Here’s a riddle for you:
They’re hailed by fans as the currency of the future and criticized by some personal finance experts as a dangerous creation.
Can you guess what it is?
Correct, it’s cryptocurrencies.
They’ve recently made headlines after bitcoin crashed about 17% in less than 24 hours, to the delight of many crypto haters who have been ranting on about its volatility for years.
Ever since the mysterious Satoshi Nakamoto published the bitcoin white paper in 2009, digital currencies have been wrapped up in controversy.
While tech giants like Amazon and Microsoft are increasingly getting involved in cryptocurrencies and even developing their own (hello Facebook), some state regulators are cracking down on crypto exchanges, pointing at their extreme volatility and speculative nature.
In this article we explain:
- How cryptocurrencies work
- What makes digital currencies so volatile
- Is it safe to put all your money in crypto
- How to protect your portfolio from crypto volatility
What are cryptocurrencies, and how do they work?
The concept of cryptocurrencies is not as complicated as it might look. After all, most of us are familiar with transferring money from one online bank account to another.
In fact, cryptocurrencies operate like normal paper currencies, but with several notable differences:
- Cryptocurrencies are peer-to-peer payment methods (just like a dollar or euro bill is, except digital), without the banks taking a cut of every transaction.
- There is no physical version of digital money.
Most cryptocurrencies, like bitcoin, ethereum or cardano, use blockchain technology, which is crucial for maintaining a secure and decentralized record of transactions.
How did cryptocurrencies start?
Bitcoin was the first blockchain-based cryptocurrency and still remains the most popular and most valuable to this day.
Since the creation of bitcoin more than a decade ago, the number of existing cryptocurrencies has expanded to over 8,000.
Their total value has recently topped $2.4 trillion, rivaling the two most valuable companies in the world, Apple and Microsoft, and amassing over 200 million users.
But like with almost any asset, there are those who love crypto and those who hate the very idea of it.
What are the pros and cons of cryptocurrencies?
Cryptocurrencies are often criticized for a number of reasons. Mainly it’s because they’re considered too volatile, or a fad, or because of their use in some illegal activities.
But many also praise them for their portability, their transparency, and their divisibility.
Supporters of cryptocurrencies say they make it easier to transfer funds directly between two parties, without the need to use a third party like a credit card company or bank.
Many crypto enthusiasts see digital assets as the future of finance as they allow transactions to sidestep third parties and are not controlled by any government.
Critics, however, usually point at the semi-anonymous nature of crypto transactions which makes them well-suited for some illegal activities, such as tax evasion and money laundering.
But the main risk, according to critics, is their speculative nature and the persistent and extreme swings in the price of bitcoin and other cryptocurrencies.
And this very volatile nature is precisely what makes some investors think these young currencies might not last, as they struggle to stabilize.
As Bill Gates once said, “I do think people get bought into these manias who may not have as much money to spare. So I’m not bullish on Bitcoin. My general thought would be that if you have less money than Elon [Musk], you should probably watch out.”
What makes crypto so volatile?
From the very beginning, the story of Bitcoin and other cryptocurrencies has been one of investors looking at their price going up and down from a few pennies in value to tens of thousands of dollars per token… and down again.
This tendency could be explained by the fact that, when the price of an asset rises very quickly, a crash is usually much more likely to happen in the future.
While some of these crashes are simple “price corrections”, a moderate adjustment in the price of an asset after a rapid increase, some are just sheer drops.
It looks like that’s been the situation of bitcoin throughout its 13 years of existence. The world’s biggest cryptocurrency has still not gotten past its tendency for dramatic ups and downs in price.
And 2021 was no exception.
This year, Bitcoin has been on a rollercoaster ride, rising and falling sharply on the back of a number of news stories, from Donald Trump calling bitcoin a “scam against the dollar” to El Salvador making it a legal tender.
Here’s the summary:
- 16 December 2020: bitcoin price hits $20,000 per coin for the first time.
- 13 April 2021: bitcoin price hits a record high of $63,375.
