Part 3 of 4 – Understanding the risks
This is part 3 of a 4 part series meant for new cryptocurrency investors to read before entering the space. The goal of this series is to determine if it investing in crypto is the right move. Head to the cryptocurrency section for more information and links to the rest of the series.
For the sake of brevity when I refer to Bitcoin just assume I am referring to any other coin or token available as well (Ether, Ripple, etc.). This series is not exclusive to Bitcoin but rather should help you understand what investing in cryptocurrency would mean for you.
This series will help you determine your motivations for wanting to invest in cryptocurrency, prepare you for the psychological games of a bubble, understand the risks involved in this new and volatile asset class, and help you determine if you have the right kind of money available to get the best result possible.
Part 3 – Understanding the Risks
Volatility & Price Risk
You’ve heard cryptocurrency is extremely volatile and carries with it a high risk, but what does that exactly mean? Volatility is the term to describe the fluctuation of daily price changes. Investors and the media usually refer to assets with high volatility as high risk.
Cryptocurrencies are highly volatile and considered high-risk assets. They carry with them more than just price risk -I will get to some of the other risks later. Typically major stocks move anywhere between 0.5-4.0% in a given day. The Flash Crash of 2010 resulted in about a 10% intraday price drop, and Black Monday 1987 resulted in a single day drop of about 22%. These major market days are extremely rare in the stock market which is why they all get special names and their own Wikipedia page.
By comparison, the price of bitcoin will swing 10-20% for no fundamental reason on any given day. The “crash” days, when a lot of cryptocurrencies sell off at once, can result in a single daily drop of anywhere from 30-60%, sometimes more. Please note these statistics are very crude estimates and not based on me actually running the numbers but just from my recollection over the past few years. The point is that cryptocurrencies often move SIGNIFICANTLY more than stocks do both to the upside and downside.
Here’s an example of what this means. Say you bought one bitcoin at $15,000. The market then suffers a fairly common 20% pull back over the next 24 hours. Now your one bitcoin is worth roughly $12,000 and just like that you are staring at a paper loss of $3000. Are you able to stomach that sort of price volatility?
It is important to consider how you would react if you watch your investment shrink by 30, 40, or 50 percent. Would you remain confident in your long-term plan or panic and get out now?
Exchanges are where you buy and sell cryptocurrencies, unlike stock exchanges, they are not heavily regulated yet. Over the life of bitcoin, there have been numerous stories of exchanges closing down, getting hacked, or doing “shady” things with customer funds.
Luckily today there are a handful of extremely reputable exchanges that have a good track record so far but the industry is still young and anything can happen. My recommendation is to open a Coinbase account and then use their GDAX platform (GDAX uses your same Coinbase account) to trade.
Most big investors do not keep their crypto holdings on the exchange because exchanges are big targets for hackers. Just because an exchange has not been hacked in the past does not mean it won’t be hacked in the future. Coinbase at least has an insurance policy of sorts in case of theft but they’ve never had to make good on it so it is hard to say how much you can trust that policy.
Also please note that if an exchange says they are FDIC insured, that is only insurance for your US Dollars on that exchange, not your crypto holdings.
Risk of Theft/ Hacks
Aside from exchanges being hacked outright, you, as a cryptocurrency investor are also a juicy target for hackers. The most common attack is known as phishing. This is when a hacker sends you to a website that looks exactly like your broker or wallet website and lets you log in, however when you submit the login form, your password and username go directly to the hacker because you are on their website, not the legitimate one.
This can happen in the form of official looking e-mails saying crypto has been sent to or from your account, or via Google ads in which hackers advertise their own links to popular exchanges. The best way to prevent a phishing attack is to ALWAYS type the address of the exchange into your browser or better yet after signing up at an exchange, create a bookmark and use that to sign in again. NEVER click a link in your e-mail (after your account has been confirmed and setup), always go to the website directly by typing it’s address or using a bookmark.
I wanted to mention this because some governments around the world have outright made cryptocurrency illegal in their countries. While I don’t think it will happen in the US, it is still entirely possible. Crypto may survive serious regulation in some major countries but it would surely stem the flow of capital into the market for some time and cause some panic selling.
This is a factor that we would have little control over and could make it impossible to liquidate your holdings. Again, I do not think this is likely, but it certainly is a risk to consider.
This is why cryptocurrency is described as a high-risk asset. Aside from major price volatility, there is a much greater risk of exchanges being hacked, you being targeted by hackers, or unseen government regulation than comes with trading more traditional assets. Now that you hopefully have a better understanding of the risks associated with crypto investing it is time to take a look at your financial situation and decide if you have the right kind of money to invest.
This is part 3 of a 4 part series meant for new cryptocurrency investors to read before entering the space/ to help determine if it is the right move for them. Head to the cryptocurrency section for more information and links to the rest of the series.