Investment risk: explanation, types and relation to crypto
Risk runs are pervasive; they are a part of our everyday life. Any type of investment known to man, from gold to real estate, stocks and even down to recent markets such as cryptocurrency, has inherent risk factors. After reading this article, you will learn the various investment risks in traditional and crypto markets and how to best manage investments to reduce risks.
What is investment risk?
Investment risks are adverse financial outcomes that impact your portfolio. The gains or losses to your portfolio depend on several factors grouped into micro and macro factors.
For instance, macro factors occur due to market conditions such as high volatility. These may include things like government policies or interest rates, global recessions, wars, pandemics and more. Essentially, macro factors impact the market as a whole.
Micro factors, on the other hand, are factors that impact a single asset or investment, such as decisions from the project team behind the crypto assets can significantly impact the asset's price.
Understanding the risk and reward dynamic
"higher risk, higher reward"
The level of risk associated with a particular investment typically correlates with the level of return the investment might achieve (in other words, the higher the risk, the higher the reward). The rationale is that investors willing to take on risky investments and potentially lose money should be rewarded for their risk.
This 'risk to profit' logic builds on the idea that different investors have different risk appetites. Each investor has a unique risk profile that determines their willingness and ability to withstand risk. Investors expect higher returns to compensate for taking those risks as investment risks rise. In traditional finance, asset classes are grouped based on their risk profile. For example, stocks are generally considered risky assets but return between 10%-20% annually compared to other asset classes like bonds and treasury bonds with a lower risk profile.
Types of investment risk: Macro risk
Here are some of the common macro risks investors might face:
Interest rate risk typically applies more to the bond asset class than stocks. It involves the risk of potential loss in investment value because of the change in interest rates. Interest rate risk is very significant to bondholders because, as interest rates rise, the market value of bonds drops in price and vice versa.
With the current inflation figures at a 40-year high of 8.5%, the FED is left with few options but to aggressively raise interest rates. Consequently, investors will be looking to move out of the bond market to protect their investments against price depreciation.
Foreign exchange risk comes with investing in foreign countries' currencies. An FX investor may find that his investment is worthless if the Canadian dollar depreciates against the US dollar.
Country risk applies to a broad asset class—stocks, bonds, options, mutual funds, and futures issued in a country. It involves the risk of a country defaulting on its financial commitments. Examples of country risks are Nigeria and Venezuela.
Political risk: A country’s political state can significantly impact investment returns on assets in the country. Political risk refers to potential loss in investment value due to political stability or changes in a country. It is a significant risk with an increase in investment time horizon. Examples include a change in government, legislative bodies, other foreign policymakers, or military control.
Business risk: This refers to the risk involved in the potential viability. It stems from whether a company will be able to make sufficient sales and generate adequate revenues to cover its operational expenses and turn a profit. Often, businesses run on heavy debt, and poor management can inevitably lead to business failure and hence loss in investments. Therefore, an investor must evaluate a company’s business operations thoroughly by considering factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.
Credit risk: This is also called default risk. It refers to the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. Credit risk is typically seen in the bond market and concerns investors who hold bonds in their portfolios. Generally, government-issued bonds like treasury bonds have the least default risk hence, low returns. On the other hand, corporate bonds tend to have the highest default risk and post higher returns. Bond-rating agencies such as Standard and Poor , Fitch and Moody can be used by investors to determine a bond's investment grade.
Counterparty risk: In contractual financial investment products such as stocks, options, bonds, and derivatives, there is always the risk that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment or trading transactions. It is also one of the risks encountered in cryptocurrency investments.
Liquidity risk: This is the risk of not being able to sell or liquidate your investment at a fair price. What this typically means is that an investor buys high and sells low. In some cases, especially in crypto markets, selling the investment may not be possible, leaving the investor stuck with worthless assets and heavy losses.
What are the unique risks that apply to cryptocurrencies?
Unlike traditional assets, crypto-assets are not backed by banks or governments. Moreso, they are highly volatile. While the underlying technology has its perks (the decentralised nature of cryptocurrencies, lack of regulation and anonymity), it poses significant risks to investors. Therefore investors must understand the risks associated with cryptocurrency investments. Here are some risks associated with cryptos.
