By now, most of us have heard stories about people losing lots of money by investing in bitcoin. Acclaimed business professionals have criticized the digital asset for simply being too volatile to be worth owning, and financial leaders have chalked it up to being nothing more than a bubble built on pure speculation likely to end up worthless.
And while it’s true that people have lost lots of money on bitcoin, that the asset is extremely volatile, and that it’s a speculative investment, those facts don’t prove if bitcoin is too risky to be worth investing in. What does? Data.
So, is bitcoin too risky to own? After all, so many people seem to indicate that it is. And if not, why do so many people think it is?
For context at the moment, bitcoin recently rose past $8,000 against the US dollar for the first time since crashing from almost $20,000 in December 2017 to near $3,200 in December 2018. As of publishing time, it is hovering around $7,700.
Full disclosure: I am invested in bitcoin and would financially benefit from its price going up. I, therefore, want to clarify the objective of this article. It is not to endorse bitcoin or speculate on what its future price trajectory looks like. Rather, the objective is to simply answer the following question: based on public, objectifiable data, is bitcoin too risky to own?
In order to answer this question, we need to define risk within the context of investing. The SEC, the government agency that largely oversees investing in the US, defines risk as “the degree of uncertainty and/or potential financial loss inherent in an investment decision.”
It’s important to consider the following two things relative to investment risk:
- Investment risk can’t be viewed meaningfully in the absence of corresponding returns. The risk-return relationship is at the core of investing. Without factoring in the potential returns an investment can yield, it’s trivial to try and determine if the investment is too risky
- Every investment has risk. Even holding US dollars has risk. What if the federal reserve, the central bank that controls the dollar, debases the currency through inflation? What if the government starts to default on its loan obligations to other nations, and the underlying cash loses its global reserve status? While the risk of this happening is considered to be de minimis, some risk always exists
It’s also important to note that this discussion is specifically regarding long term investing, where the investment capital won’t be needed for alternate purposes for a long period of time (think more than a half decade). Over a shorter horizon, where the capital will be needed within a couple of years for a big purchase, for example, it’s typically ill-advised to invest in stocks, let alone bitcoin, or really anything bearing any sort of unpredictable short term volatility. Over the long haul is where the question emerges.
With this in mind, the real question at hand is: given the historical losses and gains that bitcoin has returned, is the asset too risky to own over the long haul?
To try and find the answer, let’s explore bitcoin’s performance over time. Our price data, sourced from CoinMetrics.io, goes back to 2013–04–28, which is around the time bitcoin started picking up steam as a tradeable/investable asset. This gives us more than 6 years worth of data to analyze. For context, one bitcoin cost $135.30 on the earliest day in the dataset.
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If bitcoin was too risky to own due to its price volatility, it must be really difficult to know on which day you should buy bitcoin to come out profitable, right? That’s not what the data tells. The chart below shows bitcoin’s (BTC) daily open price since 2013–04–28 (the data is mapped on a log scale to better visualize the trend given bitcoin’s parabolic nature). Let’s use $7,500, a nice round number close to today’s price, as our line in the sand from an investment standpoint. The portion of the line highlighted in green depicts days when bitcoin’s price was lower than $7,500. The portion of the line highlighted in red depicts days when bitcoin’s price was higher than $7,500.
Based on this, you can see that it has actually been quite easy to profit off bitcoin. You could have bought bitcoin on 2,014 of the past 2,215 days (91% of the time) and made a profit given today’s price. There were only 201 days (9% of the time) over the past 6+ years where buying bitcoin would have given you a negative return through today.
Now, you’re likely asking yourself why there are so many crazy stories about people losing tons of money on bitcoin. Despite what the charts above depict, a large cohort of investors lost money by investing in bitcoin late in 2017, some of the only days where the price exceeded today’s, only to see the asset’s price plummet over the course of 2018 in a market downturn. Instead of looking into bitcoin’s history to see that it has fully recovered from multiple 80+% drawdowns in the past, much of this cohort lost confidence when the price dropped, decided to sell, and locked in their losses. Why did so many people do this? Most likely because people are usually focused on the short term and obsessed with the prices of the current moment. There’s a high chance these people invested in the first place because of FOMO when they saw lots of media coverage and rapidly rising prices. Then, when the price fell, they decided that cashing out with a loss was smarter than exercising patience and holding out for the rebound or averaging out their cost basis by buying more at a lower price.
There isn’t a market in the world where this is a winning strategy, and bitcoin is no different. There are still American homes that had money in the stock market when it crashed in 2008–2009, lost faith that it would ever rebound, and are still on the sidelines as the stock market continues to set new record highs. Had they either waited it out or invested more when the market crashed, they would be far better off financially today. Based on this, it’s very difficult to claim that bitcoin is too risky to own on the basis of volatility.
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Another way to assess the risk of bitcoin is by seeing how investors using age-old, market-tested investing tactics to invest in bitcoin have performed. This controls for investor behavior and allows the asset’s performance to speak for itself. Let’s see how bitcoin does with dollar-cost-averaging (DCA), an investing strategy where the investor deploys the same amount of capital at set increments over time. This method ensures that you lock in more units (i.e “shares” in the stock market) of your investment at lower prices and fewer units at higher prices.
Let’s jump to the worst case scenario. On 2017–12–27, bitcoin opened at its highest market value ever: $19,475.8. This day is objectively the worst possible day someone could have started to invest in bitcoin due to its price tag. Yet, you got unlucky and made your first bitcoin purchase, let’s say for $10, on that day. If you had the discipline to invest $10 every week, as DCA prescribes, from that day through today, you would have made a profit, despite bitcoin’s price today still being ~60% lower than it was when you first bought.
