3 Potentially Brutal Cryptocurrency Risks Most Investors Just Aren’t Ready for

Whether you invest in serious cryptocurrency assets like Bitcoin (BTC 2.28%) Or Solana, (GROUND -0.14%) or silly coins like dog hat (WIF -2.97%), you will need to be prepared to face the standard set of risks. Volatility, macroeconomic issues, cybersecurity threats and other pitfalls are guaranteed over a long enough period of time, and most investors are at least somewhat familiar with the consequences because they have already experienced them.

There are, however, a set of risks associated with cryptocurrencies that are less common, but potentially even more deadly to your wallet. Let’s explore three of them so you know what to watch out for and how you might fortify yourself in advance.

1. Network congestion

Investors accustomed to trading stocks are accustomed to being able to execute their trades whenever they want, as long as the market is open.

When they want to buy or sell stocks, their brokerage firm and the exchange communicate automatically, and the chances of their order getting lost along the way are close to zero, even in an era where tens or even hundreds of thousands other investors in the market are in contact. trying to execute their own transactions. With cryptocurrencies, this unhindered flow of orders to executions is not guaranteed at all.

Most recently, before last month’s network upgrade, Solana’s chain was so congested that more than 75% of transactions failed for days. In other words, no one could buy or sell coins on the chain, or transfer anything to or from anywhere. Unfortunately, many investors have found themselves trapped in positions that they would have preferred to sell or increase at the appropriate time.

The best way to defend against the impacts of such congestion is to avoid short-term tactics that are better described as day trading rather than investing. If you plan to hold onto your coins for several years, the threat of not being able to transact very efficiently for a few days or even weeks becomes much less frightening, because your main recourse will simply be to wait a little longer, which who you were planning to do anyway.

2. Unexpected correlations

Many investors view cryptocurrencies like Bitcoin as a hedge against problems in the traditional financial system and the economy in general.

This makes sense – with a problem like monetary inflation, which can make assets like cash less attractive over time, unlike Bitcoin with its fixed supply cap and immunity to currency depreciation. So, in theory, holding both Bitcoin and cash diversifies a portfolio such that the total value is more resilient to any of the larger risks that could damage any of the assets within it.

The problem is that the price of Bitcoin is nonetheless correlated with many other assets, including major stock indices. Check out this chart comparing Bitcoin to Invesco QQQ Trustan ETF that tracks the Nasdaq-100as shown here:

Bitcoin price data by YCharts

As you can see, over the past three years, Nasdaq and Bitcoin have tended to move together.

For reference, a correlation coefficient of this magnitude is considered very strong, meaning that the two components move roughly in tandem rather than in their own separate rhythms. Therefore, holding the index and holding Bitcoin in the same portfolio likely does not result in sufficient diversification to protect the overall value of the portfolio in a downturn.

Caution: Many cryptocurrencies have correlations with stocks and other more common investments, as well as macroeconomic trends and consumer confidence levels, etc.

Don’t wait until there’s a big problem for the multiple investments you hold to diversify. Do your best to hypothesize about how and why the crypto investments you are considering purchasing might have their value tied to other assets, indices, or metrics, and be sure to hedge your purchase with something that is confirmed that it is completely independent and uncorrelated.

3. Low liquidity and high slippage

When deciding whether to buy or sell a stock with a small market cap, as an independent investor working with a typical amount of money from a retirement account, there isn’t much reason to worry. worry about how the transaction itself works, as previously discussed.

Even if you decide to liquidate your holdings after a large gain, your sale will almost certainly not affect the stock price by any perceptible amount. In short, you simply aren’t moving enough capital for it to matter because there are almost always many different buyers and sellers looking to make a trade.

But with cryptocurrencies, especially smaller ones, there is absolutely no guarantee that your large buy or sell order can be absorbed by the market.

For example, if you bought Dogwifhat when its market cap was closer to $10 million than near $3 billion, where it currently stands, you likely would have had difficulty closing your position after a gain. important. The value you would attempt to convert to dollars would be a fairly large proportion of the value of the other orders.

In such a situation, your order will experience a huge slippage and you will only recover a small portion of the value you are trying to achieve. If you’re not familiar with the concept of slippage, it’s essentially what happens when you try to place trades with such large volume relative to the value of the outstanding orders that you end up driving up or down. lower the price of the asset, which causes the price of the asset to rise or fall. (potentially significantly) reducing your returns.

There are two solutions to avoid this risk.

First, don’t invest in cryptocurrencies with very small market caps, as they are essentially gambling, and most of them will go to zero anyway.

Second, rather than entering or exiting your investments all at once, try cost averaging (DCA). If you trade with much smaller tranches, you will protect yourself from some of the pain associated with the volatility of short-term price movements, and you will also be completely immune to significant losses from slippage.