In our previous article, The big crypto rush – where do you stand?, we discussed about the recent growing interest in digital currencies from retail and professional investors alike.
In this article, we look at the risk of cryptocurrencies, and explain how you can calculate and understand the risk you take with the cryptocurrencies you plan to invest in, for the return you expect to receive.
The concept of volatility and risk
To put it simply, risk is how much money you could lose when markets fluctuate.
Investments are usually trade-offs between risk and return. When you invest in any assets (securities like stocks, bonds, ETF or even property, art, commodities), you expect them to appreciate in value, i.e., you expect their prices to grow so you can make a good return. At the same time, several factors affect your portfolio. These can be market risks, liquidity risks, political risks and others. They all contribute to how the asset prices behave (increase or decrease) as a response to those risk factors.
Volatility shows how much the price of a specific security deviates from its average return. As the prices go up and down, the risk refers to how much the price can go down (since that is when you could lose money).
If the price deviates a lot from the average day after day, the security is said to be more volatile (riskier) compared with a security for which the daily price deviates just slightly from the average return.
For example: imagine that you have a security for which you expect 8% annual return. If the volatility of the price for that security is 20%, it means that you can get as much as 28% return (8% + 20%) when the security price goes up, but you can also lose as much as 12% (8%-20%) when the security price goes down. Oppositely, if for the same security volatility was just 3%, it means you could get a 11% return (8% +3%) if the prices went up but you could be safe with a positive return of 5% (8% – 3%) when prices go down.
It is therefore very important that investors know the volatility of their portfolios, so they are not anxious about the normal daily price fluctuations.
What about cryptocurrencies risk?
Digital currencies behave in the same way as other securities. Their prices will go up and down based on daily investors demand, which in turn may be influenced by many risk factors as described above.
However, cryptocurrencies are much more volatile (therefore riskier) as they respond much faster to various external events, for example announcements from companies that start using cryptocurrencies or regulatory impediments to crypto uptake in different countries.
Let’s take the example of Bitcoin. The popularity of Bitcoin kicked in during 2017 when the price went from $1,000 to almost $20,000 by the end of the year. That was a 2000% increase in only one year.
Bitcoin price chart from Jan 2017 to December 2020. Source: CoinMarketCap
Any reasonable investor would have understandably argued that that was a singular behaviour that could not be repeated. However, in 2020 the price of Bitcoin went from $7,500 to $27,500 – a change of about 275% in a calendar year.
By now, you are probably calculating the return you could have made – but wait, return is not everything you should consider.
The problem comes with analysing and accepting the risk, or the downside involved while aiming for those incredible returns. After Bitcoin hit a high of $20,000 in 2017, it saw a low of $3,600 by the end of 2018 which was a fall of almost 80% – imagine the psychological impact of that change!
How is risk calculated?
For any given security, volatility (i.e., risk) is calculated mathematically as the standard deviation of the returns from the average return.
You will find that different securities have very different levels of volatility, for example: volatility of a cash ETF would be the lowest at around 0.7-1%; a well-known retail stock like WOW (Woolworths) has a volatility of 9.5%, a newer, very popular stock like APT (Afterpay) has a volatility of around 100%, while Bitcoin has a volatility of over 430% per year.
Most often people invest in several securities not just one, including or not in cryptocurrencies. In all cases, the overall portfolio risk is a matter of:
- Individual risks for each security in the portfolio.
- The weight of the securities in the portfolio (i.e., how much has been invested in each);
- The correlations between pairs of securities. Without getting too technical, this refers to the degree to which the prices of two securities move in the same direction or in opposite directions in response to market risk factors*.
* If you want to learn more about correlations and how they are calculated, register for your upcoming free webinar on 14 Oct 2021, at: https://attendee.gotowebinar.com/register/1570085429386582286
As it can be inferred from the above points, it is very important to know not only how much you invest in each security, but also how risky (volatile) each security is, and how correlated the securities are.
The formula for calculating portfolio risk is very complex and most people (including professional investors and advisors) cannot calculate that by hand or in Excel. Professionals have their own proprietary tools. For retail investors we developed Diversiview – among other features, it helps investors understand and calculate their portfolio risk.
Let’s look at a mixed portfolio example
To exemplify, we created a portfolio of 6 investments (5 ASX stocks making up 90% of the portfolio and 1 cryptocurrency for the remaining 10%) as follows: CBA 20%, MAQ 20%, COL 20%, BHP 20%, WES 10% and BTC 10%.
We run this portfolio in Diversiview and found that the expected portfolio return was 32% and the portfolio risk around 100%. These figures meant that the example portfolio was very risky – if an investor selected this particular composition, they could get as much as 130% return if prices went up, but they could also loose a whooping 70% if the prices went down.
To summarize this article, all securities have a degree of volatility which determine risk of loss, and cryptocurrencies are highly volatile. Investors should consider several points when it comes to investing in cryptocurrency, as described in this article :
- Because the market is risky, people should not put all their money into cryptocurrencies. They should instead look at diversifying into investments that are not correlated, so they can offset their losses when markets go down.
- They should research the digital currencies they are looking to invest in, by following trends on social media, updates from the financial market and the online community forums.
- Ideally, they should also monitor the price history of the digital currencies so they can roughly assess their volatility.
- Last but not least, they should use technology and tools like Diversiview to assess not only the risk of individual assets like cryptocurrencies but also calculate the overall expected return and volatility for the portfolio.
In the next article, we will look at one example of mixed portfolio (stocks and crypto) and explain how you can calculate how much cryptocurrency you can safely include in your portfolio to keep the overall portfolio risk at minimum or an acceptable level.
About the author:
Dr Laura Rusu is the Founder and CEO of LENSELL®, a Melbourne based Fintech that aims to democratise access to financial and non-financial corporate performance information, and help people make better decisions with data driven insights.
Diversiview® by LENSELL brings data science to Australian retail investors and allows them to design and validate diversified investment portfolios to suit their own risk and return expectations. All ASX listed investments (stocks, ETFs, bonds) and the top 15 cryptocurrencies can be included in the portfolio analyses.