Intro to Crypto Investing
TL;DR: Depending on your risk appetite, crypto may be an appealing asset class. You want to avoid trying to time the market and instead, create a long-term strategy based on your financial goals. That means going through a cash-flow planning exercise and building in a safety cushion to cover your expenses so you’re not forced to sell if there’s a market drawdown. When you think about managing risk across your portfolio, consider the relative volatility and liquidity of each crypto asset. You’ll also want to consider the security and regulatory risks that are unique to crypto as an asset class and how crypto fits into your overall exposure to digital assets.
So you’ve decided to get in on the web3 revolution. Maybe you’ve been dollar-cost averaging into Bitcoin (BTC) and Ethereum (ETH) for a while, but you’re not sure how concentrated you should be or how crypto affects your overall financial profile. As a relatively new asset class, crypto offers a unique return profile (high-risk, high-return potential). By keeping your financial goals and relative risk tolerance in mind, you can build your own crypto investing strategy.
What is crypto?
"Crypto" refers to the general space of digital assets secured by a technology called public key cryptography. Those assets can take many forms including but not limited to: Bitcoin, Ethereum, NFTs, etc. Much of the interest in these assets is the ability to to trade them for profit.
What is crypto’s value as an asset class?
There are vocal promoters of crypto and detractors who see them as pure speculations, not real investments. Some benefits and risks to consider when weighing crypto as an investment opportunity vs. others include:
- High return potential
- Highly liquid
- Could be viewed as hedge against inflation
- Regulatory risks (i.e. government ban, securities treatment, etc.)
- Tax risks
- Security/technological risks (e.g. protocol may get hacked)
Note: You may have a heavy allocation to digital assets already—perhaps in your tech career or in your investments in a private or public crypto-related stock. Talk to your Financial Advisor to ensure you are monitoring your total exposure to digital assets.
General Rules of Thumb
If you have decided that you’d like to invest in crypto, there are a couple guidelines that can help mitigate risk:
- Avoid trying to time the market. They say “time in the market beats market timing”. Using leverage and shorting don't necessarily attribute well to a crypto portfolio, as these types of assets are asymmetric to the upside, meaning they can benefit greatly from positive news and jump up in price.
- Create a long-term strategy. One way to think about buying crypto with any excess cash—whether it's from a salary or proceeds from a liquidity event—is to determine the total amount that you want to allocate to crypto vs. other assets. You can then average into the position and build a repeatable, testable strategy that can be used to invest in both bull and bear markets.
How should I think about diversification?
A natural question when thinking about crypto and wealth management is how to think about diversification. This is a hotly debated topic among crypto holders. One popular industry saying is, “Concentration builds wealth. Diversification preserves wealth.” For a few reasons, crypto holders may be relatively concentrated. They might feel that the risk-return on stocks and bonds in the current interest rate environment isn’t attractive. They might also be bullish on crypto for philosophical or personal reasons. Generally, diversification will depend on your overall financial picture, personal motivations, and long-term financial goals. There’s a wide range of how concentrated investors might be. For example:
- Hold very little to no crypto. They may not want to invest in an asset class they don’t fully understand or feel uncomfortable with crypto’s relative volatility.
- 5-10% of personal net worth in crypto. These folks might see crypto as a part of their overall portfolio and an important part of their overall diversification strategy.
- Net worth is 70%+ in crypto. This is the far end of the spectrum. They might work full time in crypto (at a company or fund) and have the majority of their future earning potential tied to crypto as well.
Over the last 10 years, we've been through several crypto market cycles. There was the 2011-2013 bubble (and secondary bubble) and the 2017 bubble. We’re currently experiencing 2021 market fervor. An important exercise is thinking through the amount of money you would need to live on, assuming that everything were to go wrong (which it has before). This is especially important for those who haven't been through a previous bear market (when there is less available capital and prices significantly drop from their peak), where a lot of people got overextended and put into really tricky financial positions. Diversification can help protect against this scenario and ensure that even if there is a market correction, you’d have enough savings to meet your financial needs.
Having a safety cushion also ensures that you’re not forced to sell at the bottom or when the market sells off (often called “sequence of return risk”). A safety cushion gives you the ability to either ride out a market decline or even add some liquidity to your investment.
Look at what your monthly expenses are. Add up your mortgage or what you pay in monthly rent, food and living expenses, bills, insurance, taxes, etc. and come up with a dollar amount. That is the minimum number you need to have socked away in the event of an emergency. (As a general rule of thumb, you shouldn't be spending more than 20-30% max of your monthly paycheck.) Define an emergency target of cash on hand (3-6 months of living expenses on hand) and keep it in an FDIC-insured cash or cash-like investment vehicle (money market fund or high-yield savings account). These funds should be held in very low to risk-free accounts and not invested in the market.
How can I think about managing risk?
Once you’ve gone through the cash-flow planning exercise and have identified how much you need in your emergency savings account, you can start to think about your desired asset allocation between public markets and alternative investments (including crypto). That exact breakdown depends on your risk tolerance and personal financial goals.
Within that allocation to alternative investments, you’ll decide how much to put toward crypto assets. The makeup of that crypto portfolio should take into account the expected volatility of each selected crypto asset relative to your risk tolerance level.
For example, a BTC- or ETH-heavy portfolio may be less volatile than an alt-heavy (any cryptocurrency that is not BTC or ETH) portfolio. An alt-heavy portfolio is more likely to drop sharply in the event of a bear market because institutional buyers have significant BTC and ETH holdings. This can help provide a guide as to how risky your crypto portfolio is. From there, you can scenario-plan and ask, “What happens if my crypto portfolio were to drop 75%? Could I still sustain myself? Do I have enough cash savings set aside? How would I react if this happened?”
Another thing to consider is the liquidity of your crypto portfolio. For example, the liquidity of NFTs might totally dry up in a bear market and you may not even be able to sell and recoup your investment.
Once you have these safety precautions in mind, you can think a little bit more about diversifying into other assets. If your current liquid assets total less than $1M, it’s important to keep lower-risk assets with a specific allocation to riskier assets, whether that's DeFi, Bitcoin, Ethereum, Layer-1s, etc.
Individuals with more liquidity may want to think about diversifying into real estate or other assets in order to be able to absorb the shock of any type of financial event, whether it's inflation, deflation, rising rates, a government ban, etc.
While crypto may be more widely accessible than other investment alternatives, it has a less-proven track record as a relatively new asset class. Volatility and liquidity are important things to consider as you're thinking about the makeup of your crypto holdings and how it fits into your overall investment portfolio as a whole. In our next piece, we cover how crypto is taxed.