What is volatility? 

Volatility refers to the rate at which an asset’s price changes (both up and down). As it measures the rapidity and level of price changes, volatility is often used to measure the risk of investing in an asset. Due to various factors, including the current low levels of regulation and smaller market size, cryptocurrencies are significantly more volatile than most other asset classes.

Volatility is often used to describe risk, but they are not the same thing. Risk refers to the chances of experiencing a loss, while volatility describes how much and how quickly prices move. If those price movements also increase the chance of loss, then the risk is likewise increased.

However, volatility isn’t necessarily a positive or negative thing. In fact, it can create the potential for massive upsides. If an asset goes up in value, it’s volatile to the upside. If it goes down in value, it’s volatile to the downside.

All that matters is whether it’s going in the right direction for you or not. For example, if you short an asset, you’ll want it to go down in value. You want an asset to be volatile as long as it’s going in the right direction.

Crypto’s higher level of volatility can, in part, explain the growing interest in investing in cryptocurrency, as it enables investors to realise significant returns over relatively short periods. 

However, it is important to be aware of the risk associated with high volatility and learn how to limit potential losses, something we’ll discuss in more detail below. The crypto market’s volatility will likely decrease over time due to market growth, wider adoption, and increased regulation.

What is diversification?

Diversification refers to the distribution of capital in different types of coins and tokens to reduce the overall risk. It involves creating a portfolio made of a wide range of assets, from a range of different sectors. 

Learning how to balance risk and limit losses is an important part of investing in such a volatile market. By having a portfolio that is diversified across different assets and sectors, the risk of failure is spread out. If one asset fails to meet expectations and ends up being a poor investment, the loss is limited to the capital allocated to that particular asset.

An investor may choose to invest in some high-growth, high-risk assets (that pay off well in bull markets) as well as some lower-risk, lower-reward assets (which won’t suffer as much during bear markets).

Diversifying out of one type of asset, for example, cross-chain assets or derivatives, is vital. That way, if regulation or better solutions get in the way, you don't lose everything. 

If someone is focused on investing all of their capital into a single asset or type of asset, they under-diversify and may experience a loss or lose it all, even if the rest of the market is on the rise. In a diversified portfolio, positive-performing assets tend to neutralise those with poor or negative returns. 

For example, consider a portfolio where 10% of the total capital is allocated to 10 different assets. If one asset goes to 0, the total loss is 10%. But, if that asset gains 300% (which is a reasonable gain for a crypto asset during a bull run), the investor has made a 30% portfolio gain with a maximum worst-case of 10% risk (assuming the price of the other assets stays the same). 

Note that when it comes to investing, there is always the potential to lose it all. 

In a normal world, some assets will appreciate, and some will depreciate, but overall, an investor with a diversified portfolio should end up with good returns and limited downside risk. 

The main reason for diversification is that nothing is certain in financial markets, no matter how confident an investor is about a particular investment. 

Note that it is also possible to over-diversify. If an investor is investing in too many assets, returns will be minimal as the capital is too thinly spread.

It is all about intelligent diversification. For example, if you are invested in oil and gas, investing in some high-potential renewable energy stocks, as well as some assets outside of the energy market, such as Bitcoin and Gold, would be intelligent diversification. 

Dollar-cost average (DCA)

Dollar-cost average or DCA is an investment strategy that involves purchasing assets at regular intervals, rather than in one go.

With DCA, an investor first decides on the total amount they want to invest and then invests it in smaller, equal instalments over a specific period of time, or at specific price points. 

For example, if an investor has $500 to invest, they may purchase $100 every month rather than $500 all at once. 

Timing the market is difficult, and investors shouldn’t expect to time the market perfectly. DCA helps to remove timing from the equation. No one will catch the absolute top or the absolute bottom, but when making larger investments, price fluctuations matter. 

Dollar-cost-averaging helps to reduce the impact of volatility and the risk of making a poorly-timed investment. It can also help take emotions out of the decision-making process. 

Unless you are a full-time investor or trader and know everything that is happening in the world, there are always big unknowns, and these can dramatically impact price. Dollar-cost averaging into assets removes risks caused by this uncertainty. 

However, dollar-cost averaging doesn’t eliminate risk. The idea is simply to minimise the risk of bad timing. Other factors must be taken into consideration too. 

The key thing to note about DCA is that timing is important. DCA is typically used during times of panic and stress in the market when things are undervalued. However, note that in crypto, an investor may choose to always DCA (as long as they intend to do for the long-term), as growth prospects are very high.

By buying when others are selling, DCA can potentially help an individual take advantage of buying low and selling high. But DCA is not only useful on the way in. Someone may use DCA on the way out too, when taking profit. It’s almost impossible to catch the absolute bottom, but DCA offers a way to remove timing from the equation. 

Profit from DCAing into BTC over the last 10 years: 

What is opportunity cost?

Opportunity cost refers to the potential benefit an individual misses out on when they choose another option.

By nature, opportunity costs are unseen, so they are easily overlooked. Understanding the potential missed opportunities when choosing one investment over another enables better, more profitable decision-making. 

Let’s take a simplified example, today’s choice may be buying a $5 coffee. The trade-offs are: not being able to spend that same $5 another way today and in the future, and not having benefitted from saving $5 regularly. 

The costs and benefits of all available options must be considered and compared to evaluate opportunity costs properly. 

When making an investment decision, an investor may ask themselves: what is the benefit of this option? What do I have to give up now if I make this choice? What do I have to give up in the future to make this choice? (the cost of the path not taken). 

For example, they may need to choose between selling their assets now or holding on to them to sell later. They may secure immediate gains by selling now, but lose out on potential future gains.

