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How to Be Ready for Any Crypto Market: DCA and Time Horizons
Without an adequate understanding of the market behaviors of traders and investors, as well as the mental models they tend to use to value their holdings, it's impossible to be successful in today's climate. Markets move far too fast, based on far too wide of a variety of factors.
Taking the example of the cryptocurrency space, we can see just how influential market participants' reactions can be to an asset's price. In short, even though most investors tell themselves that they are making decisions based on hard data, the markets are saying something different.
Emotion rules the day.
Bitcoin is Event-Driven
Take Bitcoin, for example.
Throughout its history, it has consistently experienced dramatic rises and falls due to speculative reactions to market-related events. When you consider an overview of its major bear markets, it's easy to see just how true this is.
Back in 2012, Bitcoin entered its first bear market after TradeHill, which was the second-largest Bitcoin Exchange, was forced to close by regulators.
From that point, Bitcoin fell from just over $7.00 a coin to a low of $4.22 on July 11th of that year, due to both the TradeHill controversy and 2 other major hacks, which resulted in most than 60,000 Bitcoin being lost. This downturn briefly stalled from July 11th to August 6th, before picking back up on August 7th due to a lawsuit surfacing against one of the hacked exchanges from earlier in the year. In the span of 24-hours, Bitcoin began to fall again, showing just how powerful a negative event could tank its price.
Numerous other examples exist that illustrate this trend, including the bear market from 2013–2015, which was largely fueled by the events surrounding the Silk Road as well as BitInstant, and the resulting sentiment that Bitcoin might largely be a vehicle for illicit activity. While this turned out to be false, it fueled Bitcoin's largest bear market, at least until the Initial Coin Offering craze began.
The ICO Boom: Bitcoin's Most Recent and Ethereum's Major Bull Market
On December 17th, 2017, Bitcoin reached $20,000 a coin and the crypto's rocket ship seemed destined to land on the moon. Overall, the fuel for this sort of rampant speculation had been the rise of the Initial Coin Offering, which represented a new fundraising paradigm.
In case you're not familiar with the term, start by imagining a team of developers creating a simple webpage and a white paper. Generally, a white paper is a document that describes the product it wants to build and the problem it solves, as well as how all funds that are raised will be allocated. In a crypto context, especially during 2017, white papers were more like pitch decks and less like breakdowns of the technologies they were supposed to describe. These white papers were put together with the creation of ERC-20 tokens, which are cryptocurrencies that live in smart contracts. Smart contracts are software that in the case of ICOs, act as both mints and vaults for the cryptocurrencies involved. Therefore, their revolutionary feature was the fact that they made it possible to launch new cryptocurrencies without creating an entirely new blockchain.
Any team that wanted to do an ICO would create a basic crypto wallet for taking in Ether and later outputting a new ERC-20 token based on a preset ratio like 100 tokens per 1 Ether. Fundraising to a worldwide investor base was now as easy as a few clicks and a bit of marketing and the ICO craze took off with numerous examples of teams raising more than $100 million in Ether in a matter of hours, or even minutes.
By December 2017, every crypto asset was up and short-term trading began to take over the space, resulting in the crypto market hitting highs that it hasn't seen again. While Bitcoin began to fall during the tail end of December, Ethereum kept rising until mid-January 2018, when it hit $1432.88 a coin. Because of this, plus the meteoric rise of Bitcoin and everything else, 2017–early 2018 still marks crypto's most dramatic bull market to date.
Why The 2017–2018 Bull Market Happened
The 2017–2018 bull market was largely fueled by speculation, which is why it's been widely panned as a bubble.
If you think back to the dot-com bubble of the 1990s, then you get the picture. People saw the success of the early ICOs and through fear of missing out or "FOMO," started to buy into those that followed en-masse, with the expectation that if a few ICOs rocketed up in price, the rest had to. Similarly to the dot-com bubble at its height, it was inevitable that such an event would be followed by a dramatic crash. One of the key indicators that the end was nigh was the fact that the time it took Bitcoin to experience $1000 in price growth continued to shorten as 2017 went on.
