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When tackling the cryptocurrency markets, it’s very important to manage one’s investments properly. When we say manage investments, we’re not talking about choosing the right cryptocurrency to invest in, we’re talking about protecting one’s portfolio from any major form of destruction.
The truth is, it is very common for beginners to let their (losing) investments keep on going down. While it may seem like “common sense” to not let your losses grow, investors, especially beginners, let their emotions get the best of them, making them hold onto their losing positions hoping for any recovery. In this section, we discuss how to avoid all that through risk management and why it is necessary for traders and investors.
Risk management is simply the management of risks. Risk refers to the possibility of an investment to go the opposite of the expected return. For example, if you buy Bitcoin at $20,000, there is a risk of it going to $19,999 and below. Risk management helps investors prepare for the risks involved and make sure that their losses are kept under control at a tolerable level.
How to manage risk
The first step to risk management is planning. Having a sound plan and sticking to it is the way to start. A good plan is knowing your:
Aside from this, it’s also good to have a backup plan. A plan just in case any unexpected event prevents you from executing your original plan. For example, you want to sell your bitcoin, but you’re out on a vacation trip with no internet access, and the price of bitcoin starts to go down. What do you do then?
Position size is the amount allocated from your portfolio for an investment. This is the second step. Position size dictates how much risk and reward you are willing to take for a particular investment. The golden rule in position sizing is never going all in or putting all of your funds into one single investment. This is because you will be exposing yourself to too much risk, and one small mistake can wipe out your portfolio. Usually, going all in also affects the person managing the investment, causing them to have clouded judgment because there is too much risk.
Taking the concepts above into account, we can now proceed to discuss two core risk management strategies used by investors and traders.
Diversification is allocating your capital to different investments to protect and preserve your capital while still earning some profit. You may have heard of the phrase, “Don’t put all of your eggs in one basket.” Diversification in cryptocurrencies may entail the allocation of your capital in different types of cryptocurrencies like layer 1s, DeFi, stablecoins, etc. Diversification outside crypto is achieved by allocating capital to different assets, such as stocks, bonds, and real estate, apart from crypto.
Value-at-Risk represents the amount you are willing to lose in an investment. Remember our third essential bullet point in the previous section “How to manage risk”? VaR is usually quoted in percentage terms. For example, if your risk management strategy involves setting a VaR of 1% in a portfolio worth $10,000, it means you are willing to risk losing approximately $100 in this investment in case you are wrong about your outlook. VaR is a strategy mainly used by traders in managing their risk in trades.
The best market participants incorporate risk management strategies to prevent losses from getting out of control. If the risk can be managed, market participants can open themselves up to making money in the market. As a general rule, a Value at Risk (VAR) of 1%-2% is used to limit the downside for any given portfolio. For a Php 100,000 portfolio, any given trade or investment should only have a downside risk of Php 1,000 - Php 2,000. Preserving capital is a necessary investment strategy to make sure that our capital is intact and still available for deployment during such time as great market opportunities start to show up. Capital can also be preserved through portfolio diversification in various financial instruments such as bonds, currencies, and mutual funds.
In order to profit from the markets, an investment edge must be defined prior to any entry of a trade or investment. An edge is defined as something that gives you an advantage over other investors such as handling of emotions, accessing special information, or your style of reading charts. In this case, Risk Management is a very powerful tool which investors can use as one of their edges. It’s also important to know that an investment edge’s profitability may change over time as the market evolves, given that every event or situation in the markets is unique.
As your percentage of losses gets higher, the percentage needed to break even gets higher. It is important to consider this to determine how much you will be willing to risk for any given trade or investment before you cut your losses. A 50% loss would require an increase of 100% for a trade to break even. This can be illustrated in the table below.
Alongside risk management, an investor must also employ proper investing psychology in their financial decisions. Human psychology plays a huge role in investing, and can be a dangerous pitfall if not kept in check. Listed below are some of the most common behavioral traps in investing and which you need to avoid.
The anchoring trap is a bias that refers to relying too much on preconceived notions. For example, you spent the whole month doing research on a particular cryptocurrency, and you were convinced that this was going to be the next coin to skyrocket. However, a few months passed, and the coin didn’t move at all. On top of it, there were a lot of red flags starting to show, like the founders barely being active, the community gradually losing members, etc. But, because you committed a lot of time researching this coin, you refused to change your views even when the market is telling you a different thing.
You can avoid this trap by keeping your mind open to new information and ideas. There are tens of thousands of cryptocurrencies in the space to choose from as an investor and compete against as a project.
From the name itself, the confirmation trap works by seeking confirmation from others. Assuming you happen to invest in a new cryptocurrency coin, unfortunately, that coin does a rug pull a month later. You would tend to seek advice and comfort from other members of the community who also got scammed. This helps you believe that founders may come back or the project is still alive even if it won’t already.
It is best to avoid this trap by accepting the reality of investing and that it entails losses which is why risk management is important. It is also important to move on quickly to avoid hurting yourself further. Confirmation is the last thing you need.
The blindness trap is a bias where one shuts off contradicting information or views. This trap is dangerous as it prevents you from facing reality early on and prevents you from taking losses while it’s still small. An example is when there is a scandal posted online about a cryptocurrency founder, but you choose to ignore it because you have invested heavily into the project.
Similar to the solution to the anchoring trap, you must keep your mind open to new information and always be prepared for scenarios that go against you.
The relativity trap is a bias that is based on comparisons with other people’s success. You see your friend going on a trip to Europe or buying the latest car model, and you start to compare your situation and happiness to theirs.
The relativity trap is common and even natural to some of us. It's normal to feel like wanting to catch up to what other people are buying or investing in. However, you must base your happiness and investing goals on yourself and not others.
Have you ever felt like there are times when you can never go wrong? That is the superiority trap doing its job. When you feel confident about an investment or when you really think there is no better alternative, feelings of superiority will start to cloud your judgment.
This trap is no different from being too prideful. Always acknowledge that humility is also key to successful investing. Having an open mind and considering situations that go against your view also help in avoiding this trap.
In investing, it's not enough to know how to draw fancy lines on the chart, get the latest information, or hold the most popular cryptocurrencies. An investor must also practice proper risk management and be aware of the psychological traps before succeeding in any financial market. Practicing everything we’ve discussed in this module will save you a lot of money in the long run. Best of luck out there, investor!
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