Scientific Study of When to Buy Crypto & Bitcoin

A very interesting study published by the scientists from Yale University, Professor Aleh Tsyvinski and economics Ph.D. candidate Yukun Liu claims that there are “good and bad times” to buy and sell bitcoins.

There has been thousands and thousands of scientific (and not so scientific) studies on the predictors of the stock market starting with simple moving averages and ending with the correlation between winning teams in Super Bowl and the behavior of S&P 500. However, this study is quite different.

While the past performance, as we all know, is not a guarantee of future results, these scientists have discovered two non-trivial statistical phenomena:

1.) The “momentum” effect.

This is rather simple: if the price of the bitcoin increased for one week very sharply, it will continue to increase next week; the same is true for the price movements in the opposite directions.

2.) The “investor attention effect”.

More searches on Google are done for the term “bitcoin”, sharper the increase in price. And, for example, the searches for “bitcoin hack” predict a decrease in price. The correlation between such searches is far from insignificant.

Using textbook financial tools, the scientists also discovered the below.

Cryptocurrency’s basic properties They documented a high return but with a lot of volatility. Does the high return compensate for the high volatility? This is called the Sharpe ratio, which measures the performance of an asset by adjusting for risk.

Surprisingly, they found that cryptocurrency’s Sharpe ratio shows that the return is higher than the risk implied by its volatility. It’s higher than the Sharpe ratio for stocks and bonds, but not drastically so. There have been asset classes and trading strategies with Sharpe ratios that are either the same or similar to cryptocurrency’s. So if you just look at return versus volatility, cryptocurrency looks more or less normal.

Does cryptocurrency behave like other asset classes? To answer this question, they looked at whether cryptocurrency returns can be explained by the same factors that drive returns of stocks, currencies, or precious metal commodities. For stocks, they examined 155 potential risk factors in the finance literature and found that almost none of them account for the returns of cryptocurrencies. They are not like stocks.

They also found no similarities between the behavior of cryptocurrency and five major traditional currencies — the Euro, Australian dollar, Canadian dollar, Singaporean dollar, and the British pound. They also saw no link between the behavior of cryptocurrency and gold, silver, or platinum. Their findings cast doubt on the popular narratives that cryptocurrencies derive their value from either serving as a unit of account, such as the usual currencies, or as a store of value, such as precious metals.

If cryptocurrency does not behave like these traditional assets, then is it possible to predict its performance? While they discovered that cryptocurrency behaves differently than traditional asset classes, the scientists also found that investors can better understand cryptocurrencies by applying common asset pricing tools to factors specific to them. They found that some of the factors people use to predict the performance of traditional asset classes can be used to meaningfully predict cryptocurrency’s behavior.

The first is called the momentum effect, which basically means that when an asset increases in value, it will tend to rise even higher. That is a feature of just about every known asset class, and they found that it strongly affects cryptocurrency. To take advantage of momentum effect, they have designed a simple strategy that says an investor should buy Bitcoin if its value increases more than 20% in the previous week. This strategy generates outstanding returns and a very high Sharpe ratio.

The second factor strongly influencing cryptocurrency is the measure of investor attention. They asked the following: If there is an abnormally high number of mentions of the cryptocurrencies they studied in either Google search or on Twitter, will their returns go up? It turns out that they will. At the same time, they found that negative investor attention, such as an increase in the use of the search phrase “Bitcoin hack,” will generate negative returns for cryptocurrencies.

Potential factors once thought would predict cryptocurrency’s behavior The first was the cost of mining, which is the price of producing cryptocurrency. They were surprised to see that it does not predict cryptocurrency returns. The second is the price-to-“dividend” ratio, which is one of the most important factors in assessing stocks. Is the price of this stock too high compared to the earnings or the fundamental? Cryptocurrency obviously does not pay dividends, but one can still study a similar metric. They found that a proxy for a price-to-dividend ratio — asking whether the price of a cryptocurrency is too high for its fundamental — does not predict cryptocurrency returns.

The same thing is true for volatility. One would have thought that the more volatility, the higher the return to compensate that. That is not the case. Neither high nor low volatility strongly predicts cryptocurrency returns.

Based on their analysis, how much Bitcoin should a typical investor hold? When you invest in your retirement, Vanguard or whatever platform you use will suggest how to best allocate your portfolio. If you as an investor believe that Bitcoin will perform as well as it has historically, then you should hold 6% of your portfolio in Bitcoin. If you believe that it will do half as well, you should hold 4%. In all other circumstances, if you think it will do much worse, then you should still hold 1%. Of course, one has to remember that, as with any other assets, past performance is not a guarantee of future returns.

Amidst the interesting revelations in the study, Risks and Returns of Cryptocurrencies also highlights how in certain areas Bitcoin now has the power to outdo traditional bonds and stocks. Making use of the Sharpe ratio, Tsyvinski was able to demote that cryptocurrencies – in spite of wild volatility levels – actually have higher potential returns. For the purpose of the study, he examined Bitcoin, Ethereum, and Ripple, but there is no reason as to why Litecoin, Bitcoin Cash, Dash, and more can’t be just as potent when it comes to profits over the long-term.

Professor Dragan Boscovic of Arizona State University also came to a similar conclusion in an earlier study: “Institutional investors recognize this new asset as a valuable investment opportunity, which will encourage private investors, and will also encourage consumers and small businesses to trade to start from cryptocurrencies “.