As an investor, it’s important to understand the different types of risk that come with investing in various asset classes. One type of risk that is often overlooked is the risk of alpha decay. This word might sound like the SOS code of a Martian colony, but it is probably one of the most important investing terms.
Alpha decay is actually a term borrowed from the field of nuclear physics, where it refers to the process by which a radioactive nucleus emits an alpha particle. In the world of investing, alpha decay refers to the loss of an investment’s ability to generate returns that outpace the broader market over time.
In other words, a fund or investment strategy that generates alpha — or excess returns relative to a benchmark — may not be able to maintain that level of outperformance over the long term due to factors such changing market conditions.
Explaining it even easier: when we have alpha, we have a profitable strategy. When we have alpha decay, is when we lost this profit-generating advantage.
Alpha Decay In Crypto
Alpha decay can be particularly problematic for actively managed funds, which rely on the skill of their managers to identify mispricings in the market and generate excess returns. As the market becomes more efficient and information becomes more widely available, it becomes increasingly difficult for managers to maintain an edge and generate consistent alpha.
This means trading profitably heavily involces an unfair advantage. Some piece of information your competitors don't know about. In a business this is more about doing something better. In investing everyone is doing the same. Placing buy and sell orders. But the question is when?
Even cryptocurrency investors are not immune to the risk of alpha decay. While the cryptocurrency market is relatively new and still evolving, there are already signs that the market may be becoming more efficient and that generating alpha may become increasingly difficult over time.
This is particularly true for popular cryptocurrencies like Bitcoin and Ethereum, which have seen a significant influx of institutional investment and increased adoption in recent years.
Often we look back old forum posts about Bitcoin and thinking how much easier it was back then. This is true. When less people knew about crypto, it was certainly easier to generate alpha for them.
As more investors enter the market and competition increases, it may become more challenging to generate excess returns.
Additionally, the rapid pace of innovation in the cryptocurrency space means that strategies that worked in the past may become less effective as the market evolves. These all further increasing the risk of alpha decay for cryptocurrency investors.
How To Avoid Losing Our Trading Edge
One way to mitigate the risk of alpha decay is to focus on investments with structural advantages that are difficult for others to replicate. This could include investments in illiquid assets, where there may be less competition and greater opportunities for alpha generation.
This also means, on the new, less-known coins it is easier to generate alpha.
Another approach is to seek out managers with a proven track record of generating alpha over a long period of time.
While past performance is not a guarantee of future results, managers with a demonstrated ability to navigate changing market conditions and generate consistent returns may be more likely to continue doing so in the future.
Trading cryptocurrencies involves risk. The information provided on this website does not constitute investment advice, financial advice, trading advice, or any other sort of advice and you should not treat any of the article’s content as such. Author, website or the company associated with them does not recommend that any cryptocurrency should be bought, sold, or held by you. Do conduct your own due diligence and consult your financial advisor before making any investment decisions. Lastly, this article is not targeted at French citizens or residents.