For the novice investor in cryptoassets, it may seem that investing in crypto means buying either bitcoin or ethereum. The reality, however, is that there is a heterogeneous investment universe of cryptoassets, with each of these assets offering unique characteristics, such as the underlying business model and design of the token model. Coinmarketcap.com lists 2094 different cryptocurrrencies at the time of writing. It is therefore critical that investors seek to understand what is available, how it may be accessible, and, of course, the merits of each individual potential cryptoasset investment. While it is true that there are vast differences in the types of cryptoassets and underlying technology, there are many golden rules, such as diversification, that can be applied to increase the chances of making a successful cryptoasset investment.
The crypto sphere can be overwhelming
The dizzying pace of evolution in the crypto space, both in terms of the size of the universe and underlying technology, can often scare off investors. Prospective investors have two options to help them see the forest for the trees in this situation: namely, taking an active or passive approach to investment. The former requires a lot more resources in order to be executed with the best chances of success, as this approach means that each prospective investment must be researched and analyzed, which can be a heavy burden to take on. Despite the intensive nature of this approach, it can yield better outcomes, but it can also lead to much worse outcomes. The passive, or indexing approach, on the other hand, provides a much easier way for investors to gain exposure to a basket of cryptoassets based on, for instance, their total market capitalizations.
For example, a tokenized crypto index fund would offer returns based on the total market capitalizations of all of its holdings. By purchasing the tokens of such a fund, which are freely tradeable on various exchanges, investors gain access to a market cap weighted index of a selected combination of cryptocurrencies (rebalanced regularly). For the unsophisticated crypto investor, this approach is optimal and could be used within portfolios to gain generalized exposure to cryptoassets that already have some form of backing and a base level of credibility in the market, and are therefore less likely to completely erode in value.
Another area that can be hard to stomach is the price volatility of a cryptoasset investment. We have all been there, contemplating the outsized and often mouthwatering returns that we could achieve by investing in a friend’s hot tip. In this respect, a healthy dose of ‘Buyer Beware’ should be administered to calm behavioral biases, such as the overconfidence bias, that may lead to permanent capital loss.
While indexing should provide more diverse sources of return and in so doing provide for at least some smoothing of overall return volatility, it has been observed that there does exist high levels of return correlations between individual coins. This is most widely dubbed bitcoin beta, where many of the coins show healthy levels of price correlation with bitcoin (the world’s first and largest market capitalization cryptocurrency). We often witness new investors take the plunge and buy their first bitcoin holdings only to over-diversify into a magnitude of less established alternatives. Investors must bear in mind that the less established an alt coin is in terms of network value (i.e market capitalization), the more vigorous its price swings relative to bitcoin may be. In this sense, novice investors should, in general, allocate far less to more circumspect coins versus relatively established coins, such as bitcoin.
However, there are exceptions, such as the phenomenon known as a stable coin. Essentially, stable coins are digital assets which have value linked to the value of a more well-known asset or asset class, such as gold or the US dollar. In this type of structure, a cryptocurrency will largely mimic the price movement of the asset to which it is pegged. For stable coins, the relationship is unlikely to be a perfect one-to-one relationship when it comes to price movements, as there may be idiosyncrasies with the actual stable coin that would cause it to deviate away from the price of the underlying asset. One of the key benefits that stable coins offer is, depending on the linked asset, they can offer substantially lower volatility than other cryptocurrencies. For example, tether, a stable coin linked to the US dollar, shows minimal volatility relative to the US dollar. This is to be expected, with issuance of the tether cryptocurrency based on actual US dollar reserves and one tether equivalent to one US dollar. While it may not be obvious why tether exists – after all, it offers zero interest rate unlike a fiat currency bank deposit – it offers holders faster transaction times, lower transaction fees, and of course price stability.
The most popular methods of crypto investment
Investors typically invest in cryptoassets via exchanges such as Binance, Poloneix, and Bittrex. Besides using indexes, investors can also gain exposure to lesser-known types of investing such as mining and funding. While we won’t go into full detail, mining is the process of dedicating resources, generally in the form of computing power or cryptoasset holdings, with the aim of unlocking and earning ownership of cryptoassets. Mining is generally carried out by crypto and tech enthusiasts, which include hobbyists as well as highly sophisticated networks of ‘miners.’
Another way to acquire cryptoassets is through the initial funding of early stage projects. The evolution of the cryptoasset marketplace has brought with it an explosion in project financing through what is known as Initial Coin Offerings (ICOs). ICOs are essentially a fundraising mechanism for early stage projects and typically see the company issue tokens that have some utility, or promised utility, within a particular blockchain ecosystem. Investors can gain access to these tokens at various stages, including prior to exchange listings, in what is known as a private sale. Potential investors can find these opportunities via an ICO list or security tokens list.
Often the success of investing depends on what one doesn’t own. It is a general rule that cryptoasset investors should carefully vet potential investments and how the mechanics of the cryptoasset issuance, underlying business model, alignment of the team, track record and quality of the team, significant investors, and many other factors affect the prospects of the investment. Referring to the above factors, investors should carefully analyze important documents such as a project’s whitepapers and avoid projects with inexperienced and unproven teams, weak business case or need, and token or coin issuance for the sake of just raising capital. Specifically with blockchain investments, investors should fully understand why blockchain technology is essential for the project as opposed to alternative methods such as Amazon Web Services, for example. At a higher level, investors should always be wary of projects and teams that make unreasonable claims about the project. Of course, there are many other factors to consider and due diligence needs to be thorough given the nascent stage of cryptoassets.
No matter the route investors take, it is of vital importance that investors see an investment in cryptoassets in a holistic fashion by considering an investment in the context of their overall portfolio. A well thought out process in both portfolio construction and asset selection can certainly create a strong basis for the inclusion of cryptoassets within investors’ portfolios.
Disclaimer: The content of this article reflects the views of the subject and should not be taken as investment advice.