A recent study by economics researchers at the University of Sydney (USyd) shows that in the world of crypto, coins with the highest investment risks did not always yield the highest returns.
In a paper published in the Journal of Empirical Finance, the researchers analysed over 4,000 crypto coins from Bitcoin to Dogecoin and observed their performance over an eight-year period from April 2013 to December 2022.
Researchers also looked deeper at the diffusive, jump, and idiosyncratic risks undertaken by hedge funds that invested in those crypto coins. A “diffusive risk” is when a loss on investment A is covered by profits earned in investment B. On the other hand, a “jump risk” – also known as a “gap risk” – is when an investment itself is extremely risky due to market volatility.
Finally, an idiosyncratic risk refers to an investment that is inherently risky. To no one’s surprise, the “idiosyncratic risk” in this context is crypto.
It’s an “anomaly”
In the end, the economic researchers found crypto portfolios with the most idiosyncratic risks yielded an average annual return of –9.36 percent. Boo.
However, crypto portfolios with the least idiosyncratic risks yielded an average annual return of 80.6 percent. Woohoo!
One key finding of the paper was that it also defied the conventional wisdom held by many, including crypto investors, that a high risk investment was equal to high rewards. That’s not always the case. The researchers found that instead of high returns, what’s known as “low-volatility anomaly” takes place: that’s when “investors are penalised for taking bets that mimic lottery tickets.”
As to why, Dr. Simon Kwok, Senior Lecturer in Economics at USyd and a co-author of the study, explained that these factors contribute: “… limits on leverage and shorting constraints, investors’ preference for lottery-type payoffs, and investors’ behavioural biases – they are often overconfident about their prospects of ‘winning’.”
Crypto is high risk
For those who have dabbled in the crypto scene for a while, it’s not news that crypto markets can be extremely volatile. Dr. Simon Kwok told The Chainsaw that crypto’s “wild fluctuations” was precisely why some investors were so drawn to it.
“[The investors come in] with the hope that they could leverage on the upswings in price and pocket in profit before the next major downward correction,” he explained.
“But the most challenging part for even the most seasonal investors is to predict when the next downturn is.”
For example, just three weeks ago around mid-October, Bitcoin was hovering at a low of US$26,600 (AU$41,400). However, in the past few days, Bitcoin rose to US$35,000 (AU$54,500) – that represents a 10 percent price swing in just 21 days.
Where does crypto go from here? With Sam Bankman-Fried on trial, Bitcoin’s recent rally, and talks about an upcoming spot Bitcoin ETF, unless you have a crystal ball it is difficult to predict the crypto market’s movement in the coming months.
“Do your research. Don’t buy into the hype,” Dr. Kwok cautioned. So true, sir!