There’s a rule in journalism — never write a headline that can be answered with “yes” or “no.” Unfortunately, in this case, we have to break the rules a bit, because there’s quite a lot behind the one-word answer.
To get the obvious stuff out of the way: yes, cryptocurrencies are risky. Anyone who’s spent five minutes reading about them knows that they’re new, unproven, and can rise and fall in value quickly.
However, just because something is risky doesn’t necessarily mean you shouldn’t invest in it. In fact, risky assets have their place in any portfolio, if you know how to deal with them.
So let’s teach you how to handle something as risky as cryptocurrencies.
We’ve explained risk in finance before. If you don’t remember or didn’t read our post about it, you can find it here.
In short, risk is all about the probability that your investment will sink a lot, potentially even to zero. There is a little bit of risk in everything: even the stock of a respectable company might be worth nothing, if that company suddenly becomes bankrupt. There have been famous examples of huge companies suddenly ending badly, like telecommunications giant Nortel.
On the spectrum of risk, cryptocurrencies are definitely on the riskier side. We don’t quite understand how or why they move (unlike companies, cryptocurrencies don’t have quarterly earnings.) We know things like media coverage and general sentiment (how do people feel about the currency right now) can affect the price, but often, big movements happen without much warning. It often comes down to the most basic question of supply and demand: how many people are buying, and how many people are selling?
That means whatever you invest in crypto could explode in value, or crash down to a fraction of what it was worth.
Cryptocurrencies are also volatile. That’s not the same thing as being risky! Risk is about your chances of making it big or losing your money over whatever amount of time you’re planning on holding your investment. Volatility is about how big the daily movements of an asset are. For cryptocurrencies, those movements are pretty big! Some days, a cryptocurrency like Bitcoin moves more than 10%, which happens to most stocks very rarely, and is practically unheard of in ETFs. Take a look at the daily changes in bitcoin, a high-volatility asset, with the S&P 500, a notably low-volatility index.
You probably knew already that cryptocurrencies are risky and volatile. Does it mean that you shouldn’t invest in them at all?
Not necessarily. Taking an extremely low-risk approach to investing might shelter you from big losses, but it will also keep you from potentially having big gains. That’s called an opportunity cost. It’s the money you could have gotten if you hadn’t played it safe.
The easiest way to mitigate risk is to make it a small part of your portfolio. While the biggest part of your investments stay in something low-risk like an ETF, you can be a little more adventurous with the rest. The exact proportion is up to you, but if you want to follow the example of established investors, Morgan Stanley capped the amount that its clients could invest into Bitcoin at 2.5% of their net worth.
That way, you can capture some of the benefits — if the small amount explodes in value, it can make an outsized influence on your investments. If you lose a lot of it, it won’t set your investment goals back by much.
If you have a discretionary fund, a pocket for money that you can spend however you like, you could also invest some of that money into a more risky asset. Since it’s money you’re planning on spending anyway, you can afford to lose it.
I don’t like using gambling metaphors when I talk about investing, because gambling and investing are very different: in gambling, the house always wins. The longer you gamble, the bigger the chances of you losing money. When you invest responsibly, there is still risk, but it’s not nearly as high, and there’s no mathematical formula working against you.
But let’s put that aside for a moment and compare investing to playing roulette. When you make a bet, you could go for a low-risk option: bet on a colour, or on evens or odds. The most you can win is double your money, or you could lose it: each has about a 46% chance — it’s not 50:50 because there’s a small chance it’ll land on 0. Still, pretty good odds.
But you could also bet on a single number. The chances of you getting it right are about 2.6%. But if you win, you multiply your money 36 times. That’s a big risk, but a huge payout if you win.
Again, cryptocurrencies are not like betting on a single number at the roulette table. After all, your chances of losing all your money are not 97.4%, like they are in roulette.
But the principle is the same — it’s not a terrible idea to occasionally bet a chip or two on a single number, if you can afford to lose it, while playing it safe with the rest of your stash.
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