Welcome to the second edition of our "CryptoTechFin Financial Education" newsletter. In our first edition, we talked about diversification as a good practice when investing (you can read the article here). This time, we will focus on the topic of risk in investments.
Many people may see investments in cryptocurrencies as risky (and to some extent, it is!), but it is important to understand that all investments carry certain risks. We will learn some ways to properly evaluate them to protect our investments.
What is risk when it comes to investing?
The risk of an investment is the probability that the return will be less than expected, meaning that the investment made does not provide the expected return or that losses exceed the initial investment.
There are several indicators to measure risk such as Beta (β), Alpha (α), the Information Ratio... We will discuss them in later articles, but today we will focus on Maximum Drawdown and how it can be used in conjunction with Return (in the indicator called RoMaD) to evaluate different investments.
However, before that, we want to delve a little more into the importance of evaluating risk.
Why is it important to consider risk?
In summary, measuring risk will help us create a strategy that keeps potential losses under control. There is a phrase that we love because we believe it summarizes the concept very well: investing without managing risk is not investing, it's gambling. And the first step to managing risk is being able to measure it.
To understand this in detail, let's look at a hypothetical example. Let's imagine that we want to choose between investing in Google or Apple stocks. Let's assume that we only look at the returns that both companies have given us in the last 6 months.
Company | Return |
12% | |
Apple | 10% |
With this information, Apple would clearly be a more interesting investment. However, let's add more information: the evolution of the investment in both assets during these 6 months.
Now we know that the initial price in March 2021 is the same in both cases and that the gain in September 2021 is slightly higher in the case of Apple, but gain should never be the only data we use to evaluate an investment. If we look at the graph, we can see that the historical evolution of the two assets differs quite a bit.
Entonces, supongamos que tuviéramos que vender un mes antes, en agosto de 2021. En el caso de Google, el rendimiento sería 0% y en el caso de Apple, una pérdida de -25%.
Month | % Return Apple | % Return Google |
April | 16.67% | 50.00% |
May | 0.00% | 33.33% |
June | 66.67% | 66.67% |
July | -33.33% | 33.33% |
August | -25.00% | 0.00% |
September | 12.00% | 10.00% |
As we can see, in most cases (4 out of 6 times) Apple would have given us worse results than Google. Therefore, although Apple's return is currently higher, we could say that it would be a riskier investment. We could have reached the same conclusion if we had obtained the RoMaD of both the investment in Google and in Apple, as we will calculate later.
It may sound a bit drastic, but we remind you of what was mentioned at the beginning of this article: without proper risk management, investment dangerously approaches gambling.
About RoMaD
RoMaD helps us balance the risk we take with the gains we can obtain. We could say that this indicator helps us understand if the potential money we can expect to earn from the investment is proportional to the possible losses we expose ourselves to.
As mentioned earlier, there are two elements of RoMaD:
Return: refers to the gain or loss in a given time period. In other words, it is the gain obtained as a result of investments made.
Maximum drawdown: is the largest observed loss from a peak to a subsequent low point. In other words, on a chart, it is the most pronounced reduction. An example of a chart is shown below:
Continuing with our example of Google and Apple, let's mark the Maximum Drawdown of each.
Therefore, we would calculate RoMaD as:
Apple | |
12% / 60% = 0.2 | 10% / 40% = 0.25 |
From the RoMaD point of view, the investment in Google would be more interesting, as its return is higher than its historical losses.
However, its use as an exclusive indicator for evaluating investments has some drawbacks.
The maximum drawdown does not necessarily reflect the total risk of an investment, as it only considers the maximum loss recorded during a specific period.
On the other hand, in the same way, it only focuses on the last value of the return, ignoring historical return information.
RoMaD does not take into account the recovery time for losses, which can be especially problematic for long-term investments.
Finally, and partly due to the aforementioned, it is an indicator that is very focused on the short term and does not take into account the long-term performance of an investment.
Traditional stocks vs cryptocurrencies
Calculating the return on maximum drawdown (RoMaD)
To analyze traditional stocks vs cryptocurrencies, we will perform a comparative analysis of Return on Maximum Drawdown (RoMaD) for 2021 and 2022 of the following assets:
Gold: one of the best-known safe-haven assets
Oil: another important asset
IBEX 35: stock index of the 35 largest companies on the Spanish stock exchange
Bitcoin: one of the most important cryptocurrencies by market capitalization
Ethereum: another of the most important cryptocurrencies by market capitalization
Matic: Polygon token, another of the most important cryptocurrencies with the fastest growth in recent years.
StaticIndex: our index based on a 10 cryptocurrency index algorithm selected by CryptoTechFin
This analysis will allow us to compare the performance of traditional assets with that of cryptocurrencies in terms of RoMaD, which will help us determine which type of assets are more efficient to invest in.
Gold
Return: -15.21 %
RoMad: -15.21 %/ 20.43%= - 0.74
Oil
Return: 73.92%
RoMad: 73.92%/37.99% = 1.95
IBEX 35
Return: -6.02%
RoMad: -6.02%/21.76% = - 0.28
Bitcoin
Return: -18.72%
RoMad: -18.72%/ 68.92% = - 0.27
Ethereum
Return: 120.96%
RoMad: 120.96%/77.20%= 1.57
Matic
Return: 4763.76%
RoMad: 4763.76%/87.95%= 54.16
StaticIndex
Return: 185.66%
RoMad: 185.66% / 11.33% = 16.39
Conclusion
To summarize the analysis of the previous section, we present in a table the RoMaD of each asset:
Asset | RoMaD |
Oil | + 1.95 |
Gold | - 0.74 |
IBEX 35 | - 0.28 |
Bitcoin | -0.27 |
Ethereum | + 1.57 |
Matic | + 54.16 |
StaticIndex | + 16.39 |
As mentioned earlier, RoMaD is an indicator for understanding the risk/reward relationship of an investment.
In our analysis, the 2 best RoMaD results during the analyzed period are from Matic and StaticIndex. When comparing cryptocurrencies to the traditional market, we can see that Matic and StaticIndex, in second place, have a better RoMaD indicator than traditional products. We can also observe that the RoMaD of Oil is higher than the RoMaD of Bitcoin and slightly higher than that of Ethereum.
Finally, it is interesting to note how since January 2021, the RoMaD of BTC and IBEX 35 are very similar. The important thing is to understand that although the risk of cryptocurrencies is usually higher, so are the potential gains, and this is what helps us understand RoMaD.
We would like to make a side note to link this article to our previous article on diversification. As we explained, investing in a single product involves an additional type of risk, in that we are not diversifying. Thus, we can conclude that both the IBEX 35 and StaticIndex (the latter to a lesser extent) are fairly diversified products, which makes their RoMaD calculation more "stable" and less prone to changes over time, while other products like MATIC depend only on themselves and their RoMaD can be altered (for example, if we had started the comparison in January 2022, the RoMaD would be radically different).
Lastly, we want to remind you that you can subscribe to our Newsletter here so you don't miss a single edition.
We are looking forward to sharing with everyone our knowledge and experiences about this fascinating world of investments and finance.
Until the next edition!
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