As the Companisto blog points out,
"The digital currency jumped from 2,000 to 3,000 dollars (for the first time) in 23 days. Then the gap became shorter and shorter: Bitcoin went up from $10,000 to $11,000 in just one day, from $13,000 to $14,000 in just 4 hours, and from $18,000 to $19,000 in just 3 minutes."
Historically, this sort of rapid decrease tends to signal a dramatic shift towards high volumes of short-term trading, which is, in turn, an indicator of a speculative bubble. Adding to this was the fact that as ICOs became more widespread, scams did as well, which, by August 2018, had reportedly made off with more than $100 million in value. As ICO-related scams became more and more frequent, regulators began to pay more and more attention to the crypto industry at-large.
In July and December 2017, the United States Securities and Exchange Commission issued two public statements that clarified its position on crypto and ICOs. December's statement, in particular, was telling.
"By and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws. Generally speaking, these laws provide that investors deserve to know what they are investing in and the relevant risks involved. I have asked the SEC's Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws."
In retrospect, reading this, it's clear that the ICO bubble was nearing its end.
The ICO Bubble Pops
Once January 2018 hit, powerful negative sentiment began to take over the crypto space as it had at the beginning of every other bear market. Truthfully, the industry consensus is that this eventually dramatic market reversal was driven by a mixture of ICO scams, hacks of cryptocurrency exchanges, and increased regulatory pressure, all of which began to drive the bulk of the speculative traders and investors out of the space. As time pressed on, Bitcoin futures contracts were also alleged to have fueled the collapse even further as traders went from betting that market growth would never stop to betting the exact opposite with increasing intensity.
By June 2018, Bitcoin was down 50% from its price at the start of the year and the rest of the market was in a similar situation.
Why has the crypto market had such a volatile history?
Overall, it's difficult to pinpoint exactly one reason why the crypto market's been so volatile in both bull and bear markets. Still, if we fast forward to where we are now, it becomes easier to establish a case. This year, so far, Bitcoin's volatility, in particular, has been continually decreasing, excluding March, in which crypto's king briefly fell in lock-step with the stock markets. Though several sources claimed that this meant Bitcoin and by extension, crypto is correlated to the stock markets, March's crash was likely more of an anomaly as we've mentioned before.
Image Credit to BuyBitcoinWorldwide's Volatility Index
In the image above, you can see a spike in Bitcoin's volatility this past March, but what's more telling is the resultant drop. In any market, volatility decreases can be due to a wide variety of reasons, but in the case of Bitcoin's "smoothing out" this year, a simple framework can be applied.
Up until 2020, most institutional investors weren't involved in cryptocurrencies. Yes, examples like Greyscale and Morgan Creek Digital have existed for quite some time, but they plus all of the other long-term players like them are predominantly crypto-specific investors. Last month marked a shift in that respect with the well-known hedge fund manager, Paul Tudor Jones, revealing he has nearly 2% of his assets in Bitcoin and the business analytics firm, Microstrategy, buying $425 million in Bitcoin for their treasury reserves(as a store of value). Earlier this month, Square also announced a $50 million purchase of Bitcoin for their treasury reserves, after which they published a roadmap for other institutions to follow their example. This is key because it demystifies the process of buying and holding Bitcoin at an institutional scale.
In all of these cases, the narrative that Bitcoiners had been preaching since Bitcoin's white paper has been validated. Now, Bitcoin's finally being taken seriously as a long-term store of value or in the words of the crypto masses, "digital gold."
If you're wondering how this ties into our discussion above, it's simple. Until 2020, crypto was still a thinly-traded market, despite 2017's record highs. What this means in context is that it has always paled in comparison to examples like the stock and commodity markets in terms of institutional involvement.
Now we seem to be in a shift with confidence in crypto's viability increasing by the day. As institutional adoption grows, the crypto industry should become less speculator-driven and therefore, less volatile as well.
