In the YouTube video “Crypto Investing #59 – How to Take Risk in Cryptocurrency Investing”, Tai Zen, CEO and senior technical analyst for Cryptocurrency Market, explains how to manage risks in the altcoin market. Zen points out that the principles he discusses apply to any commodity market and not just altcoins.
Zen’s argument revolves around mitigating risks through diversification. The way Zen illustrates this is through a mental exercise. Suppose that an ICO/altcoin has a six-in-ten chance of failure and a two-in-ten chance of yielding a 10X or 20X return on investment. Say an investor has $1,000 to invest. If the investor places all $1,000 into a single altcoin, the investor would be more likely to get a negative return on investment, meaning he would likely lose the money he has invested.
However, if the same investor made $100 investments in ten different altcoins, the majority of the altcoins will show a negative return on investment. The four altcoins that yielded a zero or positive return on investment could bring the investor’s total return on investment on his $1,000 to between $14,000 and $34,000.
This tactic of investing small amounts in multiple commodities or stocks, known as diversification, is an effective way of shielding yourself from the natural fluctuations that happen in an active market.
While investing everything on a proven winner is the quickest way to bring a high return on an investment, it is also the riskiest. It is akin to betting everything on a single number in a game of Roulette. There are stories where individuals got lucky betting like this, like FedEx’s CEO Fred Smith – who took FedEx’s last $5,000 to Las Vegas during the company’s early years and won money to cover the fuel bill at the blackjack table – but most people are not that lucky.
With a diversified portfolio, the downturn of one altcoin matters less. By spreading investment capital over a wider field-of-play, an investor is maximizing the odds of receiving a positive return on investment.
Understanding the Risk
Diversification should be approached with caution, however. The more diversified a portfolio is, the more expensive it becomes to manage due to the transaction and other market fees. In addition, an efficiency ceiling exists for the securities that can be in a single portfolio. Research from economists E.J. Milton and M.J. Gruber shows that the benefit of increased diversification becomes negligible once a portfolio has between 20 and 30 securities in it.
With altcoins, it should be understood and appreciated that altcoins are somewhat connected. Should an altcoin share a blockchain with another altcoin, what happens with one can affect the pricing of the other. An example of this is the DAO. When the DAO collapsed, Ethereum’s market price took a hit as well. Ethereum is the hosting blockchain of the DAO.
In order to diversify effectively, you must understand the companies you are looking to diversify. Do they all share the same blockchain or other technological underpinnings? Do they all have similar management structure? Are they all offering the same type of service? It is important to do due diligence and create a portfolio that is truly diverse to shield against unwanted risk.
Zen offers one final piece of advice. Once you have made a significant profit, re-invest it in other altcoins. In what he calls his “wash and repeat” method, doing this further mitigates your risk as you are now investing money you earned and not your seed investment.
Diversification can be an effective tool for managing investment risks. This, however, requires patience and diligence. For the informed, prepared investor, however, this strategy can help to turn a modest investment into the start of an impressive portfolio.
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