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In 2014, a Reddit user created a unique price chart for Bitcoin. This had a rainbow overlay on the BTC/USD chart. And each band of the rainbow represented different market sentiments, from "Maximum Bubble Territory" at the top to "Basically a Fire Sale" at the bottom.

This later came to be known as the Bitcoin Rainbow Chart, and is a visual tool that helps us understand Bitcoin's price movement. While it's not a sure-shot model, it provides a framework to understand Bitcoin's price movements over time. This highlights trends and long-term growth in Bitcoin’s price, and where it could potentially be in the future.

Although no one can accurately predict the price, historical analysis dating back to 2012 reveals patterns that could help investors make more informed decisions. These insights are crucial, especially as some believe cryptocurrencies may lead to one of the greatest wealth transfers in history.

Lately, cryptocurrencies have become an integral part of financial discussions. From speculative gamblers to cautious investors, the market has drawn in a wide range of participants, each hoping to strike gold -- or mine Bitcoin.

Some embrace it as a store of value that could reshape global finance, while others dismiss it as a speculative bubble waiting to burst. So, let’s first talk about what Bitcoin intends to solve, and then what you need to know to come out ahead in this market.

Bitcoin & the Infinite Money Problem

Despite inflation rates recently cooling down and the stock market reaching record highs, the financial situation for many Americans has not significantly improved. Even though the S&P 500 has delivered annualized returns of approximately 10% since the 1920s, concerns about the dilution of purchasing power persist due to factors like monetary expansion. This dilution is one of the core issues Bitcoin aims to address.

Bitcoin's finite supply of 21 million coins sets it apart from traditional fiat currencies, which can be printed in unlimited quantities. Since its introduction in 2009, Bitcoin has outperformed nearly every other asset class. For instance, since 2015, Bitcoin's price has increased by over 22,000%. To put this into perspective, that's a compound annual growth rate of more than 100% -- ten times higher than that of the S&P 500.
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However, you should also acknowledge the extreme volatility. It's not uncommon for Bitcoin to drop 50% to 90% before eventually rebounding to new highs. So, how can you use this information to your advantage?

Crypto Secrets

While stories of traders turning modest investments into millions by investing in obscure coins capture public attention, the reality is such that these outcomes are exceedingly rare. Unless you get incredibly lucky, the chances of picking a cryptocurrency that yields significant profits are slim. Consider this, for instance: there are over 4,300 publicly traded companies in the United States, but there are more than 15,000 active cryptocurrencies at the moment.

According to research by Market Sentiment, over 40,000 cryptocurrencies have been traded on an exchange at least once in the last 10 years. Out of this, only 38% are still active. This means that the chance of a random coin surviving for more than a few years is roughly 1 in 3. And the chances of it being profitable? Even lower.

Interestingly, this mirrors the stock market. Research from an Arizona State University professor, who analyzed over 26,000 stocks since 1926, found that the average stock trades for only about seven years and loses money even with dividends reinvested. Only 48% of stocks delivered a profit more than a one-month treasury bill, and the most common return was a 100% loss. Moreover, just 4% of stocks accounted for the market's overall gains, while the other 96% simply kept pace with inflation.

Again, similar to the stock market, only a few cryptocurrencies contribute massively to the market capitalization and overall performance. Bitcoin alone contributes about 60% of the total crypto market capitalization, while the top 10 coins make up a whopping 89% of the market. By comparison, the top 10 companies in the S&P 500 contribute around 30%.

The Cryptocurrency Index

​Here is a Cryptocurrency index that is very interesting. On January 1st every year, $1,000 is split among the top 10 cryptocurrencies by market capitalization. They then compare it to the overall market to see which does better.

This year, despite Bitcoin performing exceptionally well, as of November 1st, the same portfolio of the top 10 coins is up just 3% since January -- compared to a 6% increase in the overall crypto market.

Much of the market, excluding Bitcoin, remained stagnant until November 4th, when a resurgence led to spectacular gains, most of which occurred in just two weeks. As of November 1st, consistently investing $1,000 annually in the top 10 coins since 2018 would result in a portfolio worth $20,829 -- far surpassing the $11,624 value of the same investment in the S&P 500. This shows us that cryptocurrency investments can yield higher returns over time despite extreme volatility.

But at the same time, in 2017, this portfolio suffered an 84% loss by year-end, with a total loss of up to 94% at its worst point. 2019 wasn’t much better. While Bitcoin saw an 89% increase, the overall portfolio returned a mere 1.74%. This is a lower yield than -- wait for it -- your bank account. Consistent investments in this index outpaced traditional markets until the bull markets of 2020 and 2021.

However, it’s also important to remember that these results are based on past performance and may not reflect future outcomes.

Why Bitcoin Has Rallied Recently

The recent surge in Bitcoin and cryptocurrency prices is driven by optimism around reduced regulation and new legislative proposals. A significant catalyst is a proposal initiated by Senator Cynthia Lummis to create a reserve fund that will control around 5% of the network's supply. This can potentially make the U.S. the largest government Bitcoin holder, akin to the country’s global gold reserves. Even President-Elect Donald Trump has publicly endorsed Bitcoin, further fueling optimism.

This interest extends to Democrats, too, who see Bitcoin’s potential as a reserve asset and a driver for America’s financial leadership. Advocates point to examples like El Salvador, whose Bitcoin holdings have surpassed $500 million, and companies like Tesla that include Bitcoin in their reserves. However, while there is potential, it does come with some inherent risks that you must consider.

A Cautionary Note

Since there are so many similarities between cryptocurrencies and penny stocks, here are some pitfalls to be mindful of:

1. Overconfidence: Research shows that investors often attribute success to skill rather than luck, leading to riskier decisions. Losses are downplayed, while wins are mentally exaggerated, creating a cycle of overconfidence and poor judgment.
2. Emotional Investing: Greed, fear, and regret heavily influence decisions. Many investors chase quick profits, hold on too long, or regret not making different choices, all impacting performance. Managing these emotions is vital for long-term success.
3. Risky Bets with Small Portfolios: Investors with less capital often take outsized risks in pursuit of unrealistic returns, which can frequently lead to losses.
4. Avoiding Traps: More often than not, the most profitable crypto investors are those who buy, hold, and do nothing. Speculative trading usually leads to substantial losses when the market crashes, while steady, long-term investors tend to fare better.

The Takeaway

While numerous factors are favorable for cryptocurrencies right now, like all other investments, you need to approach them with the necessary caution and understanding of the risks involved. The crypto market is highly volatile and speculative, and there's a solid chance you could lose a significant portion of your investment, just as much as you can gain from it.

Diversification, disciplined investing, and a long-term perspective can help mitigate some of these risks. As some analysts suggest, including a small allocation of Bitcoin in a diversified portfolio can enhance returns without significantly increasing volatility. For example, a 1% allocation to Bitcoin has historically increased portfolio returns by 1.3% with minimal additional risk.

At the end of the day, while the potential for significant wealth generation exists, it's important to invest responsibly. Only invest what you're willing to lose, consider taking profits when appropriate, and make informed decisions based on thorough research.
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That's it for this week. I hope you enjoyed this article. Let me know your thoughts by responding to this email - I read every single comment :)

Stay safe, stay invested and I will see you next week – Graham Stephan.

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