Regardless of whether you believe that cryptocurrencies will play a role in the future of finance, the recent collapse in price for some crypto assets offers important lessons for investors. This is particularly true for younger investors who, according to media reports, may have borne the brunt of these losses.
Diversify. You’ve likely heard this time and time again, 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 proper sizing of positions – don’t put a material percentage of your investable assets in any one investment. While some crypto assets may have become worthless, if you had capped the size of the investment and were properly diversified, the collapse of one holding shouldn’t create a big challenge. For instance, if you had 1% of your assets in a crypto lending platform that evaporated, it would be disappointing but should not be life-altering. With any speculative asset, you should always assume 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 fundamental asset classes such as stocks, bonds, real estate (if you can), and cash for emergency needs. The more diversification you have, the less any one investment can do you harm. Plus, these asset classes often perform differently during different market cycles. For instance, right now stocks are down significantly, but cash is fine, short-term bonds have been defensive, and real estate is holding up fairly well. Four years ago, cash was not very exciting, but stocks were. These alternating cycles of returns can help reduce risk and volatility.
When a new investment category like crypto emerges, it’s important to keep these concepts of diversification in mind. It can be tempting to chase the prospects of rapid wealth, but it must be tempered by prudent risk management. It’s alright to invest in new things. Some are the real deal, transform the business world, and end up being highly valuable. But many end up on the scrap heap of finance. If you are going to venture into new and unproven areas, do it carefully and on top of a foundation of diversification.
Reasonable returns. Whenever some area of the financial market collapses, it is often preceded by a cycle of high returns and appeal to quick riches. This was true when the first tech bubble burst in 2000, with the real estate bubble ending in 2008, and with the crypto collapse. There were big gains, and some people got rich, at least temporarily. But if you chase big gains, you should expect you may end up with big losses.
The stock market alone is risky. As you may know, it can fall 50% or more in recessions or other market panics. For taking all that risk, the long-term annualized total return from stocks is about 10%. It’s not 20% or 30%. Thus, if you believe an investment may return 20% or 30% in perpetuity, you are likely setting yourself up for disappointment or worse. There can be cycles where some assets have high returns, but it generally does not last. If you invest in a rapidly appreciating sector, be prepared for the other side of that equation.
Regulations matter. One of the challenges with crypto investments and some of the platforms they operate on is that currently, they are unregulated. While it would be nice to think that people always do the right thing, as James Madison is credited with saying, “if men were angels, no government would be needed.”
If you venture into investments that are unregulated or lightly regulated, you should expect they may carry more operational risk than things that are regulated. That means they could collapse faster, you may have fewer options 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 people who are financial professionals spend a great deal of time understanding and complying with regulations. They are important to help safeguard investors. Thus, if you are thinking of getting into something that isn’t regulated, expect that you may not have much recourse if things go badly. If you don’t know how an investment is regulated, you should not venture into it until you figure that out.
It’s unfortunate that some investors have lost sizeable percentages of their portfolios in crypto. But history is replete with these types of 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’s savings, it’s often because they failed to follow the fundamentals.
Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.