by arsonbunny

Well its happened, the crypto market just experienced the worst crash since 20xx, the bubble has burst. The idiocy of newbies FOMO-ing into anything with low nominal value lead to endless twitter timelines like this, and now nobody has any idea where the market settles. What do you do now?

In the following weeks it will be a good time to rethink your investment approach and how you arrive at your decisions. Just buying whatever is shilled on Twitter or Reddit and jumping from one crypto to another isn’t going to work like it did these last two months.

The good news is that we’re finally back closer and closer to our long term moving average which is much more healthy for entrants, the bad news is that the fear might continue compounding if outstanding issues are not dealt with. Tether is the big concern for me personally for reasons I’ve stated many times, but some relief in the short term may come if the SEC and CFTC meeting on February 6th goes well. Nobody really knows where the bottom is but I think we’re now past the “irrational exuberance” stage and we’re entering a period of more serious inspection where cryptos will actually have to prove themselves as useful. I suspect hype artists like CryptoNick and John McAfee will fall out of favor.

But perhaps most importantly use this as a learning experience, don’t try to point fingers now. The type of dumb behavior that people were engaging in that was rewarded in a bull market (chasing pumps, going all in on a shillcoin, following hype..etc) could only ever lead to what we are experiencing now. Just like so many people jumped on the crypto bandwagon during the bull run, they will just as quickly jump on whatever bandwagon is to be used to blame for the deflation of the bubble. Nobody who pumped money into garbage without any use case will accept that they themselves with their own investing behavior were the real reason for the gross overvaluation of most cryptocurrencies, and the inevitable crash.

So if you’re looking for a fresh start after the massacre (or just want to get in now), here is a guide:

Part A: Making a Investment Strategy

This is your money, put some effort into investing it with an actual strategy. Some simple yet essential advice that should apply to everyone, regardless of individual strategy:

1. Slow down and research each crypto that you’re buying for at least a week.
2. Don’t buy something just because it has risen.
3. Don’t exit a position just because it has declined.
4. Invest only as much as you can afford to lose.
5. Prepare enter and exit strategies in advance.

First take some time to think about your ROI target, set your hold periods for each position and how much you are actually ready to risk losing.

ROI targets

A lot of young investors who are in crypto have unrealistic expectations about returns and risk. A lot of them have never invested in any other type of financial asset, and hence many seem to consider a 5-10% ROI in a month to be unexciting.

But its important to temper your hype and realize why we had this exponential growth in the last year and how unlikely it is that we see 10x returns in the next year. What we saw recently was Greater Fool Theory in action. Those unexciting returns of 5-10% a month are much more of the norm, and much more healthy for an alternative investment class.

You can think about setting a target in terms of the market ROI over a relevant holding period and then add or decrease based on your own risk profile.

Example: Calculating a 2 year ROI target

Lets say you want to hold for 2 years now, how could you set a realistic target to strive for? You could look at a historical 2 year return as a base, preferably during a period similar to what we’re facing now. Now that we had a major correction, I think we can look at the two year period starting in 2015 after we had the 2014 crash. To calculate a 2 year CAGR starting in 2015:

Compounded annual growth return (CAGR): [(18/5.5)^1/2]-1 = 81%

This annual return rate of 81% comes out to about 4.9% compounded monthly. This may not sound exciting to the lambo moon crowd, but it will keep you grounded in reality. You can aim for a higher return (say 2x of that 81% rate) if you choose to take on more risky propositions. I can’t tell you what return target you should set for yourself, but just make sure its not depended on you needing to achieve continual near vertical parabolic price action in small cap shillcoins because that isn’t sustainable.

Once you have a target you can construct your risk profile (low risk vs. high risk category coins) in your portfolio based on your target.

Risk Management

Everything you buy in crypto is risky, but it still helps to think of these 3 risk categories:

• Core holdings – This is the exchange pairing cryptos and those that are well established. These are almost sure to be around in 5 years, and will recover after any bear market. The Coinbase pairs (Bitcoin, Litecoin and Ethereum) are in this class of risk, and I would also argue Monero.
• Medium Risk Speculative – These would be cryptos which generally have a working product and niche, but higher risk than Core. Things like ZCash and Ripple, relatively established history but still uncertainty over long term viability.
• High Risk Speculative – This is anything created within the last few months, ICOs, low caps, shillcoins…etc. Most cryptos are in this category.

How much risk should you take on? That depends on your own life situation for one, but also it should be proportional to how much expertise you have in both financial analysis and technology.