Volatility: A characteristic of the crypto market is very large price fluctuations. This high level of volatility makes it a risky proposition. It is not uncommon for cryptocurrency prices to move by over 1,000% in minutes. In early 2021, Dogecoin rose by over 20,000%, but by May 2021, it had lost over a third of its value. Also, a single negative popular tweet or news story about a cryptocurrency could cause its price to plummet quickly. The "doge-father", Elon Musk, is famous for swinging the price of the Dogecoin crypto asset with a single tweet . The high speculative culture that drives the cryptocurrency market means that investors quickly buy and sell their holdings when there's a sign of a price drop. These high fluctuations in prices can be largely profitable and damaging to an investor. An investor stands to incur huge losses if the price of a crypto asset suddenly drops.
Lack of regulation: The absence of an adequate regulatory framework is a very concerning issue for many investors. There is no financial institution or government backing cryptocurrencies. For example, in traditional finance, most online transactions or electronic money transfers are backed and mediated by a financial institution that exists to resolve any problem with transactions. However, in crypto, there are no authorities to protect investor safety, leaving investors to cater for themselves and take full responsibility for their investment decisions in the space. Unfortunately, the lack of regulatory oversight has resulted in heavy malicious activities in crypto markets.
Hacks and cybertheft: According to data from Chainalysis , over $14 billion was lost to crypto cyberattacks in 2021 alone. Cryptocurrency assets are hot targets for malicious cyber attackers, a factor that is mainly due to the absence of any substantial regulation, online dependence and anonymity. Also, the technical nature of the overall cryptocurrency space exposes investors to the risk of cyber hacks as most lack the technological know-how to protect their assets. The most common cyber attacks in the cryptocurrency market are phishing attacks targeted at individual investors and smart contract attacks targeted at crypto vaults and bridges.
Loss of private keys: Cryptocurrencies use pairs of cryptographic keys—a private key and a public key to facilitate transactions and interact with the blockchain. The public key is synonymous with your wallet address and can be made available to the public to receive funds. On the other hand, your private key is used to sign transactions and must remain secret and be protected at all times. Losing access to your private key means losing access to any cryptocurrency in that wallet. Many investors fall prey to this. About 20% of all Bitcoins are lost due to the loss of private keys. It Is very crucial to adopt best practices in protecting your crypto assets.
Counterparty risk: This is a common risk in peer-to-peer (P2P) cryptocurrency platforms. These exchanges involve direct transactions between two parties. There is always the risk of scams and fraudulent schemes, such as a buyer refusing to pay for cryptocurrencies received or a seller refusing to send the tokens. Counterparty risk is mitigated by using P2P platforms that provide digital asset escrow services such as Binance exchange. During the transaction, the platform holds the assets and is released to the buyer as payment is complete, and the seller confirms receipt.
Stablecoins are not exempt from investment risk. USDC is backed by fiat and susceptible to regulatory risk. There are uncertainties about the assets back USDT, with no one knowing if the stablecoin is fully backed in the event of a bank run. Even the algorithmic stablecoin, UST, is susceptible to investment risk.
Managing investment risk
So how can you reduce the risk of your investments losing value and potentially maximise your returns? While risks are inevitable and inherent in every investment decision, managing investment risk is crucial to maximising returns and building a healthy portfolio over time.
Risk management is essential as no investment opportunity is a hundred percent foolproof. Therefore, investors need to adopt good risk management practices to build a healthy portfolio and ensure a good profit-loss ratio.
Diversification: Diversification is a strategy used to minimise investment risk by spreading funds across financial instruments or asset classes. This strategy maximises returns by investing in different asset categories that would react differently to the same event. This can help an investor manage risk and reduce the volatility of an asset's price movements. While diversification is very helpful in protecting a portfolio’s value, it does not eliminate risk, especially market risk. Also, too much diversification can hurt your investment portfolio because it may be somewhat tedious to manage a diverse portfolio, especially if you have multiple holdings and investments. Diversification can also be expensive as not all investments cost the same, so buying and selling will affect your profit-loss when you consider the transaction fees and brokerage charges.