Opportunity cost is not an exact calculation. However, an investor may estimate the difference between the potential returns of each available option.

OPPORTUNITY COST = RETURN FROM THE MOST PROFITABLE OPTION – RETURN FROM CHOSEN OPTION

To properly evaluate opportunity costs, an investor needs to consider and compare the costs and benefits of every option available. Every decision has losses and gains.

Opportunity cost requires an investor to think long-term. It’s very easy to contemplate the cost incurred the moment a decision is made. 

Someone may be more likely to choose a decision that will earn them more money in the short term, but long-term growth usually involves making decisions that don’t offer a return until much later. 

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What is passive income?

Passive income is a fundamental pillar of investing and making money in general, it's why the rich are rich! Put simply, earning a passive income involves investing money into something that will generate an income or a “yield.” 

“Yield” refers to the financial returns of a particular investment strategy. Any profits that you make on that strategy is its yield. It can come from many sources, and each may have a different reward and risk profile. 

Crypto allows the creation of passive income in many ways, including yield farming, staking, and lending. 

Lending

The most basic source of yield is lending.

Lending is when depositors lend out their assets to earn a yield, which is paid by the borrowers. People borrow assets as it allows them to leverage their exposure and earn potential greater returns. Leverage simply refers to an investment strategy of using borrowed money to increase the potential return of an investment.

Make sure to take the time to understand the risk profile of the platform before participating in lending or borrowing. 

Yield farming

Yield farming, also known as liquidity mining, is a method of generating rewards with crypto holdings. In simple terms, it means locking up crypto assets and receiving rewards. Often, it involves users called liquidity providers (LPs) that add funds to liquidity pools. 

Liquidity refers to the ability to convert one asset into another asset without changing its market price. A liquidity pool is simply a pool containing two or more digital assets. Liquidity pools allow anyone to provide liquidity (by depositing assets) or take liquidity (by bulling/selling assets).

By providing liquidity to a crypto exchange, depositors earn transaction fees from that exchange. In some cases, depositors can also earn additional rewards on top of transaction fees. These are in the form of the exchange’s native token. 

Collecting these additional rewards is often referred to as “yield farming.” It can help to boost liquidity for short periods of time. 

While this may sound very lucrative, it’s essential to understand the risks associated with providing liquidity. This includes the concept of impermanent loss, which can be better understood as the opportunity cost that is paid for providing liquidity. 

​​Impermanent loss is one of the risks associated with using liquidity pools. It occurs when you provide liquidity to a liquidity pool but the price of your deposited assets alters compared to when they were deposited.

As a result of impermanent loss, liquidity providers end up with less value than they would have if they simply held the tokens.

Staking 

On proof of stake (PoS) blockchains like Ethereum and Solana, users can participate in securing the blockchain network by “staking” their ETH (Ethereum) or SOL (Solana). (Learn more about proof of stake in Module 4). 

Staking involves operating physical infrastructure to run a validator (software that verifies transactions). For those who don’t have the resources to run a validator individually, there are staking pools. 

A staking pool is simply a combination of crypto deposits in a pool managed by a collection of validators. Staking is rewarded in the form of the blockchain’s native token (SOL on Solana, ETH on Ethereum etc.) over time. 

Note you can also stake but not secure the network, PoS is when you secure the network as that is its consensus mechanism. Many protocols use staking as a way to lock up token supply, artificially increasing the price without any value actually being added to the ecosystem - this is a red flag, but often used in crypto. 

Annual percentage yield (APY)

APY = (1 + r/n)ⁿ - 1

Annual Percentage Yield or APY is the actual rate of return on investment, taking into account compound interest. Compound interest is periodically added, increasing the total. This means that each interest rate with be higher, based on the higher total amount. 

r = period rate 

n = number of compounding periods

For example, an investor is comparing an investment that pays 6% annually and an investment that pays 0.5% per month with monthly compounding.

At first glance, the yields appear the same because 12 months multiplied by 0.5% is 6%. 

However, when the effects of compounding are taken into account by calculating the APY, the money market investment actually yields (1 + .005)^12 - 1 = 0.06168 = 6.17%.

Annual Percentage rate (APR)

An annual percentage rate (APR) is the annual rate earned by an investment. APR only accounts for simple interest, the annual percentage yield (APY) takes compound interest into account

What is compound interest?

Compound interest is often referred to as “interest on interest.” It involves adding the interest earned on an investment to the initial sum invested. 

Many traders claim staking rewards and reinvest them, increasing the amount staked and thus increasing the amount of future rewards. In this way, compound interest is created. Many platforms offer auto-compounding, resulting in higher returns. 

Compound interest is more profitable than simple interest (where the accumulated interest is not combined with the initial amount). 

Let’s look at a basic example.

You have $1000 in a savings account with a 5% annual interest rate. In year 1, you’d earn $50 on the $1000. So your new balance is $1050 at the end of the first year. In year 2, you’d earn $5 on $1050 (initial investment plus the interest from the yield before), or $52.50. So, your new balance is $1102.50 at the end of year 2. 

Thanks to the power of compound interest, your savings account balance would grow exponentially over time as you earn interest on increasingly larger amounts. 

If you kept the original $1000 in this savings account for 10 years you’d end up with $1,629. After 20 years, you’d have $2,653. And, after 50 years you’d have amassed $11,468.

With compound interest, time is everything. The earlier you start, the more time you give your money to grow.

Never invest more than you can afford to lose

Finally, a basic but vital rule: don’t invest what you can’t afford to lose. Even if you strongly believe in crypto, anything can happen.

By exploring the essentials of crypto investing, including volatility, diversification, and dollar-cost averaging, you're now better prepared to tackle the tumultuous waters of the crypto market.