The recipe for superior returns is simple: time and risk. There are many types of risks, and some are more dangerous or known than others.
In traditional securities, we talk about interest rate risk and default (or credit) risk. In crypto, the risk to the investor is that the value of the cryptocurrency will fall. The last risk is liquidity risk, which is often misunderstood.
What is liquidity risk?
Liquidity risk involves sacrificing the ability to sell an investment when you want to earn a higher return. For example, if an investor has a choice between two identical types of investments, one that trades daily and one that would be locked in for five years before it could be sold, he will only buy the latter if it has the potential for a much higher return than the former.
If the return potential is worth it, illiquid investments can be an excellent investment strategy because an investor doesn't need all of his assets to be easily marketable.
The extra return required to justify an investment depends on the type of security and its degree of illiquidity. Small-cap cryptocurrencies trade erratically, so investors expect a higher return.
How to avoid liquidity risk?
When trading small-cap cryptocurrencies, I like to use the liquidity indicator on coinmarketcap to judge whether an exchange has decent to high liquidity, i.e. the coin can be easily traded.
Investors must opt to trade on exchanges that have high liquidity. One shouldn't invest in a cryptocurrency coin on an exchange that has little to no liquidity.
The investor must, therefore, target cryptocurrencies with which he or she feels comfortable and which are traded on prominent and highly liquid exchanges.
Thank you for reading and hope you have a good rest of the day!
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