Bitcoin and cryptocurrencies are known to be highly volatile. (REUTERS)

Bitcoin and other cryptocurrencies saw extreme volatility on Wednesday. Bitcoin, for instance, started trading at $42,945. It reached a high of $43,546 during the day, dropped to a low of $30,681, and finally closed the day at $37,002.

Personal finance and investing mean different things to different people, but a few broad principles make sense for all of us to follow. And some investors learnt these old lessons of investing for the first time on Wednesday. Let’s take a look at this pointwise.

1) Bitcoin and cryptocurrencies are known to be highly volatile. They go up too fast, and they fall quickly as well. On 14 April, bitcoin touched an all-time high of $64,863. From that high, it fell by 52% to the recent low of $30,681.

A 50% fall wipes out a 100% gain. Hence, investors, and there must have been many who bought bitcoin at all-time high levels, need to wait for the cryptocurrency to rally by 100% or more to recoup their losses.

2) One reason that gets offered for investing in bitcoin is that every time the price has fallen, it has gone on to newer highs in the time to come. The trouble with this argument is that just because something has happened in the past doesn’t mean it will continue to occur in the future as well. As an investor, one needs to prepare for the possibility that bitcoin prices may not repeat the same behaviour.

Nassim Nicholas Taleb calls this the turkey problem. As he writes in Anti Fragile: “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief—right when its confidence in the statement that the butcher loves turkeys is maximal.”

This is a point that needs to be kept in mind while investing.

3) The price of bitcoin closed at $30,433 on 27 January. On 13 March, it closed at $61,243, a return of a little over 100% in just one and a half months. Anyone who had invested on 27 January would have been sitting on a high profit on 13 March. But what about investors who invested on 13 March? They’d currently be sitting on huge losses.

The moral of the story being that high risk doesn’t always mean high return. It can also mean huge losses. This is another factor that needs to be kept in mind while investing.

4) Of course, believers can argue that one needs to ignore this volatility. But that is only possible if an investor has followed the oldest cliché in investing, which is, don’t put all your eggs in one basket or what experts like to call diversification. Don’t invest all your money in a single asset class. Spread it out between different asset classes and even within an asset class.

As of yesterday, many people in their 20s and 30s, learnt this investment lesson, like every generation of investors. The last generation learnt it by betting big on real estate in the noughties and then spent the teens realizing that all their money was stuck in an asset class that was not easy to sell in case of an emergency.

Investors who had bet their life on bitcoin when it was around its all-time high levels, and god forbid they are facing a money emergency now, must be in a spot of bother.

The point is that if you are investing in a cryptocurrency, given its volatility, it shouldn’t be your principal investment. It should be limited to 5-10% of your portfolio so that it provides the icing on the cake if prices go up and one is not ruined if prices crash.

5) While cryptocurrency believers might believe that prices will continue going up and reach astronomical levels, there are solid reasons that this may not continue forever. Also, remember that random comments from influencers–those who invested in it and even those who haven’t–can affect the price of this asset class.

The investing principle here is that it is important not to get emotionally attached to any investment like many investors do, which leads to an escalation of commitment. The idea behind all investing should be not just “return on capital” but also “return of capital”.

6) Finally, if you invest in cryptocurrencies and don’t believe in spreading your investments, ensure that you have a strong heart.

Whether you believe in cryptocurrencies or not, following these principles will ensure that your investments move in the right direction in the long term, simply because investment fads are exciting but temporary; the principles are boring but timeless.

Vivek Kaul is the author of Bad Money.

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(Excerpt) Read more Here | 2021-05-19 23:57:42
Image credit: source

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