Giuseppe Guglielmo @CryptoUser: "Another cryptocurrency crash. So what? Fear..."

Italy

Another cryptocurrency crash. So what? Fear is often the daughter of ignorance, so let’s start from the basics (return, volatility, and how they work). Return (r) — the relative change in price (p) over a given time period (t). It tells you how much the price has increased compared to an initial reference point t0. r = (P_t - P_t0) / P_t0 = P_t / P_t0 - 1 Volatility (sigma) — the standard deviation of returns over a given time period (t). It tells you how much returns fluctuate around their average value. sigma = sqrt{1/t*sum(r_t - r_average)} Guess what? Return and volatility are empirically related. The higher the volatility of an asset, the higher your chances of making (or losing) money. Simple as that. Once you truly understand this basic concept, volatility stops being something to fear. It could even make you happy. But to reach that point, you need to understand at least 3 important things. The 1st thing is that looking at return or volatility alone will never tell you anything meaningful. What matters is their trade-off. You should ask yourself: how much volatility am I paying for that return? This is called the Sharpe Ratio (S) — William F. Sharpe liked to call it "reward-to-variability ratio". Assuming the risk-free rate is zero, it’s simply the ratio between return (r) and volatility (sigma): S = r / sigma Well, established cryptocurrencies — like Bitcoin — tend to have a relatively high Sharpe Ratio compared to many traditional assets such as stocks, bonds, gold, among others. The 2nd thing is that short-term volatility is not the same as long-term volatility. Without going too deep into the math, volatility (sigma) scales with the square root of time (t): sigma_t = sigma_t0*sqrt(t) Return (r), on the other hand, grows linearly with time: r_t = r_t0*(t) We owe this concept to Einstein (geometric Brownian motion) and then to Markowitz, two guys who won the Nobel Prize, and who taught us something simple but powerful: the longer your time horizon, the less you should worry about volatility — the “cost” of achieving a good return gets lower as time passes. This is the mathematical reason why it’s usually better to invest for the long term and not (or only marginally) for the short term. The 3rd thing is that highly volatile assets with a strong Sharpe Ratio will eventually improve the return/volatility profile of your portfolio, but they will not protect you from tail risk. From experience, allocating around 5–15% to high-quality cryptocurrencies (like Bitcoin) can meaningfully help optimize a portfolio of stocks, bonds and/or other traditional assets. I pretty much follow a similar rule here on eToro, so you can have a look at how a portfolio crypto-boosted to the right extent has performed so far. But be careful: increasing crypto allocation too much is not a good idea. That’s the classic mistake of those seduced by easy gains. Your portfolio will always be subject to tail risk, which in statistical terms is captured by the Value at Risk (VaR). VaR tells you the maximum loss you can expect, with a certain confidence level (z), given a certain volatility (sigma). VaR_z = - z*sigma*sqrt(t) In simple words, you take the volatility (sigma) and multiply it by (z); z is a parameter that depends on the probability distribution used to model returns — and the fatter the tails of the distribution, the larger z becomes. The return distribution of cryptocurrencies has very fat left tails (negative returns), which means adverse events are more likely, because these assets are far more sensitive to news and market shifts. Now that you’ve understood this, you should also realize that: • Volatility is part of the game: without variability, there’s no reward. • Volatility is scary, but not that much if you have a long-term horizon. • You shouldn’t take on too much risk to chase high returns — because investing in cryptocurrencies imply being exposed to bigger tail losses. If you’d like to better understand these concepts, let me know — I’ll be happy to dive deeper into them. $BTC $ETH $SOL $XRP $SPX500 $NSDQ100 $DJ30 $NVDA (NVIDIA Corporation) $TSLA (Tesla Motors, Inc.) $AMZN (Amazon.com Inc) $AAPL (Apple) $MSFT (Microsoft) $GOOG (Alphabet) $META (Meta Platforms Inc)

Not investment advice. The author may have financial interests in the mentioned instruments.