Crypto Investment Strategies: Smart Allocation For Beginners

Investing in cryptocurrencies is risky due to the potential for high losses from security breaches. However, it can also be a good investment if you do it properly and as part of a diversified portfolio.

Cryptocurrencies are generally used to pay for services or as speculative investments. They are powered by blockchain technology, which maintains a tamper-resistant record of transactions and keeps track of who owns what.

The most important rule when investing in crypto is never to invest more than you can afford to lose. Other rules include using dollar-cost averaging, researching and sticking to the fundamentals, and sticking to major crypto currencies.

Most experts agree that cryptocurrencies should make up no more than 5% of your portfolio. This amount is small enough to keep investors comfortable during periods of high volatility but also large enough to have a positive impact on the portfolio if crypto prices rise.

Some of the best cryptocurrencies to invest in based on their market capitalization include Bitcoin, Ethereum, Tether, Binance Coin, Solana, U.S. Dollar Coin, XRP, Dogecoin, Toncoin, and TRON.

Diversification

• Invest in a variety of cryptocurrencies: Don't put all your eggs in one basket. Invest in a range of cryptocurrencies with exposure to various sectors. For example, consider investing in the top 10 cryptocurrencies by market cap, or focus on specific types of cryptos such as those focused on smart contracts or digital payments.
• Diversify across regions: Don't invest in crypto projects only in one region or country. Research the performance of crypto projects in different parts of the world to shield your investments from regulatory risk and balance your portfolio even in uncertain market conditions.
• Use dollar-cost averaging: This involves making small, recurring purchases of cryptocurrencies on a set schedule (e.g. weekly or monthly). This helps to reduce the impact of volatility and avoids the psychology of trying to time the market.
• Consider crypto ETFs: Exchange-traded funds (ETFs) can be an easy way to invest in a diversified portfolio of stocks and other assets, including cryptocurrencies. While the SEC hasn't approved a Bitcoin ETF, there are ETFs that focus on the underlying blockchain technology, investing in companies with an emphasis on that sector.
• Use online tools: Some online platforms, such as Makara, offer customers pre-built crypto portfolios or "bundles" that provide exposure to different themes, such as blue-chip cryptos or Web3 projects. These tools can be useful if you don't have the time or expertise to build your own portfolio.

Remember, the rules that apply to diversifying other asset classes also apply to cryptocurrencies. Diversification can help balance your portfolio, but it doesn't eliminate risk. Crypto remains a volatile and speculative investment, so only invest money you can afford to lose, and make sure crypto investments make up a small portion of your overall portfolio (generally recommended at no more than 5-10%).

Risk tolerance

Emotional Response and Long-Term Goals

Additionally, consider your investment time horizon. If you're investing for a few decades, short-term market turbulence may not significantly impact your overall goals. However, if you're saving for a more immediate goal, such as a house purchase, higher volatility could be more concerning.

Volatility of Crypto Markets

Cryptocurrencies are known for their extreme volatility compared to other asset classes. For example, in 2017, the total market capitalization of cryptocurrencies soared by almost 4,500%. But this was followed by a sharp decline in 2018, when the crypto market lost 80% of its value in just eight months. Such swings highlight the unpredictable nature of crypto investments.

Investor Profile and Recommendations

Investors' risk tolerance can vary, and recommendations are often made based on investor profiles. Aggressive investors, with a higher risk tolerance, are willing to risk losing money in pursuit of potentially better returns. They tend to be market-savvy and comfortable with volatile investments like stocks.

On the other hand, conservative investors seek guaranteed returns and are averse to volatility. They often opt for low-risk investments like bonds, money markets, or bank certificates of deposit (CDs).

Moderate investors aim to balance growth and risk, typically investing in a mix of stocks and bonds.

When it comes to crypto, experts like Mike Novogratz and Tim Enneking suggest allocating a small portion of your portfolio to crypto assets. Novogratz recommends at least 1% to 2% for everyday investors, while Enneking suggests 2% for conservative investors and 5% to 10% for enthusiasts.

Risk Mitigation Strategies

While eliminating risk in crypto is challenging, there are strategies to mitigate it. One example is arbitrage, which involves taking advantage of price discrepancies between different exchanges to make risk-free profits.

Additionally, staying informed about the crypto market and its underlying technologies can help you identify risks and potential warning signs.

Consumer Protections and Financial Literacy

It's important to remember that the cryptocurrency market currently lacks robust consumer protections. As a result, individuals using cryptocurrencies for transactions may find themselves in a financially vulnerable position if issues arise. Therefore, it's crucial to have sufficient financial literacy and a clear understanding of the risks involved before investing in or transacting with cryptocurrencies.

Liquidity constraints

Liquidity in cryptocurrency markets refers to the ability to buy or sell assets quickly without causing a significant change in price, which underpins market efficiency and stability. High liquidity ensures smoother transactions and less price slippage, making it easier for traders to execute large orders and for investors to manage their portfolios.

However, the cryptocurrency market faces challenges such as high volatility and technological constraints that can affect liquidity and market participation. For instance, the security breaches and hacks that have plagued cryptocurrency exchanges have led to sizable losses for investors, making the safe storage of cryptocurrencies more difficult than that of traditional stocks or bonds.

To address these challenges, the industry is witnessing the development of more efficient trading systems and the emergence of Decentralized Finance (DeFi) protocols, liquidity pools, and Automated Market Makers (AMMs). These innovations aim to enhance liquidity by facilitating more decentralised and efficient trading practices.