In crypto, it is recommended that new investors keep a relatively small diversified portfolio of 10 to 20 crypto projects. This allows the investor to capture the overall market trend without being spread too thin. A typical rule of thumb is to allocate 50% of your funds to less volatile assets like Bitcoin or Ethereum and 20% to stablecoins such as $UST. As you get more experienced in crypto, you will likely be able to manage a more extensive portfolio. However, it is worth noting that the more projects you hold, the more time you will need to dedicate to working on them.
Taking profit: This is an essential practice in crypto investment, yet very few people do it. Taking profits ensures that you constantly get something from the market without worrying about market downturns. Various factors determine how you make a profit. They include your time horizon, risk tolerance, financial goals etc. For instance, you could decide to take out some profits whenever an asset doubles in price, starting with your initial investment. With your initial investment taken out, you can't lose your principal in the case of a market reversal.
Finding the best yield opportunities: A rule of thumb is to keep at least 20% of your portfolio in stablecoins to enable you to buy the dip when the market goes down. Your stablecoins don't just have to sit in your wallet; seek out yield farming opportunities in stablecoins to earn more yield. A typical example is Anchor's 20% APY on $UST. Keep in mind that, due to smart contract risk, it is advisable not to stake all your stablecoins.
Staking and compounding: Make an active effort to constantly manage your staking positions to ensure you compound your returns and seek the best opportunities possible. You could use auto-compounders such as Yearn Finance or Beefy Finance, however, note that these services cut your overall yield.
Rebalancing your portfolio: Crypto assets fluctuate in prices frequently, and as tokens move at a price, the risk profile of your portfolio may change. You may find that your portfolio is heavily skewed to one or few assets. In this case, you might want to rebalance your portfolio to maintain a preferred risk profile.
Lastly, always do your due diligence before investing in any cryptocurrency project. Remember, "don't trust, verify". Also, always invest what you are willing to lose.
Risk signals to monitor the health of your digital assets
Keeping abreast of market conditions daily can help an investor make informed decisions. To manage investment risk effectively, it is essential to gauge the relative strength and health of the overall cryptocurrency market. Here are some effective tools to help guide you.
Fear & Greed Index: Sentiment is one major cause of asset price swings. The Fear & Greed Index is a popular tool used to determine how investors feel about the market.
Macro signals: Macro events significantly affect the cryptocurrency market because of the overwhelming influence of traditional finance. Therefore, paying close attention to the U.S. Dollar (DXY) and the crypto market correlations to SPX/Gold can reveal some insightful information. For example, the dollar has an inverse relationship with crypto assets, while the crypto market closely follows the equities market.
Exchange volume: Generally, higher volumes mean deeper liquidity and signals a bullish market trend. In digital assets, we monitor centralised exchanges, decentralised exchanges and look at both spot and derivatives markets.
Stablecoin supply: This is a significant indicator because US dollar-denominated stablecoins are the equivalent of cash in the cryptocurrency market. Watching the movement of stablecoins can offer an investor very insightful information. For example, investors convert their stablecoins to US dollars when they want to exit the market but leave them on exchanges if they plan on investing in the future. Therefore, as the stablecoin supply builds up, it is considered a bullish signal.
DeFi TVL: DeFi has risen to become one of the most active sub sectors in the cryptocurrency market. It encompasses the most used applications within the cryptocurrency ecosystem. Therefore, as the total value locked (TVL) grows, so does the overall crypto market.
Investment risk conclusion
As an asset class, cryptocurrencies have slowly emerged over the past decade and are now increasingly attracting institutional investors. The rise in demand requires a more professional assessment of the underlying sources of risks and opportunities. The calls for better risk management are part of the maturation of the market, which should ultimately include replacing self-regulation and automated governance with effective supervisory and regulatory structures. And the best part is, with digital assets like cryptocurrency, anyone who is a little tech-savvy and can use a blockchain explorer, or other analytical tools can get access to seemingly unlimited data to help mitigate investment risks