Editors note: This article is from Blue Fox Notes (ID: lanhubiji), author SophonEX, from medium, translated by Sien of the Blue Fox Notes public account community, and published by Odaily with authorization.
Preface: It is normal for investment if the risk is higher and the return is higher. But some assets carry unforeseen risks with meager returns. Cryptocurrencies are volatile, but there are some coins that have better return expectations than traditional assets with similar tail risks. However, the research draws conclusions based on historical data. When investing, everyone should make prudent decisions based on their own risk tolerance.
If you hear a well-known economist use words like equilibrium or normal distribution, dont argue with him; ignore him, or try putting a rat in his shirt.
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Volatility Doesnt Measure True Risk
Typically, when people quantify financial risk, they use a concept called volatility. This is really just an illusion of volatility or spread of returns. It is generally measured by the standard deviation of the share return (logarithmic return to be precise). It reflects typical day-to-day changes in stock prices. For example, if we say that the daily volatility of the stock market is 1%, then, on 2/3 of the days, the stock volatility is between -1% and 1%, and you can only see less than 1 day in 20 days jumps of more than 2%.
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(the probability density function of a normal distribution, the bell curve)
The normal distribution has many nice properties. Generally speaking, it is safe to bet your money on a 3-sigma event (such as a senior bond default), and it is safe to bet your net worth on a 6-sigma event.
However, you may also notice that there are often some uncomfortable big moves in the market that far exceed your expectations. People use the black swan event to describe it. launched and became popular, especially after the shockwaves of the 2008 financial crisis. These events are more frequent than one might expect and have a significant impact on investment returns.
Alternatively, we can refer to these black swan events as heavy tail events, since the distributions that produce these large outliers typically have thicker tails than the normal distribution. In the following sections, we refer to these events as heavy tail events, or simply tail events.
What are the causes of these events in the financial world? There are countless possible explanations, but almost none of them are benign: information asymmetry, insider trading, excessive leverage, too concentrated assets, or even blatant market manipulation? These are not conducive to the long-term healthy development of financial markets.
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How to measure heavy tail?
Briefly, we measure heavy tails using the probability of two types of tail events (mild and extreme). The more frequently these two types of events are seen, the more “manipulated” the asset is.
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(SP 500 Daily Return Distribution: 2005-1014)
Intuitively, what do these two types of outliers (mild and extreme outliers) mean? Let me illustrate with an example. Youre probably used to the SP moving up and down, usually within 1% of the trading day for many months. Suddenly one day you glance at MSNBC or open Yahoo Finance and you see a 3% market drop, every stock pundit and commentator is hyping it up, flashing numbers, countless charts, and NYSE traders holding their breath. The picture of head panic. This is what is known as a mild outlier (outlier) feeling. But what if youre looking at a 10% market crash and cant immediately understand what that means for your portfolio. Also, everyone silently checks to see if their 401k account has been turned into a 201k...then, we get the feeling of being an extreme outlier (outlier).
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SPY price chart with outlier dates colored and calculated: 2015-2019
Of course, no one likes these unpleasant surprises. Unfortunately, when asset prices are determined by only a few factors, especially if these factors are obscure to the public and understood by only a few people, then this can be even more damaging to prices. So, by measuring the frequency of these types of events, we get a good idea of how different types of assets behave when they have heavy tail risk. Note that higher volatility does not necessarily mean higher heavy-tailed risk, since you can expect volatility, then there are few unpleasant surprises. For example, no one complains about Bitcoins 3-5% volatility these days, but people will curse if the SP 500 drops 3-5%. Unforeseen outliers do the most damage.
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The Heavy Tail Risks of Cryptocurrencies
In the figure below, we show the Moderate Outlier Probability (MOP) and Extreme Outlier Probability (EOP) for a variety of asset classes, including:
US stock market
Chinese stock market
Fixed Income (U.S. 20-Year Treasury Bond)
Real assets (gold and REITs)
cryptocurrency
Circle size indicates volatility and dot position indicates heavy-tailed risk (top right corner means more heavy-tailed). Lets tease out a few key observations from this graph.
1. Cryptocurrencies are indeed highly volatile and heavy-tailed
This matches our intuition. As we can see from all the big red dots in the upper right corner of the graph, mainstream crypto tokens such as BTC and XRP do have higher volatility relative to the vast majority of traditional assets, as well as higher mild and extreme outliers. group value.
For example, Bitcoin has an extreme outlier probability of up to 4%. This is a large number, and almost every 3-4 weeks, we can hear shocking events in the Bitcoin market. A surge to new price highs, or a bloody 20% crash, an ETF regulation rumor hype, or some exchange wallet hacking scandal, the list goes on and on.
However, not all cryptocurrencies are created equal. We can see some surprisingly docile creatures.
2. Some cryptocurrencies have better heavy tail performance than traditional assets
For example, some privacy cryptocurrencies, such as Monero and Dash, actually have less heavy tails than traditional investments such as the SP 500, not to mention the highly volatile Chinese stock market, which Similar heavy tail risks to some cryptoassets. This may be due to the fact that these privacy coins are more used for transactions rather than hoarding. This can also be verified by the relative ranking of their trading volume, these cryptocurrencies have a higher trading volume ranking relative to their overall market capitalization. More market participants, more liquidity, less manipulation, less heavy tail events.
So, arguably, Monero and Dash are actually better entry options for new investors than the big crypto giants like Bitcoin and Ripple, if theyre trying to break into the crypto world. At least, the data suggest, they get a good nights sleep.
Note that these privacy cryptocurrencies are also actually quite volatile, these are random risks that you can usually observe, so can be hedged or diversified, but less heavy tailed, heavy tailed events are annoying , which can wipe out most of ones assets or blow up your leveraged positions.
Furthermore, the cryptocurrency market is rapidly developing.
3. Cryptocurrencies are maturing
Bitcoin has a history of more than ten years. Thousands of exchanges now support bitcoin trading. In the graph above, we have provided two data points for Bitcoin, one for Bitcoin before 2015 and one for Bitcoin after 2015. As shown, we see a significant drop in the extreme outlier probability for Bitcoin, which is a nice trend. Cryptocurrencies are promising to become mainstream investment assets in the future, despite their history full of booms and busts.
In the future, we will see more crypto exchanges, more legal ways to enter the crypto market, and even more stablecoins and crypto funds backed by institutions. A new ecology is brewing and developing.
Is the heavy tail risk of cryptocurrencies justified?
The high risk of cryptocurrencies often scares people away. However, take a closer look at the risk-to-reward ratio in the graph above, where the magnitude represents the average daily return. Taking on a similar level of heavy tail risk, investors have been rewarded decently even in the recent cryptocurrency crash.
If higher risk means higher return, then risk is not necessarily a bad thing for investors. Random risks can be justified. However, some risks are bad for investors, and these risks have no proportional return, or only asymmetric risk: you are only getting a relatively small return, but you are faced with unforeseen events that may eat up your capital. assets. These investments are not, in Talebs phrase, antifragile.
in conclusion
in conclusion
Cryptocurrencies typically have higher volatility and higher tail risk than other traditional assets such as stocks, bonds, and real assets. However, some cryptocurrencies (such as Monero and Dash) have similar tail risk characteristics to U.S. stock indexes, and they give investors higher return expectations, which overshadow other traditional investments. Additionally, Bitcoin’s tail risk has also declined over the past decade, which may signal a more mature market.
