Cryptocurrencies, or digital assets, have gone through a lot of turmoil so far in 2022. Since their high-water mark in late 2021, major assets like Bitcoin and Ethereum have seen dramatic pullbacks in prices. These pullbacks created a chain reaction in other areas of the digital asset market, which ultimately led to the bankruptcy of several crypto platforms – and a crash that wiped out the value of a few large cryptocurrencies.
Many coins have seen massive price drops since their all-time highs and have not recovered. As an investor, how should you approach crypto now?
Crypto basics & recent tumbles
First, a brief synopsis of crypto and recent major events:
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The blockchain technology used to trade cryptocurrencies has been hailed as a game-changer for the future of currency. Users can “confirm transactions without a need for a central clearing authority,” which democratizes access to the economy, especially for those who have historically not had access to financial institutions. Cryptocurrencies like Bitcoin, Ethereum and other coins or tokens are simply an alternative form of payment known as digital currencies. While potential drives crypto’s allure, so does speculation. And even though crypto has been lauded as “inflation-proof,” its recent tumbles affect their market value rapidly.
One of the major events that occurred recently was the dramatic collapse in value of TerraUSD, an algorithmic stablecoin, which was meant to behave like cash. TerraUSD’s algorithm was structured to keep it pegged tightly to the U.S. dollar, but the peg failed, prompting panic selling and simultaneously crashing another popular token, LUNA, which was linked to TerraUSD. Both tokens have lost tens of billions of dollars in total market capitalization.
Another major event that rocked the digital asset world was the collapse of Three Arrows Capital (3AC), a cryptocurrency hedge fund. This had a knock-on effect as other crypto trading platforms that were counterparties to 3AC had to freeze withdrawals for their clients.
Fundamental value propositions vs. ‘pump and dump’
I don’t say all of this to scare you out of investing in cryptocurrency. But I believe the prudent approach to this asset class is to focus on the fundamental value proposition of a digital asset – along with fully understanding its utility – before investing in it.
There are plenty of websites that promote new and upcoming coins based on recent spikes in performance; rosy claims about these coins’ long-term potential are inevitable. Much of this is self-serving, as seed investors in digital assets will try to promote their projects to keep prices going up, which in turn allows them to promote additional price appreciation and momentum in the coin.
Just like we have seen with the fluctuations in “meme” stocks, holders of some assets will use the internet and social media to promote the assets they currently hold in hopes they can pump and dump them. I recommend avoiding the temptation to chase returns in the new and lesser-known alternative coins. Some investors have been successful at making money with this strategy, but it carries a very high risk – and can be financially devastating for investors who are over-concentrated in these types of assets.
Bitcoin and Ethereum – the most well-established players
Federal regulation of digital assets is still pending – though it may take on a renewed priority after the recent fallout. In the meantime, a more conservative strategy would be to invest in the most established digital assets, including Bitcoin and Ethereum. Both have begun rallying in value since their mid-June lows, coinciding with positive returns in other risk assets over the same period.
Bitcoin is the largest digital asset by market capitalization and the most well-known. It is also the digital asset enjoying the greatest adoption among institutional investors. BlackRock, one of the largest asset managers in the U.S., recently announced a partnership with Coinbase to offer digital asset trading to its clients. Institutional demand for Bitcoin could provide a steady boost to its price given wider demand in portfolios. Bitcoin also continues to be used for sending and receiving global payments.
Ethereum is the second-largest digital asset by market capitalization. What makes Ethereum’s value unique is the fact that it’s used as a network for many, many other digital assets and projects – including “DeFi” or Decentralized Finance applications. As more projects are built on Ethereum’s network, the demand for its token, ether, increases. Ethereum is also working toward a major upgrade in the next quarter that would substantially reduce the energy usage of its blockchain, in theory reducing its carbon footprint by 99%! Interest in ether, and its price, has surged since early July.
Considering crypto? Consider a conservative allocation
Given the above, it’s no surprise that I typically recommend a conservative allocation to digital assets. Digital assets, compared to stocks, are highly volatile – as we have already seen in 2022. The Nasdaq composite, representing tech stocks, was down about 33% year to date at its lowest point, while the more well-known S&P 500 index (a barometer for U.S. large cap stocks) was down around 24% as its low point for the year. Bitcoin, by comparison, dropped more than 60% from its value at the end of 2021 at its lowest point.
For a well-diversified portfolio, cryptocurrencies can provide an increase in potential return and some diversification benefits when combined correctly. Digital assets, in general, have a low degree of correlation to stocks. In modern portfolio construction, low correlated assets tend to be desirable as this means that when one asset is rising or falling, the price of a low correlated asset does not move in lockstep with it. In other words, if the market is panicking and assets are selling off, you don’t want every asset in your portfolio going down at the same time.
Digital assets might also provide a little bit of excess return potential for periods when stocks are flat or trading in a range.
With any investment portfolio, it’s also important to periodically reassess the strategy and determine whether or not any strategic or tactical changes are required.
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