When is risk good?
Risk and reward are two sides of a flipped coin. This is the classic quandary of investing. Until the coin lands, you don't know which side you're gonna get.
Risk's defining feature is that the outcome is unknown. If you knew in advance that a venture would fail, undertaking it would be plain stupidity. Whereas if success were guaranteed… but it can't be. What makes the future the future is that it hasn't happened yet. Success is never truly guaranteed until after the fact, hence "execution risk."
Occasionally you might find a proverbial $20 bill lying on the sidewalk. But most of the time investing works like this: the more risk you assume, the greater your profit potential — and the greater the chance of disaster. As previously noted on this blog, "quick gains for highly volatile securities could also mean an increased risk of dramatic losses." This observation applies heartily to cryptocurrencies (whether they're securities or not).
Hence the adage about never investing more than you can afford to lose, which is the glib answer to how risky your investment portfolio should be. Just decide what amount of risk you're comfortable with, duh! Draw the rest of the owl.
While gut instinct is not to be disregarded, it's comforting to have a sensible rationale behind your capital allocation choices. Unfortunately there's no single one-size-fits-all answer; you'll have to figure out what works for your situation. Here are three factors to consider:
Personal goals
Is it important for your investments to support your values, your vision of a good future? The ideological component of an investment can be significant, especially if there are others who will band together with you, the effect is powerful. Consider the financial performance of Tesla, or Bitcoin — these assets are not valued solely based on dispassionate analysis. Optimism and activism play a role and can sway market performance.
In general, of course you want to make money, but it's good to get more specific than that. Are we talking retirement portfolio? Savings for a house, or some other large purchase, but you want to put the money to work in the meantime?
The sooner you plan to use the funds, the more you should avoid risk, so the cash is available when you need it. It's not ideal if your down payment has disappeared by the time your dream home is for sale. Which leads us to the next topic…
Investment horizon
When do you plan to cash out? For example, if you're investing for retirement, your prospective schedule is a relevant variable. But as a young person, the largest part of your portfolio is the income you'll be earning for the rest of your life!
Your horizon is the time span over which you plan to hold your investment before needing to liquidate it. Longer horizons allow more time for investments to recover from downturns. This inclines longer-horizon portfolios toward riskier assets, assuming you can withstand short-term variability and HODL.
Risk tolerance
Individual willingness to subject hard-earned money to the risk of potentially substantial losses varies widely. Risk appetite is influenced by previous experiences, dedication to goals, source of funds, life circumstances, etc.
Ask yourself, how much can you afford to lose, actually? What amount would impact your practical day-to-day spending, or your mid-term goals (like buying a house), or simply your peace of mind? Do you have an emergency fund?
In particular, debt compels you to be more cautious about taking risks. High-interest loans, such as credit card and personal loan debt, should be settled before aggressively investing. The reasoning here is straightforward: no investment assuredly yields returns, but unpaid interest will assuredly pile up. It's that pesky riskiness of risk again.
A metric like the Sharpe ratio can help you assess different options.
At this point you might be thinking, "Okay, I get it, risk is risky. But no pain, no gain. So… how much pain is theoretically optimal?" (I'm sure that's exactly how your inner narrator sounds.) Here are two time-tested approaches to investment allocation:
- Market-cap weighting
- Diversification
Market-cap weighting
Market-capitalization weighting, also simply called capitalization weighting, means investing based on the proportional values of the various entities you're buying. Capitalization weighting relies on the "wisdom of the crowd," trusting the aggregated judgment of market participants about the best investment opportunities throughout the whole world.
In market cap-weighted indexes, a company's representation within the index is based on its size, and its performance contributes to the performance of the overall index proportionately.
In other words, the company with the largest market cap will represent the largest weight in the index, meaning mega cap companies like Apple will impact the performance of the overall index more than a small cap company will.
For example, the total U.S. stock market is worth approximately $46 trillion (Siblis Research), and the entirety of the global crypto markets is worth approximately $1 trillion (CoinGecko). Let's say you want to spread your investment portfolio across those two broad markets. Using a market-cap strategy, you would invest 1/47 in cryptocurrencies, and the rest in stocks. 1/47 is approximately 2%, so if you were investing $10,000 in total, you'd allocate $200 to cryptocurrencies.
However, you might want to assume more risk than a pure market-cap strategy, in exchange for the possibility of a greater return. If retirement is still decades away, then volatility is attractive — big swings up and big swings down often go together. (Dollar-cost averaging is a way to balance the positive and negative effects of volatility.)
Or you might be a "true believer" in the advantages of crypto over traditional financial infrastructure. In that case, investing in crypto is a way to bet that the industry will rise in importance, while simultaneously "voting with your dollar" to make that vision more likely to come true.
Diversification
I addressed this topic in depth recently:
Be wary of devoting your entire savings to a single choice, like tech stocks or local real estate… or crypto. Instead, diversify your portfolio by investing in different types of assets — buy stocks and bonds and real estate and crypto. If one sector performs poorly, the others may help balance out the losses.
You can also diversify within a given asset class. Index funds were invented as a low-fuss method of diversifying your stock portfolio, automatically putting money into the economy’s top-performing companies across any and all industries.
You can even diversify within a particular sector. Take tech stocks: Amazon, Google, and Microsoft all have cloud computing divisions that compete against each other, but you as an investor don’t have to pick just one of them to back.
Diversification does have a flip side that's important to acknowledge. If one of your investments blows up (in a good way), you will only benefit in proportion to the amount of your portfolio that was allocated to that specific investment. Risk and reward are inextricably intertwined; reducing the risk of failure wiping you out also reduces the impact of wild runaway success. That's the tradeoff, and usually it's a good one; though you might have to build an efficient frontier to find out when that's the case.
Diversification takes some emotional maturity. You have to admit to yourself that you're not prescient, the future really is unknown, and trying to pick one winner (or a small handful) is like playing roulette with the market.
The Kicker
Combine all these pieces of advice together and you might believe that the best solution is to diversify into everything in the proportion that the market has valued it with a focus on how your time horizon and risk tolerance varies over time – and you wouldn't be the first! While past performance isn't a guarantee of future results, the strategy has a long history of helping people to meet their goals successfully.
At Hedgehog, we're just trying to help you get access to another chunk of the total market while keeping the cost to your time, money, and attention low. Whether you should add crypto to your portfolio will depend on your personal goals, time horizon, and risk tolerance, but we certainly believe it should be a contender.
So now that we've helped you think about what proportion of your cash you should invest in which kinds of assets, maybe it's time to think about how much cash, total, you should invest. To really understand that, we'll have to talk to you about fixed costs, variable costs, amortization, and the Kelly criterion. Tune in next time for the deets.
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