Crypto Risk Management: To VC, or Not to VC…
Given a 10% chance of a 100 times payoff, you should take that bet every time — Jeff Bezos
Understanding risk
I think most people involved in the world of crypto are aware there is risk involved. Unfortunately, when I am reading a particular project’s Telegram or Discord feed, I often see legitimate risks being disregarded as ‘Fear, Uncertainty, and Doubt’ (FUD). FUD can interfere with effective decision making. It is also there for a reason: to protect us from harm.
How does one deal with risk? At the most basic level, we need to define what risk is. From that foundation, we can roughly map out how one can most safely navigate risks within their tolerance level. With that in mind, there are two types of risk:
· Taking a risk; or
· Being at risk
Taking a risk is self-exposure to hazards while seeking opportunities. Being at risk is exposure to an external hazard. Investing in crypto (or anything really) involves both. This sounds easy enough, but it gets more complicated. The first problem is, risk is observer dependent.
Imagine you are visiting a foreign country for the first time. You decide to go on a walk through a beautiful field full of wild flowers. Before you start out, a local comes by and says ‘you can walk there, but be careful, this area is littered with land mines. They have cleared most of them, but you never know.’
The first problem is, risk is observer dependent
As the observer, your initial state was likely high certainty (albeit wrong). In the back of your mind, you might have been concerned about snakes, or bugs, or allergies, or something like that. But, generally those risks would have seemed tolerable compared to the reward of walking in a beautiful field. If you were walking in a field in your own neighborhood you probably would not give it a second thought. But, when the local tells you about the potential for landmines, then your state shifts to high uncertainty.
Which leads to the second problem. The observer must start in a state of uncertainty before they become aware of the risk they are facing. The local telling you about the landmines introduces uncertainty, which then changes your observed risk about taking a walk in the field. To reduce uncertainty, one must increase knowledge.
In the case of the field, you might see if there are maps that show where landmines have been laid, or cleared. You might see if there are people who know safe places to walk, or places that are strictly forbidden. The more information you have, the more certainty you will gain.
Now, change the scenario a little bit. Let us say before you went to the foreign country, a reliable person told you there was a million dollars in gold buried at the far end of the field and they told you about the landmines. To make matters worse, the people that cleared the mines kept no records. Now, the effort to mitigate the hazard you are facing is much higher, but the reward is also much higher.
A bold (or rash) person might just run across the field and hope for the best. A prudent person might buy a metal detector, or try to blast a path through. A very cautious person might not go at all. That is risk tolerance in a nut-shell.
I know the price, but what is the cost?
The thing is, there are costs associated with addressing the hazard. In the example above, the bold person has almost no initial cost, but they may pay a terrible price. They also will receive the highest reward by far if they succeed. The prudent person will have high initial cost, which reduces the value of the reward (reward minus expense). The cautious person has the lowest initial cost and zero reward. Only you can say you what your tolerance is; everyone is different. What I do recommend, is you establish an objective, rational plan to stay within your risk tolerance and stick to it unless or until your tolerance changes.
Investing — whether stocks, bonds, gold, crypto, or anything really — only implicates one overall hazard: losing money. Just like the minefield above, how you address that hazard has very different costs. You cannot make money from investing if you do not invest. You can lose all of your money by investing recklessly. The goal here is to help you find a sane way to be comfortably in-between.
Investing…only implicates one overall hazard: losing money
These ain’t your grand daddy’s stocks…
Investing in crypto assets is at once similar to investing in public equities (stocks), but also very different. I suggest that investing in crypto assets today is much closer to venture capital (VC). I like to say crypto is like VC for the masses. For the most part, if you are in the United States today, unless you are an accredited investor, you will not be able to participate in early seed or developmental venture capital. But, in the crypto world, most projects are the equivalent of early seed or developmental investing.
As such, the risk profile is very different from investing in public equities. There is a significant vetting process that occurs before a company is allowed to market shares to the general public. The vetting is designed to ensure publicly listed companies have a high chance of long-term success. To be sure, some publicly listed companies do fail, but compared to startups, the ratio is very low.
Venture capitalists, on the other hand, have to vet projects themselves. As accredited investors, they are given more regulatory leeway because, in essence, they can afford to lose money. But, with that comes the responsibility for ensuring against losses. There is no regulator they can complain to if the company they invested in turns out to have really poor management or business practices.