For instance, AMMs rely on liquidity pools, which are smart contracts holding reserves of two or more tokens, allowing users to trade cryptocurrencies without the need for a traditional buyer and seller. The trading is entirely managed by algorithms, and the pricing mechanism is based on the ratio of tokens in the pool, which changes with each trade, ensuring a constant total liquidity in the pool.

Another way to enhance liquidity is through liquidity providers (LPs), who add their tokens to liquidity pools in return for a share of the pool and a fraction of the transaction fees generated. However, LPs face the risk of impermanent loss, where the prices of tokens in the liquidity pool change compared to when they were deposited, potentially resulting in a loss relative to holding the tokens outside the pool.

Overall, liquidity plays a crucial role in the functioning of cryptocurrency markets, and understanding its impact is essential for devising effective trading strategies. High liquidity leads to narrower bid-ask spreads, faster trade execution, and reduced price impact and slippage, while low liquidity can cause erratic price movements and higher risks for market participants.

Volatility

Factors Affecting Volatility

There are several factors that contribute to the volatility of cryptocurrencies:

• Supply and Demand: Like most commodities, the price of Bitcoin and other cryptocurrencies is heavily influenced by supply and demand. As the supply of Bitcoin is limited to 21 million coins, its price is likely to climb as the circulating supply gets closer to this limit.
• Investor Actions: The actions of investors, particularly those with large holdings (known as "whales"), can significantly impact the price of cryptocurrencies. If whales were to suddenly liquidate their holdings, it could cause a panic among other investors, leading to a rapid drop in prices.
• Media and Influencers: Media outlets, influencers, and industry moguls can create investor concerns or hype through their predictions and opinions, leading to price fluctuations.
• Regulations: Rumors and changes in government regulations and policies can also impact the price of cryptocurrencies. For example, China's ban on cryptocurrency transactions in 2021 led to a drop in Bitcoin's price.
• Speculation: As cryptocurrency is not backed by any intrinsic value, its market value is based on speculation and the expectations of investors. This makes the price of cryptocurrencies highly sensitive to changes in investor sentiment.
• Trading Volume: Unusually high or very low trading volumes can also correspond to increased volatility.

Strategies for Managing Volatility

For investors who are comfortable with the risks associated with volatile assets, the potential for high returns can be appealing. However, for those who prefer a more conservative approach, there are strategies to limit the downside impact of volatility:

• Dollar-Cost Averaging: This involves making small, recurring purchases of cryptocurrencies on a set schedule, rather than trying to time the market. This method helps to reduce the impact of volatility by buying more when prices drop and less when they rise.
• Diversification: Diversifying investments across different asset classes, such as stocks and bonds, can help to reduce the overall risk in a portfolio.
• Stablecoins: There are now cryptocurrencies specifically designed to have low volatility, known as stablecoins. These cryptocurrencies are pegged to a reserve asset, such as the US dollar, to maintain price stability.

While volatility can offer the potential for higher returns, it also comes with higher risks. It is important for investors to carefully consider their risk tolerance and financial goals before investing in volatile assets like cryptocurrencies. As a general guideline, financial experts recommend limiting crypto exposure to less than 5% of your total portfolio.

Long-term gains

Investing in cryptocurrencies is a risky business. The market is extremely volatile and unpredictable, and there is always the possibility of losing your entire investment. However, if you are looking for long-term gains, there are a few things to keep in mind.

Firstly, it is important to do your research and understand the market. Cryptocurrencies are decentralised and secure digital money, based on blockchain technology. This means that they are not controlled by any central authority, and their value can fluctuate widely in response to news and market trends.

When considering a long-term investment in crypto, look for coins with strong fundamentals and real-world use cases. These are more likely to survive a bear market and provide sustainable returns over time. Coins that rely heavily on marketing and community support, such as meme coins, may not be the best choice for long-term investments.

Some of the best cryptocurrencies for long-term gains include:

• Bitcoin (BTC): The original cryptocurrency, Bitcoin has high liquidity, making it easy to buy and sell. It is also highly volatile, which can lead to significant gains or losses. Bitcoin has a limited supply, and its value is expected to increase over time as it gains wider adoption.
• Ethereum (ETH): Ethereum is a smart contract blockchain and the second-largest cryptocurrency by market cap. It has established itself as the leading platform for decentralised applications and is highly liquid. Ethereum's value is expected to increase as more people use its network.
• Stablecoins: These are cryptocurrencies that are pegged to the value of a fiat currency, such as the US dollar. They are less volatile than other cryptocurrencies and can be a good way to protect your investment during a bear market. Examples include USD Coin (USDC) and Tether (USDT).
• Large-cap cryptos: Similar to blue-chip stocks, large-cap cryptocurrencies like Bitcoin and Ethereum are likely to be more stable investments during a bear market due to their established track record and wider adoption.
• Decentralised Finance (DeFi) tokens: These are tokens that are used in decentralised finance applications, which provide financial services without the need for intermediaries. DeFi tokens often have strong use cases and can be a good long-term investment, but it is important to research the specific token and its underlying technology before investing.

When investing in cryptocurrencies for the long term, it is crucial to remember that this is a highly risky endeavour. Only invest what you can afford to lose, and make sure to diversify your portfolio to minimise risk. Regularly review your investments and stay up-to-date with market news and trends to make informed decisions.

Finally, remember that the cryptocurrency market is still relatively new and evolving. New technologies, regulations, and adoption by mainstream financial institutions can significantly impact the value of your investments.

Frequently asked questions