4 Lessons From Crypto’s Implosion – Morningstar | Team Cansler

Hard times

What a difference a year makes. Twelve months ago, cryptocurrencies were all the rage. The Miami Heat had recently announced that their basketball stadium would be renamed the FTX Arena, Fidelity was preparing to offer digital assets to the 401(k) plans it administers, and one dumb internet columnist wondered what might change “the current course.” from bitcoin could reverse.”

More than a few things, sir. On November 13, 2021, a single Bitcoin cost $64,470. Last Friday, the same currency closed at $16,943.

High volatility

The first lesson is the obvious one: Cryptocurrencies are extremely volatile. This statement is not surprising even for system novices, but it should be repeated. When risky assets are on the up, it’s easy to get carried away with the excitement. At such times, when public debate emphasizes possibilities rather than dangers, their possibilities seem limitless. Meanwhile, as our internet columnist pointed out, the potential problems are hard to imagine.

But these problems always exist. From afar, Bitcoin appears to have enjoyed an uninterrupted rise from 2012 to 2021, rising from an initial price of $4.25 to $46,306 by the end of the decade. That adds up to a cumulative win of 1,089,493% (yes, really). With such astronomical growth, even very large declines make a spike on a $10,000 growth chart.

However, there have been several such burglaries. On three occasions from 2012 to 2021, Bitcoin’s price fell more than 60%. Last year’s loss brings the currency’s bear-bear-bear market total to four. (If a 20% drop is considered a bear market, then a 60% drop is considered a triple bear.)

Declining diversification

Modern portfolio theory is as concerned with correlation between assets as it is with volatility. If one security is rising while the others are falling, even if that asset is dangerous in isolation, it can be beneficial to hold it in a portfolio.

In reality, this dictum is not always practical, as investor psychology intervenes. Insurance is least attractive when you need it most. It’s one thing to argue that alternative investments that crash during a bull market have behaved as expected and are therefore ready to protect the portfolio during the next downturn. It’s another to hold that asset faithfully after it falls in hopes that it will eventually earn its retirement.

If cryptocurrencies offer diversification, then they deserve at least theoretical recognition. The news here is mixed. On the plus side, major cryptocurrencies have performed similarly. Consequently, unless things change, investors need not worry about how many angels can dance on the head of each cryptocurrency needle. One digital asset looks somewhat like the next.

The growth of $10,000 for the top five cryptocurrencies from November 13, 2021 to November 11, 2022.

Less happily, however, cryptocurrencies are currently behaving like tech stocks. In their early days, cryptocurrencies were unicorns that seemed oblivious to the movements of traditional investments. However, since they hit the mainstream, that relationship has changed. Since the new year, Bitcoin has roughly tracked a 50% leveraged version of the Nasdaq 100 Index (I leveraged Invesco QQQ Trust QQQ returns for this exercise).

The growth of $10,000 for Bitcoin and a 50% leveraged version of the QQQ Fund from January 1, 2022 to November 4, 2022.

Just because cryptocurrencies behave like tech stocks doesn’t mean they will continue to do so. Nevertheless, meaningful portfolio diversification can no longer be assumed. This is a hope, not an expectation.

Event Risks

The previous chart skipped last week’s trading. That’s because the pattern changed abruptly earlier this month. As tech stocks rallied following the promising inflation report from the unemployment office, cryptocurrencies plummeted. The aforementioned cryptocurrency exchange FTX was to blame. After a few days of heated rejection, during which management assured the audience that the rumors of the company’s demise were grossly exaggerated, the company promptly ended.

The news rocked cryptocurrency prices. For one thing, the collapse of FTX led to domino effects. Digital lender BlockFi, which had a business partnership with FTX, announced that it too would halt customer payouts. Second, falling cryptocurrency prices squeezed buyers who were leveraged, forcing many to liquidate their positions to pay their bills. Bitcoin lost 21% over the week, with the other leading cryptocurrencies trailing (once again).

Bitcoin and QQQ Fund performance for the week of November 7, 2022 to November 11, 2022.

Such is the fate of an easily monitored industry. While mutual funds and major banks are tightly bound by myriad regulations enforced by government officials, cryptocurrency platforms often enjoy significant freedoms. Even if their activities are theoretically limited, there may be little oversight. For example, it now appears that FTX has illegally withdrawn funds from its client accounts.

A random walk

The most striking lesson from this year’s events was the futility of research. Cybercurrency fans can list the myriad differences between the various digital assets and debate which one has the brightest future, but their familiarity proved of no help once the cryptocurrency bear market took hold. To my knowledge, accurate knowledge has also not enabled observers to anticipate FTX’s problems. The authorities suffered along with the neophytes.

If this condition sounds familiar to you, it should. It mimics the stock market’s “random walk” model, which claims that expertise isn’t helpful because stock prices can’t be predicted. (The bid sounds extreme, but most fund shareholders believe in it given that they’re mostly buying index funds these days.) Those who want to own cryptocurrencies would do well to adopt a similar mindset. Owning digital assets inevitably means enduring steep downturns and bombshell bankruptcies. These dangers cannot be avoided.

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