Many coins have seen huge price drops from their all-time highs and have not recovered. As an investor, how should you approach cryptocurrencies now?
Basics of cryptocurrencies and recent falls
First, a brief synopsis of cryptocurrencies and recent major events:
The blockchain technology used for cryptocurrency trading has been hailed as a game changer for the future of the currency. Users can “confirm transactions without the 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 the appeal of cryptocurrencies, so does speculation. And while cryptocurrencies have been lauded as “inflation-proof,” its recent drops quickly affect their market value.
One of the major events that happened recently was the dramatic collapse in the value of TerraUSD, an algorithmic stablecoin, which was supposed to behave like cash. TerraUSD’s algorithm was structured to keep it firmly pegged to the US dollar, but the peg failed, causing panicked sales and at the same time collapsing another popular token, LUNA, which was linked to TerraUSD. Both tokens lost tens of billions of dollars in total market capitalization.
Another big event that rocked the world of digital assets was the collapse of Three Arrows Capital (3AC), a cryptocurrency hedge fund. This had a ripple effect as other cryptocurrency trading platforms that were 3AC’s counterparts had to block withdrawals for their clients.
Fundamental value propositions against “pump and dump”
I’m not saying all of this to scare you from 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, as well as fully understand its usefulness, before investing in it.
There are many websites that promote new and upcoming coins based on recent performance spikes; rosy claims about the long-term potential of these coins are inevitable. Much of this is selfish, as seed investors in digital assets will seek to promote their plans to keep prices rising, which in turn allows them to foster further price appreciation and momentum in the coin.
Just as we have seen with the fluctuations in “meme” stock, holders of certain assets will use the Internet and social media to promote the assets they currently hold in the hopes of being able to pump and dump them. I recommend avoiding the temptation to pursue yields in the new and lesser known alternative currencies. Some investors have managed to make money with this strategy, but it carries a very high risk and can be financially devastating for investors who are overly focused on this type of business.
Bitcoin and Ethereum: the most established players
Federal regulation of digital assets is still pending, although it could take on renewed priority after recent fallout. Meanwhile, a more conservative strategy would be to invest in more established digital assets, including Bitcoin and Ethereum. Both began to rise in value from mid-June lows, coinciding with positive returns from other risk assets over the same period.
Bitcoin is the largest digital asset by market capitalization and the best known. It is also the digital asset that enjoys the greatest adoption among institutional investors. BlackRock, one of the largest asset managers in the United States, recently announced a partnership with Coinbase to offer its clients digital asset trading. Institutional demand for Bitcoin could provide a steady boost to its price given the wider demand in portfolios. Bitcoin also continues to be used to send and receive global payments.
Ethereum is the second largest digital asset by market capitalization. What makes Ethereum’s value unique is the fact that it is 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 on a major upgrade in the next quarter that would substantially reduce its blockchain’s energy usage, theoretically reducing its carbon footprint by 99%! Interest in the ether and its price has increased since the beginning of July.
Considering cryptocurrencies? Consider a conservative allocation
In light of the above, it is not surprising that you typically recommend a conservative allocation to digital assets. Digital assets, relative to equities, are highly volatile, as we have already seen in 2022. The Nasdaq Composite, which represents technology stocks, has fallen about 33% year-to-date to its lowest point, while the more well-known index The S&P 500 (a barometer for large-cap US equities) fell about 24% as its lowest point for the year. Bitcoin, by comparison, fell more than 60% from its value at the end of 2021 to its lowest point.
For a well-diversified portfolio, cryptocurrencies can provide an increase in return potential and some diversification benefits when combined correctly. Digital assets, in general, have a low degree of correlation with stocks. In modern portfolio construction, low-correlation assets tend to be desirable since this means that when an asset is rising or falling, the price of a low-correlation asset does not move along with it. In other words, if the market is panicking and the assets are selling out, you don’t want all the assets in your portfolio to go down at the same time.
Digital assets could also provide some excess return potential for periods when stocks are flat or trading in a range.
With any investment portfolio, it is also important to periodically reassess the strategy and determine whether or not strategic or tactical changes are needed.
Wealth Advisor and Director of Information Technology / Security, Halbert Hargrove
Shane W. Cummings is based in Halbert Hargrove’s Denver office and holds various roles with Halbert Hargrove. As Director of Information Technology / Security, Shane’s primary goal is to enable Halbert Hargrove employees to work efficiently and effectively while safeguarding customer data. As an asset adviser, he works with clients helping them set goals and identify financial risks, creating an allocation strategy for their investments.