When cryptocurrency exchange FTX filed for bankruptcy on 11 November, it plunged the sector into crisis. Digital currencies dropped in value as investors ditched their investments, an investigation was launched into the company, and some commentators labelled the event crypto’s “2008 moment”. But what can the events teach investors?
There’s no denying the collapse of FTX has had, and will continue to have, a dramatic impact on how cryptocurrency is seen by the world. Alongside the reputational damage it’s suffered, crypto has lost trust and credibility – crucial for any emerging asset class. Greater regulatory scrutiny will follow, but whether it will ever fully recover is at this point unclear.
Whether you’re a crypto-believer or a sceptic, the last few weeks contain valuable lessons for all investors to take away.
1. Invest in what you understand – or entrust your money to people who do
The collapse of FTX was rapid, and surprised its users, investors, and the broader crypto community.
Over one million customers had money invested in the exchange – and there’s no guarantee they will ever get it back.
The speed of FTX’s collapse and investors’ inability to recoup their losses highlights the risks of investing in a highly speculative and unregulated industry. Investors will have been unable to monitor the health of the company and no checks were in place to safeguard their money when the problems were unearthed.
Regulation sometimes gets criticised for slowing down innovation, but its real purpose is to protect consumers. The wider investment industry has evolved to have several checks and balances in place – fund and wealth managers, including Nutmeg, are required to place client assets with custodians to make sure that investors’ funds are held separately to the money used to run the business.
Many wealth managers, including Nutmeg, invest through exchange-traded funds (ETFs). The underlining companies held through these funds are different to those that operate in the cryptocurrency space. Because they are publicly listed and traded on an exchange, such as the well-recognised FTSE 100 and S&P 500, they are required to be transparent about the health of their business.
When you see companies posting their results, or issuing profit warnings, they aren’t just doing it because they want to – it’s an obligation they’re fulfilling to their shareholders. Investors need to know where they stand and so can make judgement calls about whether to stay invested, sell shares, or buy more.
In the case of FTX, the lack of regulatory scrutiny kept investors in the dark, meaning they couldn’t act until it was too late.
The lesson here is to invest in what you understand, or at least correctly assess the level of risk you’re taking. Investing in a nascent asset class like cryptocurrencies or, for example, smaller illiquid companies with no revenue, carries enormous risk of permanent loss of capital. Even investing in larger, more established businesses can be problematic if no due diligence is carried out.
2. Diversify for downside protection
Diversification is frequently touted as one of the golden rules of investing, and for good reason. It’s important in all market environments, as the FTX collapse showed.
After the company went bankrupt, fear spread across the cryptocurrency market. Currencies went into a correlated sell-off, meaning they all went down at the same time. The CoinDesk Market Index (CMI) shows that, in aggregate, the cryptocurrency market fell sharply during November, with the event driving the performance of the entire asset class.
If you’d held one cryptocurrency, or had all your money in crypto, you would likely be facing steep losses this year, and may also be struggling to cash in your investments at a time when many other investors are trying to do the same.
It’s a reminder for investors to diversify not just across different asset classes, but within them as well.
We know that global markets have by and large had a difficult 2022. However, by investing across different markets, you can spread the risk across multiple asset classes, sectors and companies, thus reducing your exposure to any single one of them providing disappointing returns.
Let’s look at equity markets as an example. While both the S&P 500 in the US and FTSE 100 in the UK delivered negative returns in the first 10 months of 2022, the former had fallen by double digits and the latter was down only marginally overall.
One of the reasons for this is that the FTSE 100 contains several energy companies, a sector which has largely had a bumper year. By having exposure to more than one index, you may be able to reduce the amount of drawdown you see in your portfolio.
It doesn’t guarantee good performance, but it can help shield against the worst market downturns.
3. Boring can be beautiful
It can be exciting to invest in the next big thing – especially when it’s touted as the future of money and validated in the headlines as the frontier of technology.
But it’s incredibly risky to invest all your money in something that isn’t fully understood or regulated. So, for the important stuff, it’s best to stick to what is known and what is trusted. It may not feel revolutionary, but it’s designed to get you to where you want to be in one piece.
This doesn’t mean taking no risk or less risk. It means following sound principles that you can stick to over time, particularly when markets are going through a challenging period. It’s about investing with your head not your heart, and being able to tune out the noise to focus on what you can control in order to achieve your long-term goals. After all, investors who have a longer-term strategy in place are usually best positioned to ride out day to day market movements.
If you’re interested in taking riskier bets in up-and-coming areas, just make sure it’s with money you can afford to lose.
The Nutmeg view
At Nutmeg, we aim to offer investments for our clients that have the potential to perform over a long-term horizon. Our investment team is constantly analysing the global macro environment to create portfolios that deliver long-term positive returns – and to make sure that our investors are taking on an amount of risk they’re comfortable with.
We would never completely write off an asset class – we will continue to keep an eye on the crypto world, and if one day we think there’s a possibility that it maybe become a long-term, viable and attractive asset class, we may reassess whether it belongs in our globally diversified portfolios.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.