The general starting point I would recommend is:

• 50-70% for newbies in Low Risk Core, then you can go down to 30% as you gains confidence and experience
• Always try to keep at least a 1/3rd in safe core positions
• Don’t go all in on speculative picks.

Some more core principles on risk management to consider:

• Diversify across sectors and rebalance your allocations periodically.
• Consider using dollar cost averaging to enter a position. This generally means investing a X amount over several periods, instead of at once. You can also use downward biased dollar cost averaging to mitigate against downward risk. For example instead of investing $1000 at once in a position at market price, you can buy $500 at the market price today then set several limit orders at slightly lower intervals (for example $250 at 5% lower than market price, $250 at 10% lower than market price). This way your average cost of acquisition will be lower if the crypto happens to decline over the short term.
• Don’t have more than 5-10% of your net worth in crypto.
• Have the majority of your holdings in things you feel good holding for at least 2 years. Don’t use the majority of your investment for day trading or short term investing.
• Remember you didn’t actually make any money until you take some profits, so take do some profits when everyone else is at peak FOMO-ing mode.
• Have some fiat in reserve at a FDIC-insured exchange (ex. Gemini), and be ready to add to your winning positions on a pullback. This should be part of your entry strategy.
• Consider what level of loss you can’t accept in a position with a high risk factor, and use stop-limit orders to hedge against sudden crashes. Set you stop price at about 5-10% above your lowest limit. Stop-limit orders aren’t perfect but they’re better than having no hedging strategy for a risky microcap in case of some meltdown. Only you can determine what bags you are unwilling to hold.

You can think of each crypto having a risk factor that is the summation of the general crypto market risk (Rm), but also its own inherent risk specific to its own goals (Ri).

Rt = Rm +Ri

The market risk is something you cannot avoid, it is essentially the risk that is carried by the entire market over things like regulations. What you can minimize though the Ri, the specific risks with your crypto. That will depend on the team composition, geographic risks (for example Chinese coins like NEO carry regulatory risks specific to China), competition within the space and likelihood of adoption and other factors, which I’ll describe in Part 2: Crypto Picking Methodology.

Portfolio Allocation

Along with thinking about your portfolio in terms of risk categories described above, I really find it helpful to think about the segments you are in. OnChainFX has some segment categorization but I generally like to bring it down to:

• Core holdings – BTC, Ethereum, LTC…etc
• Platform segment – Ethereum, NEO, Ark…etc
• Privacy segment – Monero, Zcash, PivX..etc
• Finance/Bank settlement segment – Ripple, Stellar…etc
• Enterprise Blockchain solutions segment – VeChain, Walton, Factom…etc
• Promising Tech segment – NANO/Raiblock, Cardano…etc

Think about your “Circle of Competence”, your body of knowledge that allows you to evaluate an investment. Your ability to properly judge risk and potential is going to largely correlated to your understanding of the subject matter. If you don’t know anything about how supply chains functions, how can you competently judge whether VeChain or WaltonChain will achieve adoption? If you don’t understand anything about the tech when you read the Cardano paper, are you really able to determine how likely it is to be adopted?

Consider the historic correlations between your holdings. Generally when Bitcoin pumps, altcoins dump but at what rate depends on the coin. When Bitcoin goes sideways we tend to see pumping in altcoins, while when Bitcoin goes down, everything goes down.

You should diversify but really shouldn’t be in much more than around 12 cryptos, because you simply don’t have enough competency to accurately access the risk across every segment and for every type of crypto you come across. If you have over 20 different cryptos in your portfolio you should probably think about consolidating to a few sectors you understand well.

Part B: Crypto Picking Methodology (Due Dilligence)

Do you struggle on how to fundamentally analyze cryptocurrencies? Here is a 3-step methodology to follow to perform your due dilligence:

Step 1: Filtering and Research

There is so much out there that you can get overwhelmed. The best way to start is to think back to your own portfolio allocation strategy and what you would like to get more off. For example in my view enterprise-focused blockchain solutions will be important in the next few years, and so I look to create a list of various cryptos that are in that segment.

Upfolio has brief descriptions of the top 100 cryptos and is filterable by categories, for example you can click the “Enterprise” category and you have a neat list of VEN, FCT, WTC…etc.

