In the world of virtual money there many people that own cryptocurrencies as a form of investment. The reasons for this may vary from protecting oneself from the inflation that affects fiat money, to speculating on the future of money itself. Whatever the goal may be, one should always assess the risks involved before making an investment decision. Price risk is one of these risks.
Risk versus Return
When seeing strong gains on a certain virtual currency such as Bitcoin had over the past several years, it can be tempting to invest your money hoping to get a similar return. But a basic rule in Economics that the highest (expected) returns are generally accompanied by equally big risks. Likewise, the safest investments such as government bonds would only yield the lowest return.
Price risk depends on the volatility of the held financial instrument. Volatility is nothing more than a measure of variation of price over time. In other words, it’s a measure of how wide the swings of an investment’s price can be. These movements can be downward as well as upward. The wider, the harder it can become to be emotionally unconcerned. This is why the choice for a certain risk profile should always be a conscious one.
In cryptocurrencies, these swings can be very wide. A recent example of extreme swings is Auroracoin. After a warning on this coin was featured on Dogeconomist a few days ago, the price went on to increase from about $58 at the time of the article to a peak of about $100, only to fall back to $20 shortly after. There is only little data available on Auroracoin, but a small data set from Cryptsy reveals that the daily volatility in AUR/USD rates during this period was about 64%.* What this means is that, statistically, each day has a 32% chance that there will be a swing of more than 64% in AUR/USD rates. Over the same period, BTC/USD and DOGE/USD rates have a volatility of 7% and 6% respectively. It should be stressed that this concerns limited data and that past performance is not indicative of future returns.
Nonetheless, the previous shows again why Auroracoin should be considered an extremely risky investment. It also reminds us that there is a significant risk to investing in cryptocurrencies in general, as a daily volatility of 6% is still a lot. This doesn’t mean cryptocurrencies are bad to invest in, but only that you should be ready to accept strong downward as well as upward movements. This is a big step towards worry-free investing.
*Cryptsy data on Auroracoin is available af of March 2, 2014. At the time of writing, only five observations are available for analysis. A better measure of historical volatility would be obtained by considering a 30 or 90 day time period. A 5 day time period should thus be considered a very rough estimate. The standard deviation is taken from the percentage changes in prices.