Whether you’re investing in serious cryptocurrency assets like Bitcoin (CRYPTO: BTC) or Solana, (CRYPTO: SOL) or silly meme coins like Dogwifhat (CRYPTO: WIF), you’ll need to be ready for the standard set of risks. Volatility, macroeconomic issues, cybersecurity threats, and other pitfalls are guaranteed over a long enough period, and most investors are at least somewhat familiar with the consequences because they’ve experienced them before.
There are, however, a set of cryptocurrency risks that are less common, but potentially even more deadly for your portfolio. Let’s explore three of them so that you’ll know what to look out for and how you might be able to fortify yourself ahead of time.
1. Network congestion
Investors who are accustomed to trading stocks are used to being able to execute their trades whenever they want, as long as the market is open.
When they want to buy or sell shares, their brokerage and the stock exchange communicate automatically, and the chances of their order getting lost in the works is close to nil, even during times when tens or hundreds of thousands of other investors across the market are trying to execute trades of their own. With cryptocurrencies, this unimpeded flow of orders into executions is not at all guaranteed.
Most recently, before its network upgrade last month, Solana’s chain was so congested that more than 75% of transactions failed for days on end. In other words, nobody could buy or sell any coins on the chain, nor could they transfer anything to or from anywhere. It is unfortunately a reality that many investors were thus trapped in positions that they would have preferred to sell or to add to at the opportune moment.
The best way to defend against the impacts of such congestion is to avoid short-term tactics that are better described as day trading rather than investing. If you plan to hold onto your coins for several years, the threat of not being able to transact very effectively for a few days or even weeks becomes a whole lot less scary, because your primary recourse will simply be to wait a bit longer, which you were planning on doing anyway.
2. Unexpected correlations
Many investors think of cryptocurrencies like Bitcoin as hedges against problems in the traditional financial system and the economy at large.
That makes sense — with a problem like monetary inflation, which can make assets like cash less appealing over time, as opposed to Bitcoin with its fixed supply ceiling and immunity to currency debasement. So in theory, holding both Bitcoin and cash diversifies a portfolio such that the total value is more resilient to one of the biggest risks that could damage one of the assets inside of it.
The trouble is that Bitcoin’s price is nonetheless correlated with many other assets, including with major stock market indexes. Check out this chart comparing Bitcoin to the Invesco QQQ Trust, an ETF that tracks the Nasdaq-100, as shown here:
As you can see, during the past three years, the Nasdaq and Bitcoin have tended to move together.
For reference, a correlation coefficient of this magnitude is considered very strong, which is to say that the two components move roughly in tandem rather than in their own separate rhythms. Therefore holding the index and holding Bitcoin in the same portfolio probably does not result in enough diversification to protect the portfolio’s overall value in the event of a downturn.
Beware: Many cryptocurrencies exhibit correlations with stocks and other more mainstream investments, as well as with macroeconomic trends and consumer confidence levels and so on.
Don’t wait until there is a big problem for multiple investments you hold to diversify. Do your best to hypothesize about how and why any crypto investments you’re considering buying might have their value connected to other assets, indexes, or metrics, and be sure to hedge your purchase with something that’s confirmed to be totally unrelated and uncorrelated.
3. Poor liquidity and high slippage
When you decide to buy or sell a stock with a small market cap, as an independent investor working with an amount of money that’s typical for a retirement account there is not much reason to worry about the functionality of the transaction itself, as discussed earlier.
Even if you are deciding to liquidate your holdings after a big gain, your sale will almost certainly not affect the price of the stock by a perceptible amount. In short, you’re simply not moving enough capital around for it to matter, as there are almost always many different buyers and sellers looking to transact.
But with cryptocurrencies, especially the smaller ones, there is absolutely no guarantee that your large buy or sell order can be absorbed by the market.
For example, if you bought Dogwifhat when its market cap was closer to $10 million than near $3 billion, where it is now, you would probably have struggled to close your position after a large gain. The value you would be trying to convert into dollars would represent a fairly large proportion of the value of the other orders.
In such a situation, your order will experience tremendous slippage, and you will only recoup a small portion of the value that you are trying to realize. If you’re not familiar with the concept of slippage, it’s basically what happens when you are trying to transact with such a large volume relative to the value of orders outstanding that you end up driving the price of the asset either up or down, thereby (potentially dramatically) reducing your returns.
There are two solutions to avoid this risk.
First, don’t invest in cryptocurrencies with very small market caps because it’s essentially gambling, and most of them will go to zero anyway.
Second, rather than entering or exiting your investments all at once, try dollar-cost averaging (DCAing). If you transact with much smaller chunks, you’ll guard yourself against some of the pain of the volatility in short-term price movements, and you’ll also be totally immune to significant losses stemming from slippage too.
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Alex Carchidi has positions in Bitcoin, Solana, and WIF. The Motley Fool has positions in and recommends Bitcoin and Solana. The Motley Fool has a disclosure policy.
3 Potentially Brutal Cryptocurrency Risks That Most Investors Simply Aren’t Ready For was originally published by The Motley Fool