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3 Potentially Brutal Cryptocurrency Risks Most Investors Simply Aren’t Prepared For
Stock experience will not help you prepare for these risks.
Whether you are investing in serious cryptocurrency assets like Bitcoin (Bitcoin 2.46%) or Solana(SUN -0.05%) or silly meme coins like Dog hat (WIF -2.95%), you will need to be prepared for the standard set of risks. Volatility, macroeconomic issues, cybersecurity threats, and other pitfalls are guaranteed for a long enough period, and most investors are at least somewhat familiar with the consequences because they have experienced them before.
There are, however, a set of cryptocurrency risks that are less common but potentially even more deadly for your portfolio. Let’s explore three of them so you know what to look for and how you can strengthen yourself in advance.
1. Network congestion
Investors who are used to trading stocks are used to being able to execute their trades whenever they want, as long as the market is open.
When you want to buy or sell shares, your broker and the stock exchange communicate automatically, and the chances of your order getting lost are almost zero, even at times when tens or hundreds of thousands of other investors across the market are trying to execute. trading on your own. With cryptocurrencies, this unimpeded flow of orders to executions is by no means guaranteed.
More recently, before last month’s network upgrade, the Solana chain was so congested that more than 75% of transactions failed for days on end. In other words, no one could buy or sell coins on the network, nor transfer anything to or from anywhere. Unfortunately, it is a reality that many investors have been trapped in positions that they would have preferred to sell or increase at the appropriate time.
The best way to defend against the impacts of such congestion is to avoid short-term tactics that are best described as trade day instead of investing. If you plan to hold your coins for several years, the threat of not being able to transact very effectively for a few days or even weeks becomes much less scary because your main recourse will be to simply wait a little longer, which is what you were planning to do. anyway.
2. Unexpected correlations
Many investors think of cryptocurrencies like Bitcoin as protection against problems in the traditional financial system and the broader economy.
This makes sense – with a problem like monetary inflation, which can make assets like cash less attractive over time, as opposed to Bitcoin with its fixed supply cap and immunity to currency devaluation. So in theory, holding Bitcoin and cash diversifies a portfolio such that the total value is more resilient to one of the larger risks that could damage one of the assets within it.
The problem is that the price of Bitcoin is still correlated with many other assets, including main stock market indices. Check out this chart comparing Bitcoin to Invesco QQQ Trustan ETF that tracks the Nasdaq-100as shown here:
Bitcoin Price given by Y Charts
As you can see, during the last three years, the Nasdaq and Bitcoin have tended to move together.
For reference, a correlation coefficient of this magnitude is considered very strong, meaning that the two components move roughly in concert rather than at their own separate rates. Therefore, holding the index and keeping Bitcoin in the same wallet is unlikely to result in sufficient diversification to protect the overall value of the portfolio in the event of a recession.
Beware: Many cryptocurrencies show correlations with stocks and other more conventional investments, as well as macroeconomic trends and levels of consumer confidence, and so on.
Don’t wait until there’s a big problem for several investments you hold to diversify. Do your best to hypothesize how and why any crypto investment you’re considering buying might have its value connected to other assets, indices, or metrics, and be sure to hedge your purchase with something that has been confirmed as fully unrelated and uncorrelated.
3. Weak liquidity and high slippage
When you decide to buy or sell a stock with a small market valueAs an independent investor working with a typical retirement account amount of money, there is not much reason to worry about the functionality of the transaction itself, as discussed previously.
Even if you decide to liquidate your holdings after a big gain, your sale almost certainly won’t affect the stock price by a noticeable amount. In short, you simply aren’t moving enough capital for this to matter, as there are almost always many different buyers and sellers looking to transact.
But with cryptocurrencies, especially smaller ones, there is absolutely no guarantee that your large buy or sell order can be absorbed by the market.
For example, if you bought Dogwifhat when its market cap was closer to $10 million than $3 billion, where it is now, you would likely have difficulty closing your position after a big gain. The amount you would try to convert into dollars would represent a fairly large proportion of the value of the other orders.
In such a situation, your order will suffer tremendous slippage and you will only recover a small part of the amount you are trying to get. If you’re not familiar with the concept of slippage, it’s basically what happens when you try to trade with such a large volume relative to the value of pending orders that you end up raising or lowering the price of the asset, thus (potentially dramatically) reducing your returns. .
There are two solutions to avoid this risk.
First, don’t invest in cryptocurrencies with very small market capitalizations because it is essentially a gamble, and most of them will go to zero anyway.
Secondly, instead of getting in or out of your investments all at once, try dollar-cost averaging (DCAing). If you trade in much smaller chunks, you will protect yourself against some of the pain of volatility in short-term price movements and will also be completely immune to significant losses from slippage.