Sound Money

Dear new bitcoiner (useful for all HODLers),

Congrats on dipping your toes into the bitcoin waters. Bitcoin has the potential to generate significant benefits for you, your family and your portfolio. Benefits will also accrue to our communities as we gravitate towards a sounder money world. In this note I contextualize historical bitcoin volatility so that you’re prepared for the next phase of this journey. TLDR: Bitcoin volatility is trending lower but sharp drawdowns should still be expected, even in bull-markets. Preparation should contribute towards constructive experience in the coming quarters.

1. Bitcoin tends to experience 80%-90% drawdowns during bear-markets. I.E. The value of your investment can lose 90% in value! The graph below shows the drawdowns, rebased to 100 at the start of each bear-market (peak price in cycle), where each line represents the price of bitcoin during that bear-market.

Unless you’re investing in small capitalization stocks, this type of downside volatility is unheard of in traditional financial markets. It is psychologically traumatic to go through this experience.

Fortunately, A bear market is unlikely over the coming quarters because we appear to be in the early stages of a bull-market. Nevertheless, awareness of the 80%-90% drawdown is important because it may return in the coming years.

2. Downside volatility is still expected during bull-markets. Historically, the maximum decline during a bull-market was 70%. In the 2011-2013 cycle there was a sharp correction during the late stages of that cycle, but the market still rallied to new record highs (grey line in graph below). The graph shows bitcoin bull markets, re-based to 100 at the start of each bull market (cyclical bottom in price), where each line represents the bitcoin price during that cycle). Outside of the 2013 experience, there was a 53% price correction during the 2020 covid19 induced liquidity squeeze. That type of sharp liquidity squeeze is a rare event. Gold, equities and property all capitulated during March 2020. What I’m trying to get at is that these events were quite rare. We should mentally prepare for them, but the 50%-70% range isn’t my base case drawdown expectations during bull-markets.

3. Drawdowns in the 30-40% range have occurred more frequently during previous bull-markets and this is my base-line expectation for the downside risk in coming months. As an example, it’s possible that the bitcoin price could fall from $13K today to $10K, which would be a 30% decline. I don’t expect us to break below $10K again but more on that in another note.

A couple more comments on bitcoin volatility before I wrap up this note:

4. Bitcoin volatility is elevated but it is declining over time. I’ve shown two volatility measures below to prove this point. I expect this declining trend to continue as adoption increases (both in terms of consumers and merchants offering services) and financial infrastructure improves.

5. The graph below shows bitcoin’s elevated 30-day realised volatiltiy relative to other asset classes. Interesting that 30-day realised volatility recently fell below Amazon and Apple. Bitcoin’s volatility is narrowing relative to equities, which may cause some large equity holders to consider the opportunity in bitcoin. “If it’s already as volatile as a favourite tech stock, then why not nibble?”

Conclusion: Bitcoin volatility is declining, and this trend is expected to continue but volatility is still elevated. And its anxiety provoking for new holders. Bear market drawdowns in the 80%-90% region are unlikely over the coming quarters but mentally prepare anyway because those dark days will return. 30%-40% drawdowns are my base-case expectations. These may present opportunities for those looking to increase exposure, if they are able to manage the anxiety. Preparation is important so that you don’t get squeezed out of your position when experiencing “what if it goes to zero” fear during your first bitcoin drawdown.

5 preparation steps:

1. Ask yourself, “what will I do when the price falls 40%?” Feel it ahead of time.
2. Understand the reason why you purchased and the timeframe over which you expected this to happen. I.E. If you have a long-term timeframe, do you care about the short-term price?
3. Look at bitcoin within your total portfolio context. Read more about that here. Bitcoin isn’t your only investment. In fact, it might be the smallest investment you have. It’s just the most volatile one! And there is an application on your phone which allows you to see the price at any moment.
4. Don’t look your phone! I know it’s hard but checking daily prices will make you feel like a hero when the price goes up, and make you feel like an idiot during a sharp drawdown.
5. Invest your time in understanding bitcoin, the problems with our current monetary system and explain these concepts to others. The better you understand the long-term potential for society, the less price volatility matters.

If you’ve failed to prepare adequately and are struggling with downside price volatility, read this article.

Good luck!