19 min readCryptocurrencies are in the headlines again, following their rebound from the latest bear market- bitcoin alone gained roughly 160% in 2023- and the approval of spot bitcoin exchange-traded funds (ETFs) by the US Securities and Exchange Commission (SEC).
However, crypto is still an unknown quantity to many, which may deter some investors. This blog post- the first in a series intended to demystify this relatively new asset class- explains why volatility plays an important role in a healthy market. Parts two and three address misconceptions around crypto’s environmental and social impact.
Understanding Volatility
While volatile assets are typically considered higher risk, fluctuating prices are a sign of a healthy market because they facilitate price discovery (the way participants determine the fair price for an asset).
One of the main causes of volatility is the circulation of new information. In the case of the stock market, this could be the release of a company’s quarterly earnings report or the introduction of legislation impacting a particular sector. Fluctuations reflect investors’ efforts to work out how this information should affect the asset price. For instance, if a company beats its earnings forecast, its share may rise.
Volatility also readjusts asset prices when they increase without justification. Former Federal Reserve chairman Alan Greenspan labelled this effect ‘irrational exuberance’, ironically just before the dotcom bubble in the late 1990s, when money poured into stocks leveraging a new technology called the internet. The bubble burst in the early 2000s, partly because investors realised earnings couldn’t support some valuations, and the tech-heavy NASDAQ index dropped by 77%. This episode had one redeeming feature- companies with unsustainable business models perished, while survivors, like Amazon, went on to thrive.
Market Dynamics and Influencing Factors
Compared to traditional asset classes, the crypto market is still small. Bitcoin, the most dominant crypto by some distance, has a market capitalisation of $1,198 billion (as of 28 February 2024), making it the 10th biggest asset class overall. In comparison, Ether, the next largest crypto, has a market cap of $399 billion (as of 28 February 2024). For context, the total value of the 500 US companies listed on the S&P 500 is $42.795 trillion (as of 6 March 2024).
The crypto market’s low liquidity makes it more prone to volatility than other asset classes. The types of factors that cause price fluctuations include:
Macroeconomics and geopolitics- investors increasingly treat bitcoin as a store of value, so central bank policies such as changing interest rates and political instability can affect demand.
Regulatory developments- crypto regulations constantly evolve, and investors tend to dislike uncertainty. Conversely, regulatory clarity is generally welcomed.
Underlying tech- blockchain is a relatively immature technology, so advancements boost demand for crypto while security vulnerabilities reduce it.
Market sentiment- emotions like fear and greed influence investment decisions, especially when amplified by social media and press coverage. Alternative.me launched a crypto version of CNN’s Fear and Greed Index in early 2018.
However, demand for crypto as an asset class has steadily increased over the years. Digital asset investment products currently hold $82 billion (as of 4 March 2024) according to research by CoinShares. Inflows hit (a record) $2.45 billion in the week commencing 12 February 2024, boosted by the approval of spot bitcoin ETFs.
Peer Comparisons and Volatility
Comparing crypto with other asset classes demonstrates how volatility naturally occurs in mature markets.
Gold- the world’s largest asset class with a market cap of $13.71 trillion (as of 28 February 2024)- is closely associated with bitcoin given they both serve as stores of value. The yellow metal experienced a correction (a decline of between 10% and 20%) in 2019 and bear markets (a decline of more than 20%) starting in 2011 and 2020, before recovering to hit an all-time high at the end of 2023.
Tech stocks can also be considered a proxy for crypto, particularly bitcoin. They’re among the largest equities on the global markets, accounting for six out of the top ten asset classes by market cap. 9th-ranked Meta (parent company of Facebook), which went public in 2012, experienced significant volatility in September 2021, falling from a peak of nearly $378 to $90 in November 2022, a drop of just over 75%. But it had regained a majority of those losses by the start of 2024.
Dollar Cost Averaging: Making the Most of Crypto’s Volatility
While the crypto markets remain volatile, investors can take advantage by leveraging a trading strategy called dollar cost averaging (DCA).
DCA involves investing in an asset at regular intervals (typically monthly), either a fixed amount of money or units of a product like a crypto exchange-traded product. The theory is that investors purchase more of an asset when the price is low and less when the price is high, which should lower the average cost of the entire holding.
By encouraging investors to continue buying regardless of market conditions, DCA reduces the impact of volatility on returns. It also eliminates distractions such as media hype from the decision-making process and promotes holding for the long term as investors don’t have to worry about trying to time the market.
Learn more about dollar cost averaging.
Conclusion
Volatility is a sign of a healthy market because it supports price discovery. One of the main drivers of fluctuations is investors figuring out how new information should affect an asset’s price. What’s more, if an asset doesn’t readjust in response to negative information, it could continue rising whether or not fundamentals justify it, potentially leading to a bubble.
The crypto market cap is relatively small compared to other asset classes, making it prone to volatility. But it has grown rapidly in a short amount of time and received a significant boost when the SEC approved spot bitcoin ETFs.
Crypto is following the same trajectory as gold and tech stocks in terms of market capitalisation and volatility. Gold and Meta have both experienced severe price fluctuations in the last five years.
Investors can reduce the impact of volatility on returns by using a trading strategy called dollar cost averaging, which involves regularly purchasing an asset regardless of the market conditions.