Venture capitalists…have to vet projects themselves
The way venture capitalists do this varies widely. Some spend a great deal of time researching a company, or talking to the owners/board members. They might look over the books, or see what sort of successes the company has already had, or see how they are different from competitors. Regardless of the method they use, the goal is to make a well-educated guess about whether or not a company will succeed. But, it is always a guess at the end of the day.
Consider Amazon for a moment. Imagine being approached by Jeff Bezos in 1994 with the idea of selling books online. What questions would you ask before you invested? Would you have given him the time of day? Some guy with a bunch of books in his garage and a grand idea of using this internet-thing to sell them? By 1999, Amazon had a $30 billion market cap, and listen closely to the push back he gets during an interview with CNBC. Hear anything that sounds like FUD?
Listen to Bezos’ answers, they were right on point. He outright says he does not know if Amazon is going to work. A company with a $30 billion-dollar market share and a CEO that says he does not know if it will work? Would you have dumped $1000 dollars into this crazy idea even then? Would you have held the stock after it tanked in value during the dot-com bust? Most did not. The ones that did got rich.
Every time you buy a crypto asset on the DEX, it is like investing in a potential Amazon in 1994. If you are buying a crypto asset on a major CEX, it is like investing in a potential Amazon on the NASDAQ in 1999. In 1994 Amazon is a very high-risk investment. It is just an idea by a smart, driven guy. By 1999, the risk is lower, but still very high compared to buying Coca-Cola, or Johnson & Johnson. To be clear, there is not yet a single crypto company in existence that has the same level of certainty or stability as publicly traded equities in the US.
Should I trade or hodl?
Which brings me to another point, VC does not typically trade…they hodl. Some hodl until the company gets off the ground, some hodl until the company is publicly listed, and some hodl for even longer. It all depends on the VCs exit strategy, but VC is not generally buying startups to trade for other startups. Which is to say, trading strategies in the crypto space (usually adapted from the equities and forex markets) are not resting on sound principles. In general, crypto trading strategies often grossly underestimate the size, scope, and likelihood of tail probability events occurring during their trading window.
In other words, those trades can backfire massively, and without warning. Are there people making money trading crypto? Yes, absolutely. Is it within my risk tolerance? Absolutely not. Obviously, you can spend your money however you like. Me personally, I do not recommend any trading strategy in the crypto space. As the field matures, lower risk trading strategies might emerge. I adamantly believe we are not there yet, but hey, YMMV.
Understand, the success rate for VC is somewhere around 7.5%. I can only guess, but I imagine the success rate for crypto investors is probably similar, depending on how one defines ‘success’. In other words, to have a stable, realistic chance of making money, you need to invest in fourteen to fifteen high quality projects to find one winner. Yes, you might make money trading shitcoins that are getting hyped on YouTube or Reddit, but it is really just gambling. That might be okay for you. I cannot tell you what your risk tolerance is.
…the success rate for VC is somewhere around 7.5%
I can give you some suggestions that I believe are safer
Take what you will from them, just remember no matter what — if you are putting money into crypto — it is absolutely, 100%, zero-doubt a high-risk venture. If you decide to participate in crypto investing, you have a strong chance of losing everything you put in. Invest accordingly. If I were starting out today, I would:
· Avoid Bitcoin like it was a brain-eating zombie
· Find six to eight crypto projects that appeal to me on a major CEX, like Coinbase, and buy equal percentages of each, say $100 each (or $1000, or whatever)
· Find six to eight crypto projects that appeal to me on a major DEX, like PancakeSwap or UniSwap, and buy equal percentages of each ($100, $1000, whatever)
· Hold and watch
· Sell 10–40% of my stake if a project reaches a 400–500% increase in value
· Move profit off to a legitimate stable coin (e.g., Paxos Gold)
· Wait a year to convert profit to cash (reduce capital gains tax)
· Realize gains
· Hold and watch
· Rinse and repeat
This is not a guaranteed strategy. I believe it is a lower risk, higher return strategy than trading. Of course, some people will be luckier than others. Some projects might look great on paper and never deliver. Regulations might shut another project down. The founders might start arguing, or one might sleep with the other’s partner. The plane the executives are on might crash. A war might break out.
Point is, at the early and developmental stages, there are far more things that can go wrong for a project than can go right. And, that is what makes crypto VC kind of fun…you get to see how well your vision for the future aligns with the market. To be smart about it, remember the Count of Monte Cristo, “…all human wisdom is contained in these two words, ‘wait and hope.’” Do that, and you might just get lucky.
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