The Importance of Risk Management and Psychology When Trading Crypto
In 2017, as crypto mania escalated, we witnessed extreme cases where individuals decided to make huge bets on bitcoin. Some liquidated all their assets and invested their life savings. Most of these investors were subsequently gored by the same bull that had led them and then rekt during the ensuing bear market of 2018. Knowing your risk appetite and understanding trading psychology are essential before investing in cryptocurrency.
Also Read: Back to Basics: What Is Money?
Irrational Exuberance Is All Part of the Cycle
The crypto market is still young, and so volatility is part of the game. Before entering for the first time, it is important to be aware that the market is prone to the phenomena of irrational exuberance.
Diversification is a key part of risk management. As the saying goes, don’t put all your eggs in one basket, which raises the question: how important is it to have exposure to a range of assets and cryptocurrencies?
It is worth diversifying your investment holdings in order to mitigate risk. The modern portfolio theory (MPT), a hypothesis put forward by Harry Markowitz, a Nobel prize-winning economist and author of the classic 1952 article “Portfolio Selection,” states that by diversifying assets you will minimize risk and get the mean. Markowitz’s research has also shown that investors can assemble the perfect portfolio.
MPT is a mathematical framework for building a portfolio of assets so that the expected return is maximized for a given amount of risk. The mathematical framework MPT has been applied by a number of groups. Recent research by the Bocconi Students Investment Club at Bocconi University in Milan showed that applying the MPT framework to crypto beat all other portfolios, at the cost of greater volatility.
The Bocconi Students Investment Club concluded: “Our findings, consistently with MPT, are that portfolio variance can be significantly lowered by exploiting low covariances between coins.”
Buy Low, Sell High?
The ability to buy low and sell high requires traders to able to determine roughly when the low and high prices for digital assets will be. Unfortunately this strategy is difficult to execute, as evidenced by the year-long fall in bitcoin and cryptocurrency prices which have affected the psychology and emotions of many market participants.
As humans, we are conditioned to follow the crowd. Fear of missing out (FOMO) and fear, uncertainty and doubt (FUD) play a huge role in the psychology of crypto investing. Many investors will instinctively react to something in the news which can drive prices down to record levels, enforcing the “fear” factor which will then convince traders to sell their investment for a loss.
2017 headlines claiming China is banning cryptocurrency exchanges or JP Morgan’s Jamie Dimon asserting that bitcoin is worse than tulip bulbs are classic examples of FUD that can negatively affect asset prices. Crypto investors have now become more resilient to this sort of sensationalist news and bitcoin bashing.
Establish Your Personal Attitude to Risk
Greed, for lack of a better word, is not good. There are numerous tales about people who were so passionate about bitcoin and the cryptocurrency revolution they went all in. One such person is 39 year-old Didi Taihuttu, a Netherlands native who sold everything he owns including his home and valuable belongings for bitcoin. Another young man was so convinced that cryptocurrency was the future, he gave up his apartment and wound up living in his car while putting every spare cent towards his crypto portfolio.
If you have a family to support and barely enough funds to survive, is it really worth gambling and going all in crypto? It only makes sense that before investing you should research the technology, and most importantly develop your understanding of the market psychology. That way, you’ll maximize your prospects of profit and avoid trading on emotions alone.
What are the factors influencing crypto prices? Let us know in the comments section below.
Images courtesy of Shutterstock.
Need to calculate your bitcoin holdings? Check our tools section.