Wednesday 21 April 2021 9:18 pm

Keeping Bitcoin volatility risk at bay

At around 1am on March 13 2020, something extraordinary happened to the price of Bitcoin.

After tanking more than 40 per cent the previous day, it rallied from below $4,000 to over $5,400 in less than an hour. Now, over a year on from Bitcoin’s flash Corona crash, its price is sitting above $50,000.

Investors who were brave enough to buy the March 2020 Bitcoin dip have done rather well for themselves. But for the rest of us, that opportunity is long gone. With Bitcoin having already done a “10 bagger” in just over a year, the question remains: is now a good time to get in?

You could make the argument that Bitcoin is a finite digital commodity—hence its price should continue to rise versus non-finite fiat currencies over time. Then again, Bitcoin has already gone up by so much, so it could be due a sizable correction before that happens.

In truth, it is impossible to predict what Bitcoin will do next. It does what it likes, when it likes. This makes timing the market extremely difficult to do. With that said, there are a few simple techniques to potentially reduce the risk of buying Bitcoin – or indeed, other volatile cryptocurrencies that are potentially on one’s radar.

Don’t put all your eggs in the Bitcoin basket

Bitcoin’s average price appreciation has been about 200 per cent per year since 2012. But during that time, it has had six drawdowns that were greater than 50 per cent. In other words, holders who were all in on Bitcoin would have seen their portfolios halve in value several times while on the path the crypto riches. For these investors to recover from a 50 per cent drawdown, Bitcoin had to double in value.

This problem becomes exponentially worse as losses grow larger. Consider the bear market of 2018, for example, where Bitcoin shed 84 per cent of its dollar value. Here, Bitcoin had to go up more than six times to recover from this loss – that took about three years.

Very few investors have the fortitude to patiently weather these types of price declines. And many capitulate and sell at a loss right before the bottom. It is human nature to let our emotions get the better of us when investing. Yet despite our best efforts, it is almost impossible to overcome them.

A far easier way to not be driven by our emotions is to build investment portfolios that are less likely to take massive losses in the first place. This is where diversification comes to our aid. Investors who had allocated between one and five per cent of their portfolios to bitcoin since 2012 would have still achieved exceptional returns.

Rebalancing is key

Diversification usually works wonders to offset risk. But with an asset like Bitcoin, which has racked up astonishing gains in comparison to other investments, portfolio rebalancing is also crucial for reducing volatility.

Consider an investor who assigned just one per cent of a portfolio to bitcoin in 2012, with the rest in the S&P 500 US stocks index. By the end of 2020, that portfolio would have comprised more than 90 per cent in Bitcoin and less than 10 per cent in the S&P 500. As Bitcoin’s price increased relative to US stocks, the investor became overly exposed to Bitcoin’s volatility.

However, by rebalancing once per quarter, for example, the investor would have reset the portfolio’s Bitcoin exposure back to one per cent at regular intervals. This would have resulted in the investor buying Bitcoin when it underperformed US stocks and selling Bitcoin when it outperformed US stocks. Put another way, the investor would have been impelled to buy Bitcoin low and sell it high.

Overall, the rebalanced portfolio would have beaten the S&P 500 without increasing the size of its largest drawdown. This would also have been the case with an up to five per cent Bitcoin allocation.

Invest small sums often, rather than a large sum all at once

The biggest fear most people have about buying Bitcoin is that they buy it at the top – right before a major crash – and lose a substantial portion of their initial investment. Yet by investing small amounts each month, the potential for this to happen quickly falls away.  

Pound cost averaging is an ever-popular strategy for gradually building up exposure to bitcoin. By investing the same number of pounds each month, investors can buy bitcoin over a range of prices. When prices are low, they buy more Bitcoin with the same number of pounds. When prices are high, they buy relatively fewer Bitcoin. This can help them get in at good average prices over time.

Value averaging is a more aggressive accumulation strategy than pound cost averaging. Here, an investor would choose a “value path” that determines the GBP amount of bitcoin to hold at the end of each month. The investor would then buy more or less Bitcoin each month depending on how close the GBP value is to that value path. This implies larger investments in months when Bitcoin is cheap, and smaller investments in months when it is more expensive.

In months where the GBP value of Bitcoin is in surplus to the value path, the investor would sell bitcoin to get back to it. Since there is planned selling involved, value averaging offers a middle ground between shorter-term trading and long-term investing. This strategy may suit those wishing to accumulate bitcoin over a certain time frame, but also take profits along the way if prices get too high. 

Of course, selling Bitcoin in a strong bull run may lead to lower returns in the long run. Be that as it may, nobody ever became poor by taking profits – especially if those proceeds are invested in other assets. Different investments go up over time, but they don’t all go up at the same time.

Each to their own

Ultimately, each investor will have their own tolerance for taking risks. Higher risks can lead to higher returns over time, but also more downside in the short term. Those who like and can afford to take more risk would be comfortable allocating more of their investable wealth to Bitcoin and other digital assets. But regardless of one’s proclivity for risk, having a long-term view is usually best when it comes to Bitcoin.

Disclaimer: Nothing in this article should be considered investment advice.

Jonathan Hobbs, CFA, author of Digital Assets and The Crypto Portfolio.

Twitter: @jbhobbs