As of 2019–05–19, someone who deployed this strategy in these circumstances would have invested $750 for a total of ~0.1245 bitcoin, with an ending market value of $904.68, yielding a $154.68 profit.
Based on this, the data indicates that people who lost big money on bitcoin over the past 18 months owe it more to undisciplined, emotionally driven behavior, and less to inherent long-term unmanageable risk in the asset. Similarly, in the financial crisis, the S&P 500 dropped around 50%, but those who actively used DCA despite the drastic crash were rewarded handsomely for their discipline and patience years later. This isn’t to say that every single asset in history has come back from every major crash, but from the historical data on bitcoin until this point, it is difficult to conclude that it is too risky to own given its performance in even the worst case scenario where investors deployed basic, age-old investing strategies.
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To assess risk best, let’s turn to the performance of bitcoin compared against the stock market head to head. We’ll use SPY, an ETF that tracks the S&P 500, as a proxy for the index. Let’s look at annualized returns over the past 6 years to assess how investors would have fared at different allocation levels if they decided to diversify into bitcoin.
Some notes on the table below:
- All the returns are annualized with the exception of 2019, which displays YTD returns
- Investments were made at the start of the year
- SPY returns do not factor in dividends
- These figures are not inflation adjusted
Any exposure, even a 1% allocation, to bitcoin would have yielded higher returns than the S&P 500 index, called alpha, in every year listed here except for 2018. Since bitcoin’s price hasn’t yet fully re-achieved its 2018 starting price, it has negatively contributed to portfolio returns if you bought at the start of that year and haven’t since. The corresponding alpha figures (i.e. performance relative to the S&P 500) to the above table is listed below:
From 2014 to 2017, diversifying 10% of your portfolio into bitcoin at the beginning of the year would have given you a double-digit advantage in annual returns over the S&P 500. There actually seems to be some risk in not investing in bitcoin, as you forgo the opportunity to profit from an asset that has handsomely rewarded investors over time with even minimal exposure.
Let’s imagine another worst-case scenario: bitcoin hypothetically falls to $0 right after you invest in it. You still invested the rest of your money into SPY, but your bitcoin investments are now worthless. We’ll apply that to each of the same time intervals we have already been looking at. If the true alpha (i.e. the returns that actually played out in reality) of your investments offset the worst-case losses when bitcoin went to $0, then it’s possible to argue that bitcoin is worth the risk. If the opposite is true, then maybe bitcoin is too risky after all. Let’s see how each situation plays out:
This shows that the true returns of bitcoin have frequently yielded high enough returns that they would more than offset even worst-case scenario losses. To illustrate, let’s say you invested 95% of your money into SPY and 5% into bitcoin at the start of 2017, and the worst case scenario of bitcoin falling to $0 happened. Your annual returns through today would now be -3.22% less than if you had invested 100% into SPY. In reality, bitcoin did not go to $0, and in fact, increased in value, and your portfolio did 7.58% better than the S&P 500 because you were invested in bitcoin over this period. The difference of the true alpha (7.58%) and the worst case scenario alpha (-3.22%) is 4.36%, a positive, indicating that the diversification into bitcoin was worth the risk when you factor in the future return.
So while bitcoin has undeniable risk, when you factor in the returns, the losses associated with the risk start to look more manageable. Of course, there are also some red tiles in the above table, which would support the case that bitcoin is, in fact, too risky even when you factor in the returns. While it’s true that there are more green tiles than red, perhaps the most insightful takeaway is the fact that the further back in time the investment was made, the lower the relative risk. Again, investing is a long term game.
Even with all of this, past returns do not guarantee future ones in any market. Even if all of the above tiles were green, that would not safeguard you from future unprecedented downturns that extend far longer than we’ve seen in bitcoin, the stock market, and elsewhere. The best we can do is educate ourselves on the facts, and use them in the best way we see fit.
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In reality, the question “is bitcoin too risky to own” from the onset is largely a moot one since every person has a different risk profile. What’s too risky for me might not be too risky for you, even when we look at the same exact numbers. Further, financial situations are affected by more variables than imaginable, so trying to lay a blanket statement on top of investment risk is in many ways trivial. Lastly, you can always cut back on risk by cutting back on the size of the investment. For example, it’s hard to rationalize that investing $5 into a risky asset can be viewed as all that risky, whereas a $5,000,000 investment is a different story.
With all that being said, for someone who already owns US stocks, it appears difficult, if possible at all, to conclude that bitcoin is too risky to own after reviewing the data. So, why do so many people believe it to be true? Metrics such as volatility and price appeal more to the human mind than rationality and data-backed research, often influencing investors to develop notions that don’t reflect the full story. At this point, it appears likely that the narrative of bitcoin being too risky to own is more anecdotal than it is founded on features inherent to the asset.
Thanks for reading!
- The bitcoin price data used in this analysis comes from CoinMetrics.io, a data aggregator site focused on crypto markets. Their price data, sourced from CoinMarketCap.com, is the daily opening price.
- The SPY data used in this analysis comes from Yahoo Finance via the quantmod package in R.
- Shoutout to Ari Paul and this twitter thread for contributing some of the ideas that led to the creation of this article.
- All of my code used to make this post can be found here.
- This is not financial advice. Do your own research.
- Update on 2019–06–11: at the time of publishing, the author owned SPY.
- Update on 2019–07–05: all opionions are my own.