Blockchain
Why High Cryptocurrency Volatility Can Be a Good Thing for Investors
Today’s newsletter marks my one year anniversary of curating the Crypto for Advisor newsletter. Time flies when you’re having fun, and it’s hard to believe I’m 52 issues under my belt. Thank you to CoinDesk and especially Kim Klemballa for giving me this opportunity along with all of our valued newsletter contributors who dedicate their time to building this industry, as your contributions are invaluable. As we continue our crypto journey together, I hope to see new contributors and continued engagement with ideas and topics as we strive to provide advisor education globally. Your educational needs, opinions, and insights are what shape this newsletter, as it truly is Crypto for Advisors!
We know the last couple of years have been challenging in the cryptocurrency industry, but 2024 has brought back excitement and energy. We are seeing many exciting product launches and regulatory advancements. I look forward to continuing to provide content to our valued audience and keeping them informed of timely and relevant developments.
In today’s issue, André Dragosch, head of research at ETC Group, discusses the volatility of cryptocurrencies, including bitcoin and ether, and how they compare to other emerging technology investments. Bryan Courchesne, CEO of DAIM, explains how advisors can manage cryptocurrency volatility in client portfolios.
Happy Independence Day to our American readers.
Traditional financial investors tend to avoid cryptocurrencies due to their high volatility.
To be fair, cryptocurrency volatility is relatively high compared to traditional asset classes like stocks, bonds, and most commodities.
Over the past three months, the annualized volatility of bitcoin and ether has been 45% and 50%, respectively, while the S&P 500 volatility has been around 15%.
A recent survey of institutional investors by Fidelity also identified high volatility as the main obstacle to investing in cryptocurrencies.
However, the truth is that high returns come with high risks, namely volatility.
In other words, where there is growth, there is volatility.
Most stock investors know this, as most large-cap, high-growth stocks, like Tesla, still tend to have high double-digit volatility.
Will the tokenization of real-world assets (RWA) take hold and Ethereum become the go-to platform?
Will Bitcoin Replace the US Dollar as the Global Reserve Currency?
While these types of scenarios have become increasingly likely in recent years, there remains a climate of uncertainty surrounding these issues.
Uncertainty tends to create volatility.
Amazon’s story holds important lessons in this regard. In the late 1990s, most Wall Street analysts thought “selling books online” was a silly idea. There was a lot of uncertainty about whether online retailing and the Internet in general would go mainstream.
Just as uncertainty around technology has decreased, Amazon stock price volatility has also decreased over time.
Few investors seem to remember that in the late 1990s, Amazon stock had annualized volatility of over 300%; today, volatility is well below 50%.
We have already observed a similar structural decline in volatility in the case of cryptocurrencies.
One reason is that bitcoin’s scarcity has increased with each halving, making it more “gold-like.” Halvings are best understood as a supply shock that cuts bitcoin’s supply growth in half (-50%). Thus, bitcoin’s character as an asset class has changed over time
While bitcoin volatility was around 200% during the first epoch, the roughly four-year time span between the cryptocurrency’s pre-scheduled “halvings” of miner rewards, up until 2012, has dropped to just 45% more recently. Similar observations can be made regarding ether.
In a 60/40 global stock-bond portfolio, the maximum Sharpe ratio is achieved by increasing the bitcoin allocation to about 14%, at the expense of the global equity weighting.
The Sharpe ratio of major cryptocurrencies such as bitcoin or ether is significantly above 1, meaning that investors are more than compensated for being exposed to greater volatility.
Looking ahead, the decline in volatility is set to continue with each new halving. The next one is scheduled for 2028.
The increasing adoption of this technology by institutional and retail investors is also expected to structurally reduce volatility over time.
The reason is that increasing heterogeneity among investors will lead to greater dissent among buyers and sellers, which will dampen volatility: the essence of Edgar Peters’s fractal market hypothesis.
Remember: where there is growth, there is volatility.
Q. How can advisors help their clients manage cryptocurrency volatility?
A. Cryptocurrencies, in their short history, have undoubtedly been a volatile asset. But that doesn’t mean they should be ignored by advisors. Advisors shouldn’t look at assets in isolation, but rather how they interact with others in a well-balanced portfolio. Diversification is key when building a portfolio that can deliver long-term results. Asset prices move in cycles, sometimes together but more or less distinct. This can be measured by an asset’s correlation with other assets. A lower correlation means the assets are less likely to move together. If one asset is up 35% for the year, another asset might only be up 4%. If assets are negatively correlated, one asset will rise over a given period while the other falls. This is important in the context of an investment portfolio because while assets can be volatile on their own, including them with other, less correlated assets can reduce the overall volatility of a portfolio.
Q. Is there a correlation between the volatility of cryptocurrencies and that of other assets?
A. In terms of correlation, a volatile asset like cryptocurrency is actually very important to reduce the overall volatility of a portfolio. Reducing the overall volatility of a portfolio is important because it helps to smooth out investment returns over time. This is important for many reasons. For example, an investor may have significant and unpredictable liquidity needs. If they have a portfolio of highly correlated assets and those assets are experiencing poor returns, they would withdraw a larger percentage of their portfolio than if they were to have a portfolio that included less correlated assets. Cryptocurrencies, having a low correlation to traditional assets, could help in this regard. Their volatility has historically been positively skewed, so even if it has large swings, when all other assets are down, it can provide a cushion to your portfolio. Smoothing returns also helps from a cognitive perspective for most investors. People can get too emotional when looking at their portfolio performance. Big price moves have a visceral effect, where big moves up make people want to buy more (usually right before a dip) and big moves down make people shy away and pull out (right before performance rebounds). Including at least a small portion of cryptocurrency (less correlated) in a portfolio smooths out its returns, so when investors check in, they see more modest gains or losses. This helps keep the portfolio out of sight and mind, which generally improves the chances of long-term success. Cryptocurrency, while volatile, should not be viewed in isolation, but in the context of how it can help create a truly diversified portfolio that will help build long-term wealth for investors.
Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.