Despite this, it's early yet and crypto's long-term history indicates that dramatic price movements can still occur since the market remains powerfully event-driven. Consequently, as you begin your crypto journey, it's important to have the right mindset and choose the right approach for you.
Define Yourself in the Market, Set Your Limits
Succeeding as a crypto investor or trader means picking a strategy that works for you, which starts with a simple question.
Are you a trader or an investor?
Once you clarify whether you're looking to trade or invest or both, it's important to set one or more clear time horizons for your activities.
A time horizon is a period in which you want to be invested in or be trading, for example, Bitcoin, before moving out of your position (selling your holdings). As a measure, it's used very differently for traders and investors, which is why it's important to define yourself before attempting to set one.
Because the Bitcoin and Ether markets largely consist of investors or "HODLers," we'll stick to them as our key example here, but you can look forward to a future post in which we analyze traders' time horizons as well.
As a general rule, when choosing a time horizon for investing in Bitcoin or Ether, think the longer, the better. History supports this assertion since, for example, Bitcoin's 12-month ROI was 92% in 2019, but its 5-year ROI up to June 30, 2020, was 3500%. In Ether's case, matters are a bit different since it hasn't experienced a positive yearly ROI since 2017. Even so, if you had invested in 1 Ether back in January 2017 and held it until now, you'd have made 5,242.86% on your initial investment (from $7–$364).
Using these stats, it is possible to say that 3–5 years or more is the ideal time horizon for any crypto investment. In any case, regardless of the exact number of years you choose, it's important to stick to your choice through all sorts of markets and re-evaluate your investment once your time horizon is reached.
Through doing so, you begin to protect yourself against the influence of fear, greed, doubt, and overall, making any sort of purely emotionally-driven decision related to your investment.
What next?: Dollar-Cost Averaging
The benefits of setting a time horizon go beyond taking the influence of emotions out of your investing/trading.
With a clear time horizon, you can then decide whether you want to purchase all of the cryptos you will want at once or "dollar-cost average" into your desired position over time. If you've never heard of dollar-cost averaging or DCA, just think of an investor buying a certain amount of an asset at predetermined times like once a month, no matter what sort of market that asset's experiencing. It could be in a drastic downturn or vice-versa, but whatever the case, the investor keeps buying on a strict schedule. The primary benefit of such an approach is that you smooth out the effect of volatility on your investment and your portfolio at large.
Picture a portfolio that has $15,000 in bonds and $25,000 in stocks, which comes to a traditional 60/40 allocation. Introducing 1 Bitcoin into said portfolio today would result in its value rising to $51,337 (as of October 12) and its resultant allocations being 29.2% bonds, 48.7% stocks, and 22% Bitcoin. Since volatility doesn't rise linearly, it's difficult to estimate without rigorous analysis what this sort of sudden shift would mean for the portfolio involved. Still, using Coinshares' recent report on Bitcoin's effect on a traditional portfolio, certain insights come to light.
First, introducing only 4% Bitcoin into "a 60/40 portfolio" results in a volatility jump from 8.6–9.8% (using data from October 2015-July 2020), but a doubling of the corresponding portfolio's Sharpe Ratio (0.78–1.67), which measures how efficient it is at generating returns related to the overall risk it experiences. Since CoinShares ran this study with quarterly rebalancing, their results equate to a bull case for dollar-cost averaging each quarter.
Imagine doing this each month while keeping close attention to the percentages of all of the assets involved. Even if the overall Bitcoin in a portfolio were always kept at 4%, history suggests that your overall returns would be double that of a portfolio with no Bitcoin at all, while your risk increases (as measured by volatility) would be negligible. This is the crux of dollar-cost-averaging. You buy into an asset at a preset amount on a predetermined schedule and resist changing those measures no matter what the market does. This results in increased returns, with minimal increased risk.
This text is intended to inform and is not an investment recommendation.