&l;p&g;&l;img class=&q;dam-image getty size-large wp-image-944641014&q; src=&q;https://specials-images.forbesimg.com/dam/imageserve/944641014/960×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; Berlin, Germany – April 10: In this photo illustration a coin of the crypto currency Bitcoin stands on a hard disk on April 10, 2018 in Berlin, Germany. (Photo Illustration by Thomas Trutschel/Photothek via Getty Images)
Crypto naysers who think Bitcoin is &a;ldquo;the ultimate bubble&a;rdquo; love to point at so-called HODLers and laugh.
HODLers are crypto investors who buy and hold their positions regardless of price. Whether the market is up, down or sideways, these folks stay invested, confident in the long-term value of crypto. The term &l;a href=&q;https://bitcointalk.org/index.php?topic=375643.0&q; target=&q;_blank&q;&g;was created in 2013 in a Bitcoin chat forum&l;/a&g; by an investor who was watching Bitcoin&a;rsquo;s price fall sharply but decided not to sell. He wrote a post titled, &a;ldquo;I am HODLing,&a;rdquo; meaning to write &a;ldquo;HOLDing.&a;rdquo;
The misspelling caught on with the Bitcoin community. Eventually, working backward, they turned it into an evocative acronym: &l;strong&g;H&l;/strong&g;old &l;strong&g;O&l;/strong&g;n for &l;strong&g;D&l;/strong&g;ear &l;strong&g;L&l;/strong&g;ife. Anyone who has watched Bitcoin&a;rsquo;s recent volatility knows that the acronym can sometimes feel spot-on.
To the mainstream investment community, however, it&a;rsquo;s the epitome of crypto insanity. You can almost hear them tut-tutting from behind their mahoganied desks:
&l;em&g;Look at these fools, holding their imaginary money with no regard to price. They just sit there and watch while their portfolios fall by 50% or more. Insanity!&l;/em&g;
But HODLing is actually the only valid strategy for most crypto investors. After all, it&a;rsquo;s just &a;ldquo;buy and hold&a;rdquo; in an updated wrapper.
Consider that, on the day the term HODLing was first mentioned, Bitcoin prices fell 24.67%, part of a 46% slide that took place from Dec. 10 to Dec. 18. You can see why people&a;nbsp;were panicked.
But Bitcoin prices are up 1,338% since that time.&a;nbsp;While it hasn&a;rsquo;t been a direct path&a;mdash;prices tumbled to $183 by Aug. 18, 2015, before staging a massive rally&l;span&g;&a;mdash;i&l;/span&g;f the person who coined HODL had $10,000 invested in Bitcoin at that time, it would be worth $143,829 today.
Who&a;rsquo;s laughing now?&l;!–nextpage–&g;
&l;strong&g;The Critical Flaw In HODLing&l;/strong&g;
Despite this spectacular example, investors who naively HODL make a fundamental mistake that can prove costly over time.
Let&a;rsquo;s imagine that our HODLing investor started 2013 with the following portfolio:
&l;/p&g;&l;ul&g;&l;li&g;55% Stocks &a;ndash; Vanguard Total World Stock ETF (VT)&l;/li&g;
&l;li&g;40% Bonds &a;ndash; Vanguard Total Bond Market ETF (BND)&l;/li&g;
&l;li&g;5% Bitcoin (BTC)&l;/li&g;
This portfolio would have delivered spectacular returns, rising 446% from Jan. 1, 2013 through April 16, 2018. That&a;rsquo;s more than 10X the 39% total return of a traditional 60% equity/40% bond portfolio over the same time period.
But the massive return comes at a price, which is exponentially higher risk: The monthly volatility of the portfolio spikes from 6.8% for the traditional 60/40 portfolio to 39% for the Bitcoin portfolio, while the maximum drawdown rises from 12.2% to a startling 58.4%. The Sharpe ratio of the portfolio&a;mdash;a measure of the portfolio&a;rsquo;s risk-adjusted return&a;mdash; falls slightly from 0.92 to 0.90, as the massive increase in risk overwhelms the higher returns Bitcoin offers.
The&a;nbsp;issue, however, has nothing to do with Bitcoin itself. Instead, it has to do with how the portfolio is managed.&a;nbsp; Specifically,&a;nbsp;the substantial rise in Bitcoin&a;rsquo;s price over this time causes it to eventually dominate the portfolio, with its allocation rising from 5% to more than 98% of the portfolio at its peak.
&l;img class=&q;size-full wp-image-7&q; src=&q;http://blogs-images.forbes.com/matthougan/files/2018/04/Picture3.jpg?width=960&q; alt=&q;&q; data-height=&q;529&q; data-width=&q;974&q;&g; Given the huge volatility in crypto, rebalancing is critical.
This is patently absurd: No investor wants 98% of their portfolio in Bitcoin. The solution, of course, is to systematically rebalance the portfolio, so allocations stay in line with an investor&a;rsquo;s goal.
Imagine, for instance, that our investor started with a 5% allocation to Bitcoin but rebalanced whenever their allocation rose or fell by 50%, e.g., they sold when Bitcoin hit 7.5% of their portfolio and bought when Bitcoin hit 2.5% of their portfolio, always bringing their Bitcoin allocation back in line with the targeted 5%.
This systematically rebalanced Bitcoin portfolio still delivers very strong returns, rising 104% over the time period we looked at, but it does so with much lower risk. Specifically, the monthly volatility is cut by nearly 75% compared to the portfolio that held Bitcoin without rebalancing, falling from 39% to just 10.2%, while the maximum drawdown is slashed from 58.4% to just 8.6%. Remarkably, that&a;rsquo;s a lower drawdown than the 12.2%&a;nbsp;experienced by the traditional 60/40 portfolio without Bitcoin.&a;nbsp; In other words, despite being extremely volatile as a stand-alone asset,&a;nbsp; Bitcoin actually lowered the maximum drawdown of our portfolio, thanks to its low correlation to the both&a;nbsp;stocks and bonds.
Not surprisingly, the Sharpe ratio of this systematically rebalanced portfolio is much higher than either the traditional 60/40 portfolio or the un-rebalanced Bitcoin portfolio, clocking in at 1.35, roughly 50% higher than either of its peers.
HODLers get dismissed by traditional investors as rubes: crypto maniacs who buy and hold regardless of price. But buying and holding is the only rational approach in an asset as volatile as Bitcoin, where trying to time the market is nearly impossible.
Still, HODLers can&a;rsquo;t just sit idle: To maximize their risk-adjusted returns and maintain a reasonable portfolio, they need to systematically rebalance their portfolio over time. The rebalancing function forces investors to sell high and buy low, keeping portfolio allocations in check.
As with all investments, having a disciplined, rules-based approach is important in crypto.
&l;hr&g;&l;em&g;Disclaimer: The information contained herein is not investment advice. Past performance is no guarantee of future returns. Crypto assets are extremely volatile and are only appropriate for certain investors. Consult with your investment professional before making any investment.&l;/em&g;