Once you have a list of potential candidates, its time to read about them:

• Critically evaluate the website. If it’s a cocktail of nonsensical buzzwords, if its unprofessional and poorly made, stay away. Always look for a roadmap, compare to what was actually delivered so far. Always check the team, try to find them on LinkedIn and what they did in the past.
• Read the whitepaper or business development plan. You should fully understand how this crypto functions and how its trying to create value. If there is no use case or if the use case does not require or benefit from a blockchain, move on.
• Check the blockchain explorer. How is the token distribution across accounts? Are the big accounts selling? Try to figure out who the whales are (not always easy!) and what the foundation/founder account is based on the initial allocation.
• Look at the Github repos, does it look empty or is there plenty of activity?
• Search out the subreddit and look at a few Medium or Steem blogs about the coin. How “shilly” is the community, and how much engagement is there between developer and the community?
• I would also go through the BitcoinTalk thread and Twitter mentions, judge both the length and quality of the discussion.

You can actually filter out a lot of scams and bad investments by simply keeping your eye out on the following red flags:

• allocations that give way too much to the founder
• guaranteed promises of returns (Bitcooonnneeeect!)
• vague whitepapers filled with buzzwords
• vague timelines and no clear use case
• Github with no useful code and sparse activity
• a team that is difficult to find information on

Step 2: Passing a potential pick through a checklist

Once you feel fairly confident that a pick is worth analyzing further, run them through a standardized checklist of questions. This is one I use, you can add other questions yourself:

The last question is the most important.

This is where the riskiness of your crypto is evaluated, the Ri I talked about above. Here you should be able to accurate place the crypto into one of the three risk categories. I also like to run through this checklist of blockchain benefits and consider which specific properties of the blockchain are being used by the specific crypto to provide some increased utility over the current transactional method:

Step 3: Create a valuation model

You don’t need to get into full modeling or have a financial background. Even a simple model that just tries to derive a valuation through relative terms will put you above most crypto investors. Some simple valuation methods that anyone can do:

Probablistic Scenario Valuation

This is all about thinking of scenarios and probability, a helpful exercise in itself. For example: Bill Miller, a prominent value investor, wrote a probabilistic valuation case for Bitcoin in 2015. He looked at two possible scenarios for probabalistic valuation:

1. becoming a store-of-value equal to gold (a $6.4 trillion value), with a .25% probability of occurring
2. replacing payment processors like VISA, MasterCard, etc. (a $350 million dollar value) with a 2.5% probability

Combining those scenarios would give you the total expected market cap: (0.25% x 6.4 trillion) + (2.5% x 350 million). Divide this by the outstanding supply and you have your valuation.

Metcalfe’s Law

Metcalfe’s Law which states that the value of a network is proportional to the square of the number of connected users of the system (n^2). So you can compare various currencies based on their market cap and square of active users or traffic. We can alter this to crypto by thinking about it in terms of both users and transactions:

For example, compare the Coinbase pairs:

Generally the higher the ratio, the higher the valuation given for each address/transaction.

Market Cap to Industry comparisons

Another easy one is simply looking at the total market for the industry that the coin is supposedly targeting and comparing it to the market cap of the coin. Think of the market cap not only with circulating supply like its shown on CMC but including total supply. For example the total supply for Dentacoin is 1,841,395,638,392, and when multiplied by its price in early January we get a market cap that is actually higher than the entire industry it aims to disrupt: Dentistry.

More complex valuation models

If you would like to get into more fleshed out models with Excel, I highly recommend Chris Burniske’s blog about using Quantity Theory of Money to build an equivalent of a DCF analysis for crypto.

Here is an Excel file example of OMG done by Nodar Janashia using Chris’ model .

You should create multiple scenarios with multiple assumptions, both positive and negative. Have a base scenario and then moderately optimistic/pessimistic and highly optimistic/pessimistic scenario.

Personally I like to see at least a 50% upward potential before investing from my moderately pessimistic scenario, but you can set your own safety margin.

The real beneficial thing about modelling isn’t even the price or valuation comparisons it spits out, but that it forces you to think about why the coin has value and what your own assumption about the future are. For example the discount rate you apply to the net present utility formula drastically affects the valuation, and it reflects your own assumptions of how risky the crypto is. What exactly would be a reasonable discount rate? What about the digital economy you are assuming for the coin, what levers affects its size and adoption and how likely are your assumptions to come true? You’ll be a drastically more intelligent investor if you think about the fundamental variables that give your coin the market cap you think it should hold.

Summing it up

The time for lambo psychosis is over. But that’s no reason to feel down, this is a new day and what many were waiting for. I’ve put together in one place here how to construct a portfolio allocation (taking into consideration risk and return targets), and how to go through a systematic crypto picking method. I’m won’t tell you what to buy, you should always decide that for yourself and DYOR. But as long as you follow a rational and thorough methodology (feel free to modify anything I said above to suit your own needs) you will feel pretty good about your investments, even in times like these.