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Sunday, July 3, 2022

A Deep Dive Into My Cryptocurrency Investment Process

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Before we add any security to our portfolio, we should follow a defined process to ensure that we are making a good financial decision. To do this, we can use Investment Decision Making Framework. This is an Evidence-Based process with the following questions.


1. What is my Strategy (Investment Strategy)?

What is your investment strategy and how do we want to leverage this opportunity? This can be further divided into 3 rules.


1.1. The investment strategy must be consistent with our personal skills, interests, values and abilities.

Even the best investment opportunity is worthless if we cannot execute it rightly. Most of us are unable to invest in another ETH-killer project in a seed round. Even if something is available for us, we need enough time to enter, monitor and exit this position (think about alternative investments like arts or numismatics).

We also need appropriate skills to execute a certain strategy which is more difficult than just press buys in your investment account. UST-MIM degen strategy is a good example – if you read this and still don’t understand it – it’s ok. We will cover different crypto strategies later (starting with less complicated).

1.2. The investment strategy must be consistent with your portfolio objectives.

In the previous article, we defined our investment strategy. We should take this into account during our investment decision process. Is speculating on this coin or entering a degen farm, make me closer to my financial goals? What about our time horizon and risk appetite?

1.3. You must follow the investment strategy long enough to benefit from the competitive advantage without being distracted by other investment alternatives.

The perfect illustration of this principle is the investment group where you are getting the buy and sell signals. When we are in the bull market, almost all projects are rising. Are you prepared to stay with your investment during a correction or even bear market?

2. How Does This Investment Make Business Sense (Business Case)?

Excessive valuations and above the market returns can only be supported if a significant competitive advantage offer barriers to the entry of future competitors, exists. This is extremely important in crypto, where we always have perfect investment opportunities.

Why this project will make you a billionaire, not other? Or why other people don’t see this opportunity? Hint – if someone on Twitter with 1 million followers is sharing with you a new gem is not probably the best investment advice.

Even in crypto, you should think what is the Unique Value Proposition provided by your project, unless you are trading and considering only the price. Fundamentals don’t matter in a short term, but as the crypto market becomes more mature, the value prevails. Just look at the top-performing tokens from 2017.

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Now it’s time to check how this investment will fit into our portfolio.

3. Portfolio Impact (Assets Allocation)

Each new security should:

  1. Lower portfolio risks (be uncorrelated with other assets)
  1. Raise return (have higher returns portfolio)

If it meets two criteria, add it. If it meets none of the given criteria, leave it. If meets one of the criteria, it depends on what is more important for you – higher return or lower risk.

In the financial markets, we have dedicated tools like Portfolio Visualizer to analyze it, but crypto is much harder to assess. We will dive deeper into the risk management part of the Cryptocurrency Investment Framework. Let’s now move to value estimation.

4. Estimates of Intrinsic Value (Valuation)

The intrinsic value of an asset or business is a function of its expected cash flows over its life and the risk in those cash flows. To simplify it, we can think about that as estimated returns.

4.1. Estimates returns – What are the assumptions and drivers behind the expected return? What is the probability?

We don’t know the future, or at least I don’t know it. We can only predict it based on different assumptions. How likely they are and what are the factors and their impact on it? We cannot calculate probability in a standard way. Too many variables, especially in crypto. What we can do is to assess how likely different scenarios are, and how they are related. Let’s also think of the source of those returns.

4.2. Source of investment return (positive expectation, competitive advantage, explicable market edge)

This one is important in DeFi, we will see high, very high APY. How sustainable do you think it is?

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The next part is closely related to this – risk.

5. How Can I Lose Money With This Investment (Understanding Risk)?

The most important investment advice is not to lose your money. Yes, you can earn less, but if you lose too much, it’s a game over to you. It’s not just good advice, in fact it also has roots in mathematics.

5.1. Risk identification & mitigation

We should be able to identify and mitigate our risk. It can be done in many ways, depending on the circumstances. You can find many examples of risk management templates.

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5.2. Remaining uncontrolled risk which doesn’t overlap with other investments

The remaining risk should be uncorrelated with other risks for better achievement of diversification. You probably don’t have an impact on law in your country, but maybe you can spread your securities to different jurisdictions? This is the reason why I am not putting all of my money in crypto, even if I can get a better return than from equities.

6. Comparison of Price With Its Intrinsic Value (Relative Valuation)

Even if we have a good investment to consider, it can be a wrong decision due to high valuation. Except for what we are buying, we should also think about when we are doing this. Very often, the timing makes a major difference between good and best investments. To know when is a time to buy, we should be able to evaluate our security.

7. What Is My Exit Strategy (Exit Criteria)?

Time is also important for selling. Therefore, we shouldn’t marry with our investments. We are buying something because it meets our criteria. When it stops, we should sell it. No investment is appropriate forever. After all, as times changes, market condition changes, and ultimately your objectives also change.

8. Adding a Journal Entry (Evaluation)

We can summarize here why we are buying something and answer all or some of our previous questions. Add also more details to capture your emotions? What are you feeling doing this? What is the context? This will be helpful in the later part to assess how our psychology is impacting our investment decision. We will cover Investment Psychology in the next articles.

Framework

Let’s now put everything into our framework.

1. What is my Strategy (Investment Strategy)?

  • The investment strategy must be consistent with our personal skills, interests, values and abilities.
  • The investment strategy must be consistent with your portfolio objectives.
  • You must follow the investment strategy long enough to benefit from the competitive advantage without being distracted by other investment alternatives.

2. How Does This Investment Make Business Sense (Business Case)?

3. Portfolio Impact (Assets Allocation)

4. Estimates of Intrinsic Value (Valuation)

  • Estimate returns – What are the assumptions and drivers behind the expected return? What is the probability?
  • Source of investment return (positive expectation, competitive advantage, explicable market edge)

5. How Can I Lose Money With This Investment (Understanding Risk)?

  • Risk identification & mitigation
  • Remaining uncontrolled risk which doesn’t overlap with other investments

6. Comparison of Price With Its Intrinsic Value (Relative Valuation)

7. What Is My Exit Strategy (Exit Criteria)?

8. Adding a Journal Entry (Evaluation)

How To Use This Framework?

Now you have a framework. It is a time to use it in Your investment process.

Take your last investment or any previous investment which you remember, and try to answer each of these questions.

The next step is to apply it for the next investment decision.

The last step is to modify it to your needs. I created this framework for myself, it’s also used by other people, but maybe you need a little adjustment? Experiment with the order and add new questions or take-off points that are not helping you. Even the best investment framework won’t work if it’s not adjusted to your needs and personality.

Play around and have fun!

What Next?

In the next posts, we will check another pillar from Cryptocurrency Investment Framework. Stay tuned and follow me on Twitter to get a sneak peek of what is coming!

The content of this story DO NOT represent the views of HackerNoon and are meant as information only from the lens of the independent contributor. Please DYOR before investing.


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