Bitcoin's volatility should burn investors. It hasn't

Bitcoin's volatility, as measured by annualised standard deviation, has clocked more than 200 per cent since 2010. PHOTO: REUTERS

NEW YORK (BLOOMBERG) - Just over 10 years old, bitcoin might already be the best-performing investment of all time. It might also be the most volatile, and volatility has a way of luring people into ill-timed and costly investing choices. So with all the headlines about bitcoin's meteoric rise, it seems reasonable to ask how its investors are doing.

There's no denying bitcoin's astonishing success. Its price has grown a stupefying 796,933 times since 2010. For perspective, the Dow Jones Industrial Average has grown 869 times since its inception in 1896. That means bitcoin's price appreciation has been 917 times that of the Dow in less than a tenth of the time.

With a surge like that, it doesn't take a big investment to make a pile of money. A measly US$100 (S$132) bet on bitcoin on Day One, or close to it, would have blossomed into close to US$80 million. And investors didn't have to be there from the beginning to rack up big gains. They just had to hop on somewhere along the line and hang on to their coins.

The trouble is, bitcoin's wild swings don't make it easy to hold on. Its volatility, as measured by annualized standard deviation, has clocked more than 200 per cent since 2010, or close to 15 times that of the S&P 500 Index during the same period. Investors who were in and out of bitcoin had as much opportunity to lose a fortune as make one.

Investments with far less volatility than bitcoin have been known to trip up investors. Faced with big and unpredictable price moves, those who have trouble staying in their seat are more likely to buy on the way up and sell on the way down rather than the other way around. Morningstar's annual "Mind the Gap" report attempts to quantify the impact of investors' behavior on their investment returns by measuring the so-called behaviour gap, or the difference between the performance reported by investment funds and the returns investors in those funds manage to capture. The results strongly suggest that more volatility leads to bigger gaps, and not in investors' favour.

While gaps can be caused by numerous factors, volatility seems to be a key one. According to the latest report, investors have fared best in allocation funds, or those that combine stocks, bonds and other investments. The gap in those funds was 0.4 per cent a year over 10 years through 2019, meaning that on average investors captured a higher return than the one reported by their funds. One reason, as Morningstar puts it, is that "by virtue of their diversified approach, allocation funds tend to have more-stable performance and are easier to own than funds that are subject to more-dramatic performance swings." By contrast, investors in sector-specific stock funds, which tend to be more erratic, gave back 1.35 per cent a year, the widest gap in either direction.

If volatility is inversely related to the behaviour gap, then bitcoin's gap should be alarmingly negative. It's difficult to track the money flowing in and out of bitcoin, which is part of the charm, so it's hard to be sure. But the available numbers suggest just the opposite - investors appear to have deftly navigated its harrowing highs and lows, buying on the way down and selling on the way up.

Bitcoin has already been through two spectacular boom-bust cycles. It surged to a high of US$1,137 from just US$0.08 from July 2010 to November 2013, and then tumbled 84 per cent to US$183 by January 2015. It happened again three years later. Bitcoin peaked at more than US$19,000 in December 2017 and then plunged 83 per cent over the next year, landing at about US$3,100 in December 2018.

Here's the surprising part: According to CryptoQuant, a cryptocurrency data provider that attempts to gauge bitcoin's flows on top cryptocurrency exchanges, there have also been two swells in net flows to bitcoin. Based on rolling one-year flows since April 2012, the longest period available, those two swells align almost perfectly with the timing of bitcoin's two busts. During the first washout, bitcoin was still a novelty, so a few whales - lingo for investors who own a lot of bitcoin - may have had a disproportionate impact on flows. But by the second one, bitcoin was more widely owned, so the flows represent a broader cross section of investors.

Either way, investors shoveled more money into bitcoin on the way down than up, and it's not even close. Investors poured a net US$8.5 billion into bitcoin during the two busts, and they pulled a net US$3.2 billion the rest of the time. If bitcoin has a behaviour gap, it's more likely positive than negative - and it might even be hugely positive, as far as gaps go.

Is it possible that bitcoin enthusiasts are a more evolved species of investors who can exploit its terrifying volatility rather than get mauled by it? Here's another reason to think so: One-year net flows to bitcoin turned negative for the first time last June and have declined sharply ever since. In fact, net outflows were the highest ever during the last 12 months through January, even as bitcoin has soared to new heights. Rather than chase bitcoin higher, investors appear to be running for the exit.

Granted, it's still early days for bitcoin, and a third bust could change everything. But as of now, bitcoin's investors may be even more incredible than the digital coin itself.

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