We have seen some real pockets of irrational exuberance, bordering on mania in financial markets over the last two years, the most prominent of these being cryptocurrencies.
Money poured into the crypto market pushed prices up to eye-watering levels before it all collapsed in the recent market sell-off, erasing almost $2 trillion of value in a matter of months.
Investing is a journey of constant learning. And often the best lessons come from times of adversity. When one of our investments doesn't go as planned, we take the time to reflect on it and understand if there are any lessons that we can take away to avoid having a repeat in the future.
With that in mind, what can investors learn from the crypto crash to apply in their own investing?
#1: Know what you are investing in
Did the people who invested in crypto really understand all the risks? Did they understand they could lose it all, either through theft, fraud or the exchanges and brokers becoming insolvent? Probably not.
Instead, they focused on the potential for high returns. It was hard to ignore the prospect of a 20 per cent yield, when money in the bank was earning next-to-nothing. But these risks were real and have in fact become reality in recent months. The crypto market is still a financial 'wild west' given the lack of rules and regulations.
Unfortunately, this is all too common. According to the Retirement Commission, more than half of New Zealanders do not search for any information at all before buying financial products. But it is crucial that investors go into every investment with eyes open as to what we are buying, what the risks are and how it aligns with our long-term investment needs.
#2: Do not bet more than you can afford to lose
For some it was a bit of fun, wagering small amounts of money in the crypto market. But others invested larger sums, even entire life savings. This was money they could not afford to lose. Following the crash, many have lost everything.
Last year I read a glowing profile of a family who sold their house to invest in crypto – with these actions being presented in a positive light. Would we say the same of someone who mortgaged the house and put it 'all on red' down at the casino? This was reckless behaviour and should not be encouraged.
#3: Don't put all your eggs in one basket
Another way to manage risk is diversification. And that doesn't mean buying 10 different cryptocurrencies! Instead, an investment portfolio should be diversified across different asset types. Though it does not guarantee against loss, diversification reduces risks, smooths out returns and helps improve long-term portfolio performance.
Crypto investors were so blinded by the promise of high returns and quick riches they forgot this basic rule, and safety was forgotten. Spreading money around different 'coins' provided no diversification when the entire market crashed.
#4: Don't pay more than something is worth
Whether it is the hottest new cryptocurrency or the next big tech company, what you pay determines the eventual return you will get. If you overpay, you will most likely get poor returns.
And there is a valid question as to whether crypto is worth anything at all.
When we own shares in a company, we have a claim on the future profits of that business. When we own a bond, we expect to have the loan repaid plus interest. But cryptocurrencies have no intrinsic value, they are only worth what the person you sell it to is willing to pay. As we have seen in recent months, this 'value' is rapidly shrinking.
I recently read of an investor who received an offer of $7000 for an NFT (a type of crypto asset that have become popular in recent years). That doesn't sound bad until you find out that he had paid $2.9 million a year prior. What something is worth and what you pay for it really matters.
#5: Resist FOMO or fear of missing out
While the rallying call for many crypto believers was "HODL" (Hold On for Dear Life"), perhaps "FOMO" would have been more appropriate.
Half of crypto investors only started investing in 2021 at the peak of the cycle, enticed by the 'easy' money that they saw friends, colleagues and family making. Or the celebrity endorsements from the likes of Matt Damon or Kim Kardashian. The rise of 'gamified' investing apps like Robinhood, coupled with social media seems to have exacerbated this trend.
This is not a recent phenomenon – it is human nature to compare ourselves to peers. Investors fear being poor when everyone around them is getting rich. But history has shown that following the crowd into the latest hot investment is not the path to riches, in fact it often leads to ruin.
So how to resist FOMO? Have a clear investment plan and stick to it. If you do that, you will do well over the long term, and with much less risk than chasing fads. Do your own research, know what you are invested in, and focus on the long-term. And if you need help deciding on the right investment plan for your needs, getting advice from a qualified adviser can be invaluable. All of these tips will help you resist that urge to jump into the next investment craze.
- Chris Waters is a Senior Investment Analyst – International Shares at Fisher Funds.