The volatility of Bitcoin attracts some investors while deterring others. Let's explore why this new asset experiences such dramatic price fluctuations, a phenomenon that long-term 'HODLers' have become accustomed to.

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What is Volatility?

In financial terms, volatility refers to rapid and unpredictable fluctuations in the price of an asset. Assets that regularly experience considerable price fluctuations are deemed more volatile than those whose prices do not fluctuate significantly.

Bitcoin is a relatively new asset that has monetized itself from absolute zero to $69,000 at its previous market peak in 2021. Zooming out over Bitcoin’s 15-year history highlights Bitcoin’s incredible performance over the long term. However, it is crucial to acknowledge that its path to monetization has been marked by euphoric price increases and subsequent price crashes over multiple market cycles. 

Due to these significant price fluctuations, Bitcoin is widely acknowledged as a volatile asset, particularly when contrasted with traditional investments such as bonds or equity. While volatility may result in above-average returns when investing, it can also be a source of financial loss.

Why is Bitcoin Volatile?

While many factors contribute to the volatility of Bitcoin, it is crucial to understand that it is not an inherent characteristic of Bitcoin as a technology but rather a reflection of its young and evolving nature, the existence of financial speculation, and Bitcoin’s small market capitalization. Below we will explore the main drivers behind Bitcoin’s volatility and examine whether we can expect Bitcoin’s volatility to decrease over the long run.

Bitcoin is a New Asset Class

“Volatility is a symptom that people have no idea of the underlying value”

-Jeremy Grantham

Bitcoin has been around for 15 years, and in this relatively short time, it has gone from a small project from an anonymous creator to an asset held by millions of people around the world.

The world is still discerning how best to value Bitcoin and determine the role it will play in the global economy. In other words, Bitcoin is undergoing price discovery as an asset. In this phase of monetization and price discovery, it is natural for Bitcoin to be volatile given the challenge of accurately valuing it. Many regard Bitcoin as digital gold, offering hints on how best to value this emerging asset.

Furthermore, during this phase of price discovery, people’s perceptions of the asset can be readily influenced. Since there is no central authority and no way to know its equilibrium value, comments and projections from established figures or firms can have a wide variance and ultimately affect people’s conviction in Bitcoin, further contributing to its volatility.

Investor Speculation

Financial speculation emerges as one of the primary drivers behind Bitcoin’s volatility as well. Institutional investors, drawn in by the potential for significant returns, are active market participants in Bitcoin and often use leverage to amplify their positions.

Similarly, retail investors also contribute to the speculative dynamics. Fuelled by social media coverage and the allure of quick profits, traders often participate in the Bitcoin market. Together, the combination of institutional and retail investors speculating on Bitcoin, often using irresponsible levels of leverage, significantly contributes to Bitcoin’s price fluctuations in either direction.

Bitcoin has a Small Market Capitalization

Further contributing to Bitcoin’s volatility is its relatively small market capitalization. Despite continuous growth in Bitcoin’s market cap and liquidity over the past decade, it remains below $1 trillion. This represents a market cap similar to companies such as Meta or Berkshire Hathaway, but still far from the market cap of assets like gold which stands at $13 trillion. The relatively small market capitalization and thus lower liquidity imply it is possible for a single entity to materially affect the price of Bitcoin by deciding to buy or sell the asset. 

Will Bitcoin Remain Volatile?

While Bitcoin’s volatility may act as a deterrent to investors entering the market, it is reasonable to expect Bitcoin’s volatility to decrease over time for a variety of reasons. As more investors, firms, and nation-states adopt Bitcoin and participate in its market, its growing liquidity and investor base will contribute to the maturation of Bitcoin as an asset and decrease its overall volatility.

Additionally, clearer regulations around Bitcoin can further dampen volatility by reducing the amount of financial speculation in the market. Given these reasons and more, expecting a gradual decrease in Bitcoin’s volatility over time seems reasonable. A closer examination of the Bitcoin Volatility Index solidifies these expectations — there is a discernible decrease in Bitcoin’s volatility over its 15-year existence.

In conclusion, Bitcoin’s volatility stems from a confluence of factors intrinsic to its young and evolving nature. As a new asset class, Bitcoin is undergoing continuous price discovery, with its value still attempting to be deciphered by the world at large. Combined with financial speculation and smaller market capitalization than many other traditional assets, Bitcoin emerges as a volatile asset. Looking ahead, as Bitcoin matures and gains wider acceptance, the balance between speculation and fundamental value may shift, potentially dampening its extreme price swings. Regardless, comprehending and acknowledging the dynamics behind its volatility is crucial for navigating the world of Bitcoin.