- 22 June 2021: price falls below $30,000 for the first time in 5 months.
- 23 August 2021: bitcoin price returns to above the $50,000 mark
- 20 October 2021: value goes up to $67,000.
- 27 October 2021: price crashes to $58,000.
- 5 November: bitcoin reaches record high of $68,521.
Finally, the latest price drop happened at the start of December 2021, with Bitcoin losing around 17% of its value in a matter of hours, going down from $57,000 to around $47,000, before partially recovering.
Some explained this sudden drop by the general downturn in global stocks caused by the uncertainty around the new Omicron variant of the Covid virus and the high inflation levels plaguing most countries.
But, as Mark Northway, investment manager at Sparrows Capital says, the general problem with cryptocurrencies is that their price is not based on any intrinsic value but determined by only one thing: confidence.
In other words, if you decide to buy crypto, you should be prepared for a bumpy ride.
Take a look at the chart that compares the annualized weekly volatility of different assets in 2021. It pretty much speaks for itself:
Can I lose all my money in crypto?
As we’ve seen, crypto can be very volatile and risky, unlike more conventional investments like the stock market or safe-haven assets such as precious metals.
In general, investment analysts outline three main ways you can lose your money with bitcoin:
- The value drops and you sell: crypto is volatile, and its price largely determined by investor sentiment, which means that many crypto investors tend to sell out of fear during a drop. So you can lose your money if you end up selling for less than you bought it for.
- Your memory can play tricks on you: experts estimate 20% of all cryptocurrency has either been forgotten about or lost, according to Crypto data firm Chainalysis. So make sure you remember all your passwords and keys!
- Cyber crime: according to Atlas VPN, scammers and hackers are believed to steal around $10million worth of cryptocurrency every day. Your cryptocurrencies should be stored in secure ledgers or with reliable partners.
But like with any other investment, making a profit with cryptocurrencies depends on what price you buy and sell them for.
This seems like a no-brainer to most, but with the high level of speculation and daily trading associated with cryptocurrencies, many investors lose track of this very simple concept.
They buy and sell crypto out of fear of loss or fear of missing out (known as FOMO), without taking into consideration the price at which they buy and the duration of their holding.
Here’s an example:
- If you had bought some bitcoin at the beginning of 2020 and sold them on 31 December 2020, you would have made roughly a 300% profit.
- If you had invested in bitcoin in early 2018 and sold out on 31 December 2018, you would have made a 70% loss.
The bottom line is, and we all agree with experts on this one: before investing, it’s important to do your due diligence and avoid pinning all your hopes on one asset, especially one as volatile as cryptocurrencies.
How do I protect myself from Bitcoin volatility?
According to many personal finance experts, one way to avoid steep losses from your crypto investment is to spread your money around and back it up with more stable investments like physical gold and precious metals.
One of their main arguments is that gold has maintained its value through centuries and has traditionally been used by investors to protect their portfolios from risk.
According to George Milling-Stanley, chief gold strategist at State Street’s SPDR ETFs, gold has a track record of improving risk-adjusted returns over longer time periods — “the holy grail of any asset allocator.”
As Milling-Stanley puts it: “The historical promise of gold to investors has always been twofold: one, that over the long term — and I stress this, over the long term — gold can improve your returns and it can also help to reduce your volatility.”
Why? The chart below explains it quite well.
Compared to bitcoin’s extreme volatility and steep price drops, the gold price has been quite stable, and even moved up steadily, over the past few years. That’s why, balancing up a more risky asset with a more stable one could help protect you from potential losses.
(Read our SPOTLIGHT article Should You Buy Gold or Bitcoin to learn how they can act as complementary assets in an investment portfolio).
So, if you’re planning to get on the crypto rollercoaster any time soon, make sure you’re ready for the potential risks ahead by going through this simple checklist:
- Remember to avoid buying or selling out of fear or FOMO.
- Make sure you store your crypto in a secure place or exchange.
- Protect yourself from volatility.
If you haven’t checked that last box, now could be a good time to buy gold before embarking on your crypto journey.
