If you follow me on Twitter (please do) then you are probable aware I am not a fan of cryptocurrency. That does not mean I am telling anyone not to invest in crypto, rather, invest wisely if you chose too.
Disclosure: I am a believer in the tech, blockchain. How will blockchain be integrated within our lives? That’s for smarter people than me to figure out. My goal, help you make wise decisions as it relates to investing.
The Multi-Billion Dollar Elephant
As this is a personal finance blog I will be remiss if I do not address the multi-Billion dollar elephant in the room, cryptocurrencies.
Let’s get everything on the table shall we.
- Is there potential to make money? Yes
- Is there potential to lose money? Yes
- Will you become a multi-gazillionair like the few people the internet raves about? No
- Can you invest in crypto as part of a diversified portfolio strategy? Yes
- Should you? This, my friends, is the “how much are you willing to lose” dollar question
What is crypto?
- A “currency,” item of exchange for goods and services
- A Speculative Investment
Crypto – Currency
My opinion, some potential, but it is not a currency, or it is so far failing as a currency. Doesn’t mean these conditions will not change in the future, but my two cents:
Currency Definition: the fact or quality of being generally accepted or in use. (a medium of exchange in an economy)
A successful currency, or rather its value, is underpinned by an successful economy that is fiscally stable.
Would you invest in Venezuela’s economy and currency?
A successful currency is not wildly volatile such using it as a medium of exchange will not lead to the hyper valuation or devaluation of goods and services purchased which the next individual can not reasonably exchange for similar or same goods and services.
The volatility, high transactions fees, anonymity, black market, and the speed of exchange are hindering crypto as a currency.
I am not alone, several major firms have stopped accepting certain cryptocurrencies for some of these reasons. Other crypto’s are being developed to solve these concerns, but which one will be adopted? Very early days, for me, I’ll wait and see.
My last point, I do not mean to be such a drag, is many use the “supply and demand” argument, which is a legitimate economic concept, to validate valuation.
Small supply yes, but demand? No. Speculation is not a demand which can sustain valuation. Adoption and use as a currency “medium of exchange of goods and services” will create real demand to balance valuation with supply.
This does not mean cryptocurrency is not an investment.
I said my bit, I am sure this will get debated, which is a good thing. These reasons are the reasons, right or wrong why Crypto is not in my investment portfolio. Does not meet my investment test or risk threshold, but that’s ok. Let’s move on to actually looking at crypto as an investment and how to apply to your portfolio.
Crypto – Investment
It is not that crypto can/should not be part of your investment portfolio but rather added as a component to your balanced portfolio rather than it be your portfolio. I recently completed a survey where many people admittedly have taken a large position in crypto, though also classified themselves as financially conservative.
With everything you purchase, know what you are buying and why. Know that crypto is an investment and you have choices with where to invest your money. Many choices.
Treat cryptocurrencies like any other investment: Rank and ensure it fits within your risk tolerance.
Not sure what your risk tolerance is? There are many tools available on the web, for simplicity try BMO’s. Do not worry about the actual recommendations BMO gives, rather get a sense of the questions, your answers, and the type of investor you “appear” to be.
Crypto, in my humble opinion, falls in to the Speculative investment box; aka, High Risk Investment, High Volatility Investment, Aggressive Growth, Equity Growth, etc. Many names for the same thing, I will go with Speculative.
Long story short, depending on your time horizon, tolerance for risk, net worth, and investment objectives the amount of your portfolio recommended to allocate to Speculative Investments ranges from 0% to around 15%. (General Rule)
Goal of investing: meet or beat market returns over a long time period through an economic cycle.
What are long turn average market returns? About 6%, around 8% on total return indexes which include the reinvestment of dividends.
Even the very best portfolio managers do not beat the market every year, it is extremely difficult to do. Many can beat the market when times are good, however, when the business cycle in in it’s trough or a recession, on average through the entire business cycle the market wins out.
Think you can do that every year till retirement with the majority of your investments in Speculative Investments? Good luck I say, gooooood luck.
Power of Portfolio Diversification
Let’s look at portfolio diversification and how it mitigates rate of return risk in a very simple example:
|100% Crypto Investment||10% Crypto Investment
|Buy Crypto at $10,000 sell at a massive return of $40,000||$40,000||$4,000|
|Rate of return = 5%||$0||$9,450|
|Rate of Return||300%||34.5%|
34.5%, that is darn good returns folks, almost 4 times that of the total market return.
But what about if you pick the wrong Crypto, and goes to $0?
|100% Crypto Investment||10% Crypto Investment
|Buy Crypto at $10,000 sell at $0||$0||$0|
|Rate of return = 5%||$0||$9,450|
|Rate of Return||-100%||-5.5%|
I will take a -5.5% vs a -100% return all day.
The above are extreme examples, but I hope you get my point, investing a heavy amount in a speculative investment which is inherently risky will unlikely make you above market average rates of return consistently. However, investing a portion of your account in a Speculative Investment can still provide you well above market rates of return with less downside risk.
Do not chase the short term gain
Is -100% to 300% a good risk reward for long term investing? I will not go in to great detail on Risk/Reward the website Investopedia has a great Article. So how to the above investments play out?
Investing 100% in crypto provides a 3:1 ratio, where a diversified portfolio provides 3.45:1. The diversified portfolio provides a greater amount of return for the risk.
Well I hope I gave you some incite in the risk reward of Speculative Investing. The above focused on Crypto investing, but let’s just take a brief minute and talk about Speculative Investing in general.
A diversified portfolio is a cornerstone or successful long term risk mitigation. Same thing goes for the speculative portion of your portfolio, diversify:
Examples of other Speculative Investments:
- Several different crypto currencies to reduce the risk of one failing
- Buy not in to crypto by in to the technology, look for companies that develop blockchain tech
- Small cap stocks
- Emerging Economies and Markets
- Resource or Precious Metals
Not sure which are the right companies? Diversify with ETF’s or Mutual Funds. They hold many companies to take away the the risk of choice. There are many options now in this space including more Speculative segments.
This post was not meant to steer you away from Speculative Investing or Cryptocurrencies. As you know, they do not meet my risk threshold and I do not believe in them enough (“yet”). If I do not believe, I do not invest. Another way more successful investor has a similar concept, Mr Warren Buffet.. but again I digress.
The point, and what we did learn and discuss, was the introduction of a few concepts:
- Know your risk tolerance and thresholds
- Develop a total portfolio view when you invest
- Do not dive in due to speculation because you feel you are “missing the boat” and thereby make incorrect risk decisions
- Diversify your Speculative Investments, it very hard to pick a winner and next to impossible to time the market
I really wanted to provide some colour on my views on crypto as well as highlight that crypto needs to be treated as an investment. As such, only invest how much you can afford (learn more in Part 1 of my personal budget post) and take a diversified portfolio approach.
Diversification, though simple in concept, is quite large with many different opinions by many different professions and I only scratched the service here to develop a point. Will look to expand on this topic and more in future post.
As always, feel free to make comments below, I expect there will be some disagreements on my views on crypto. But hey, I am up to further my understanding, or misunderstanding, so please, let’s engage in a good discussion.