70% annualised daily volatility seems terrifying, but pales before Shiba Inu’s 216% volatility. Dwelling on that, it means a typical (logarithmic) annual change in Shiba Inu would be over 200%. And it’s not all from the upside either: Nano, XRP, NEM, Litecoin and NEO have all experienced drawdowns over 93%, most notably Nano’s 99% fall. However, that doesn’t by itself mean investors shouldn’t buy it. Analogously to equities, as long as the returns are high enough, it simply means that any holding should be smaller.
Tied into the volatility point, albeit more subtly, is survivorship bias. It’s easy to regret not investing in Dogecoin, but thousands of other coins failed, including Onecoin (fraud), Boringcoin (lack of interest in a ‘joke coin’) and NHCT (which had a valuable goal, but simply failed). Columbia Pacific estimates that around 2,000 coins have failed. Yet we tend to only hear about the successes.
A more qualitative answer is that investors, in general, should avoid assets they don’t understand. Shiba Inu, for instance, has no technical or functional advantages.It started life quite literally as a joke. Its value comes from its popularity as a meme, and from Elon Musk’s tweets. That hasn’t prevented astonishing performance, but it’s hard to see it as economically viable in the long term.
There’s also an open question of how it will fare in the next financial crisis. What evidence we have is mixed. Cryptocurrencies crashed hard in 2018 and early 2020, and the major ones recovered (though many smaller coins failed). Set against that, however, Bitcoin suffered a c.50% drawdown as the pandemic kicked in over February and March 2020. While government action limited the 2020 crash, it suggests that crypto probably won’t offer any meaningful diversification in the downside.
One of the arguments for crypto is that it could be ‘digital gold’, a store of value when confidence in everything else has failed. And it could be. In a major war, for instance, decentralised money may be far more appealing than anything dependent on the government. Right now, though, crypto prices seem to be even more dependent on general market optimism than equities. So the future of crypto may well depend on just how long it is before the next big financial crisis.
https://www.columbiapacificwm.com/blog/insights/general/questions-about-cryptocurrency-here-are-21-answers/
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