When it comes to investing, the adage “buy low, sell high” is one of the most well-known but least-practiced principles. Our brains are hardwired to do the exact opposite, since rising asset prices trigger our desire to buy for fear of missing out, while price dips tempt us to sell to avoid the fear of further losses.
Cases of extreme volatility, like what’s seen in cryptocurrency (crypto) markets, can cause investors to make hasty decisions based on these emotional responses.
Learning how to manage your reactions during volatile periods helps to ensure that emotional, and potentially irrational, decisions do not disrupt a long-term investment strategy.
Understanding Market Volatility
In investing vernacular, “volatility” tends to carry a negative connotation, but the term simply describes the changes in the price of an asset. Though frequent corrections and pullbacks are associated with “volatile markets,” significant positive price movements qualify as volatility as well. As such, high volatility should not be conflated with low price performance; it simply defines a period of wide price dispersion. For example, 2020 was considered an extremely volatile year due to the global COVID-19 pandemic. The CBOE Volatility Index (VIX) reached an all-time high in March 2020, indicating that expectations of volatility in the following 30-day period were higher than at any other time since the creation of the index in 1993. Despite that level of volatility, the S&P 500® still delivered a positive 18% return for the year in one of the fastest market corrections in history (Figure 1).
Figure 1. VIX vs. S&P 500 Total Return
High volatility isn’t necessarily a bad thing!
|Year||Average VIX||S&P 500 Total Return|
As of 12/31/2021 | Source: Bloomberg, L.P.
In our view, the primary risk involved in these periods of high volatility lies in investors’ reactions to short-term price fluctuations. Through the 20-year period ended December 31, 2020, for example, the S&P 500 delivered an average annual return of 5.5%. However, if an investor missed just the best 20 days over that 20-year period, their annual return would fall to -1.1%. In the extreme volatility of 2020, an investor only needed to be out of the market for two days, and instead of that 18% return mentioned previously, they would have been dealt a losing -1% return for the entire year. For long-term investors, it is imperative to look beyond near-term volatility and remain invested through volatile periods, which can lead to higher returns in the long run.
Elevated Volatility in Crypto Markets
Investors in traditional markets could probably describe in vivid detail what it was like to experience a 34% S&P 500 drawdown in March 2020. Crypto markets, on the other hand, would consider that 34% decline below average. Consider bitcoin as a proxy because it has the longest history: it has averaged an annual intra-year drawdown of 55% over the past ten years! In other words, a bitcoin investor would have experienced an average decline of 55% at some point in every calendar year for the past ten years. Even the most disciplined investor may have a difficult time remembering the “buy low, sell high” mantra while experiencing such extreme price swings.
Because crypto markets have a less developed ecosystem of institutional investors, less regulation regarding the use of leverage, and trading platforms that are open 24/7, they typically have less liquidity than other asset classes, which can make price movements especially pronounced.
Combined with the influence of incredibly active social media coverage of crypto markets, it can be especially difficult to make reliable predictions on future performance. Similarly, it is too early to determine what a “normal” level of volatility in crypto markets might look like, but it tends to outpace even the most volatile stocks in the S&P 500. Consider monthly returns over the following period in 2017 and 2018, in which bitcoin had one of the largest drawdowns in its history (Figure 2).
Figure 2. Monthly Returns (%)
Volatile monthly returns in a period of wide price swings
As of 12/31/2018 | Source: Bloomberg, L.P
As you can see, S&P 500 returns stayed relatively stable, with a standard deviation of 14%. Advanced Micro Devices, Inc., the most volatile asset in the S&P 500 at the time, had a much higher standard deviation of 78%. But bitcoin’s standard deviation was highest of all at 98%, meaning that the monthly returns had a very high dispersion from the mean. A bitcoin investor enticed to enter the market in 2017 when prices were rising would have faced an extremely volatile year. Had this investor lost the will to remain invested and sold in December 2018, they would have faced losses of around 80%, a clear violation of the “buy low, sell high” principle.
Avoiding Emotional Decisions
Understanding that crypto markets are volatile due to their structure rather than just their novelty is the first step in managing investment decisions during large price swings. The following are further strategies to reduce the likelihood of making impulsive decisions when it comes to crypto investments.
Every investor should identify and consider their own personal risk tolerance. Take stock of your reaction during past periods of volatility. If the March 2020 sell-off still triggers negative memories as an investor, then a highly volatile investment like crypto might not be an appropriate allocation.
Set parameters around sizing a crypto allocation before initiating a transaction, such as defining a target allocation weight of 2%. This should keep investors from making hasty decisions and potentially allocating an outsized position that goes beyond their initial risk tolerance level. Keep your plan of action recorded in an Investment Policy Statement (IPS). We recommend writing down your investment rationale and thinking through how a decision will affect your short- and long-term investment goals. Before making any further decisions related to crypto, refer back to your IPS, which takes out the potential emotion and sense of urgency during periods of high market volatility.
Refrain from watching crypto price fluctuations too closely. Our brains react more strongly to losses than to gains, which can make it especially difficult to stay invested through volatility when constantly checking your crypto portfolio.
Handling the highs and lows
In our view, the fact that the crypto ecosystem is larger than the S&P 600® Small Cap Index by market capitalization proves its staying power.
That being said, due to the extreme volatility prevalent in crypto markets, it is still not suitable for all investors, and those with low appetite for risk may want to avoid the space entirely.
For investors looking to take part in this fast-paced market, managing emotions through volatile periods can help mitigate the risk of potentially irrational decisions harming long-term investment goals.
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Figure 2. Monthly Returns (%)
Volatile monthly returns in a period of wide price swings (view image)