Digital currencies experienced a strong rally in 2017, which some declared a bubble. These notable increases were followed by similarly notable declines in 2018, which many pointed to as evidence that these digital assets had in fact gone into a bubble. Cryptocurrency traders can benefit from learning market history, and rise and fall is just one example.
Sentiment Drives Asset Bubbles
One key takeaway from the cryptocurrency "bubble" is that sentiment plays a large role in driving asset bubbles. Many investors have flocked to digital currencies with the mindset that these innovative mediums of exchange represent the future. Some people are true believers in this respect.
Jerry Brito, founding executive director of Coin Center, told Fortune that "It's always been kind of obvious to me that this technology is as profoundly revolutionary as the Internet was and is." However, some investors may have been a bit too optimistic.
Bitcoin's price hit an all-time high of nearly US$20,000 in December 2017, according to CoinDesk. Roughly one year later, the digital currency is trading at close to US$4,000 - less than 20% of the price it had at its peak. It seems unlikely that in the space of a year, the probability of Bitcoin becoming the currency of the future became that much lower.
A more likely explanation is that the sharp gains and losses were the result of irrational market behaviour. As prices climbed, speculators hopped on the bandwagon and retail investors, who may not have been particularly well-informed, flooded into the market. Many of these investors may have been enticed by astronomical gains, as Bitcoin prices climbed from less than US$1,000 to US$20,000 in under a year.
Another notable takeaway is that the bursting of bubbles can prove beneficial to investors by eliminating projects that are too weak to survive. Some have referred to the period that began after the digital currency bubble burst as "crypto winter," a time that only the strongest would be able to endure. While digital currency prices were climbing sharply, investors had countless places to put their money.
If the so-called "crypto winter" eliminated many of these, traders may have a far easier time deciding where to invest. These investors may consider themselves luckier than most, as they would be able to choose from varying projects that had managed to live through tough times. To that point, several large companies, including tech giants IBM, Microsoft and Apple, were founded during recessions. If the digital currency sector follows a similar pattern, the so-called "crypto winter" could help the industry in forging future leaders.
While Amazon was not founded in the midst of a recession, it was born in the dot-com era, another period that many have compared to the crypto bubble that manifested in 2017. When the irrational exuberance that fueled the dot-com bubble gave way to realism, Amazon survived. If the digital currency industry follows a similar pattern, it could produce the crypto of Amazon.
Another thing that digital currency traders should bear in mind is that some analysts have made highly optimistic predictions about assets right before their sharp rises in value were about to give way to substantial losses.
Larry Kudlow, a well-known economist who served for presidents Reagan and Trump stated in December 2007: "There's no recession coming. The pessimistas were wrong. It's not going to happen. At a bare minimum, we are looking at Goldilocks 2.0. (And that's a minimum). Goldilocks is alive and well. The Bush boom is alive and well. It's finishing up its sixth consecutive year with more to come. Yes, it's still the greatest story never told."
In February 2008, Kudlow predicted: "I'm going to bet that the economy will be rebounding sometime this summer, if not sooner. We are in a slow patch. That's all. It's nothing to get up in arms about."
In December 2017, entrepreneur John McAfee, who founded antivirus software firm McAfee Associates, Inc., tweeted the following: "Bitcoin now at $16,600.00. Those of you in the old school who believe this is a bubble simply have not understood the new mathematics of the Blockchain, or you did not cared enough to try. Bubbles are mathematically impossible in this new paradigm. So are corrections and all else."
The sharp rise and decline in Bitcoin prices that took place between 2017 and 2018 provides evidence that asset bubbles do, in fact, exist.
Traders will need to confront a new reality. During the runup, some startup companies held initial coin offerings (ICOs), sales in which they issued tokens to interested investors in exchange for Ether, Bitcoin and fiat currencies. Investors who bought some of these tokens experienced very promising returns.
"The days of investing in an ICO and getting 75x on it in six months are gone," Ari Lewis, who cofounded digital asset management firm Grasshopper Capital, told The Financial Times in August 2018.
Another takeaway from the bubble in digital currency prices is the value of diversification. The basic idea behind diversification is not putting all of one's eggs into one basket. If a trader has a portfolio with many different assets instead of just one, they can help reduce the risk of loss. Basically, if one of these assets falls in value over a certain period, the other portfolio components may appreciate in that time. Investors who want to develop a well-diversified portfolio may consider incorporating many different asset classes, such as stocks, bonds, real estate and commodities.
If investors want to include Bitcoin in their portfolio, they should make sure the digital currency makes up only a small amount of its total value, several analysts have claimed. Aleh Tsyvinski, an economist who teaches at Yale, has offered this point of view.
Tsyvinski said in an interview: "If you as an investor believe that bitcoin will perform as well as it has historically, then you should hold 6% of your portfolio in bitcoin. If you believe that it will do half as well, you should hold 4%. In all other circumstances, if you think it will do much worse, then you should still hold 1%."
Nick Maggiulli, an analytics manager and investment blogger, has stated that "the optimal portfolio" should contain 2% Bitcoin and 98% other assets. "Bitcoin does add value to a portfolio, but only when held in small doses," he wrote. "A little bitcoin goes a long way."
Crypto traders can learn many things from the bursting of the digital currency bubble. For starters, they should know that the astronomical increase in Bitcoin prices, followed by their sharp decline, shows the impact that sentiment has on asset values.
The price bubble may have very well been created by irrational exuberance, in other words strong optimism on the part of people who believed that Bitcoin would end up being the currency of the future. It very well may be the currency (or one of the currencies) of the future, but this optimistic forecast may not be enough to justify the robust gains it enjoyed in 2017.
Investors should also keep in mind that the bursting of the bubble could do them a favor, in that the harsh conditions may very well force weaker projects out of existence and ensure that only the strong survive. When the dust has settled, investors (and traders) may have far fewer options, making their selection process a bit more straightforward.
Another key learning point is the value of diversification. If investors had put a small portion of their portfolio into Bitcoin, for example 1% or even 5%, a sharp drop in Bitcoin prices wouldn't be as concerning.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…