Regardless of whether you think cryptocurrencies will play a role in the future of finance, the recent price drop for some crypto assets offers important lessons for investors. This is especially true for younger investors who, according to media reports, may have borne the brunt of these losses.
diversify. You’ve probably heard this over and over, but the foundation of any prudent investment portfolio is proper risk management. One aspect of risk management is diversification. Another element of risk management is sizing your positions – don’t put a significant percentage of your investable wealth in any one investment. While some crypto assets may have become worthless, the collapse of a holding shouldn’t pose much of a challenge if you limited the size of the investment and were properly diversified. For example, if you had 1% of your wealth in a crypto lending platform evaporating, that would be disappointing, but shouldn’t be life-changing. With any speculative asset, you should always assume that it can go to zero. So don’t invest more than you can afford to lose.
Diversification also means diversification of asset types. A well-diversified portfolio should consist of a few basic asset classes, such as stocks, bonds, real estate (if possible), and cash for emergencies. The more diversification you have, the less an investment can hurt you. In addition, these asset classes often perform differently during different market cycles. For example, stocks are significantly down right now, but cash is fine, short-dated bonds have been defensive, and real estate is holding up pretty well. Four years ago, cash wasn’t very exciting, but stocks were. These alternating cycles of returns can help reduce risk and volatility.
When a new asset class like crypto emerges, it’s important to keep these diversification concepts in mind. It can be tempting to chase after the prospects of quick wealth, but it must be mitigated through prudent risk management. It’s okay to invest in new things. Some are the real deal, transform the business world, and end up being very valuable. But many end up on the financial scrap heap. When venturing into new and untested areas, do so carefully and based on diversification.
Reasonable returns. Whenever an area of the financial market collapses, it is often preceded by a cycle of high returns and the allure of get-rich-quick. This was true when the first tech bubble burst in 2000, when the housing bubble ended in 2008, and when crypto collapsed. There were big wins, and some people got rich, at least temporarily. But if you’re chasing big wins, be prepared to end up with big losses.
The stock market alone is risky. As you may know, it can fall 50% or more during recessions or other market panics. For taking on all that risk, the long-term annualized total return of stocks is about 10%. It’s not 20% or 30%. So if you think an investment can return 20% or 30% in the long run, you’re probably setting yourself up for disappointment or worse. There can be cycles where some assets produce high returns, but these are generally not permanent. If you’re investing in a rapidly rising sector, be prepared for the other side of this equation.
Regulations are important. One of the challenges with crypto investments and some of the platforms they operate on is that they are currently unregulated. While it would be nice to think that people always do what is right, as James Madison is credited with saying, “If people were angels, there would be no need for government.”
If you venture into unregulated or lightly regulated assets, you should expect them to carry more operational risk than regulated things. That means they could collapse quicker, you may have fewer opportunities to get your money back, you may have fewer legal rights, and the government may not step in to help.
I realize this is a technical area of finance, but finance professionals spend a lot of time understanding and complying with regulations. They are important to protect investors. So if you’re thinking of getting into something that isn’t regulated, reckon that you might not have much recourse if things go bad. If you don’t know how an investment is regulated, don’t get involved until you find out.
It is unfortunate that some investors have lost significant percentages of their portfolios in crypto. But history is full of such lessons. Do yourself a favor and implement good risk management strategies for your money. When you read stories about people who have lost their life savings, it’s often because they didn’t follow the basics.
Charlie Farrell is a partner and director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the date of publication and are subject to change due to changes in market or economic conditions and may not necessarily materialize. All investments involve risk, including the loss of capital.