6 Essential Principles of Crypto Risk Management

8 min read
I
Risk Management
Pontus Lagerberg
June 8, 2022

While the world of crypto and DeFi is exciting and filled with plenty of opportunities for high returns, it also comes with a lot of unique risk, which has caused many people to lose money. 

In the past ten years there have been several severe market cycles in crypto, and most recently the collapse of the Luna/Terra ecosystem caused hundreds of billions of dollars in losses for the crypto economy.

In the face of the risks associated with crypto, it is essential to follow risk management principles to assure long term success, which is what we are going to cover in this article.

* The strategies covered in this article should not be considered financial advice, and are merely a reflection of my personal opinion and philosophy on crypto risk management. *

Principle 1: Have a Long Term Perspective

While crypto can be very volatile in the short term, it is highly likely that the ecosystem as a whole will continue growing over time. 

This means that if you invest with a 10 year time horizon you are less likely to experience losses than if you try to time the market.

If you buy crypto when the market is hot and sell it when the market goes through a correction, you will never make money in crypto.

The state of the crypto markets right now bears much resemblance to the state of the tech stock market in the late 90s, with a huge hype for a technology that has not fully matured yet.

Just like the tech bubble crash of 2000, many tokens are now experiencing declining prices, but over the long term, high quality tokens still have a lot of room to grow.

This can be exemplified by Amazon, which after its IPO in 1997 went on to appreciate in value by more than 40x, only to drop in value by more than 90 % in the tech bubble crash of 2000.

While investors who sold their Amazon shares in the crash likely lost a lot of money, the investors who kept holding their shares until today made amazing returns.

When applying this long term thinking to crypto, short term price declines start to matter less, and true value starts to matter more, which will not only help you sleep better at night, but also provide you with better results over time.

When applying this long term approach, these are some of the things to keep in mind:

  • Only invest in projects that you have researched and believe will be valuable in a decade
  • Avoid using leverage such as futures or crypto collateralized loans 
  • Avoid short term trading strategies 

Principle 2: Use Your Holdings to Generate Yield

The DeFi space is abound with opportunities to use tokens to generate yield which often greatly outperforms traditional interest rates and dividend yields. 

These opportunities come in many shapes and forms, and include strategies like staking a token to secure a blockchain, providing liquidity to decentralized exchanges, and lending to other crypto users.

Over time these yield opportunities allow you to accumulate more tokens, which helps soften the blow of price declines and improve your long term results.

While it is possible to get double digit yields on many tokens, it is important to understand that yield opportunities come with different levels of risk and reward, and that rates change over time.

Additionally, some yield opportunities include a mix of several tokens, which affects portfolio allocation over time and may cause what’s known as impermanent loss.

With this in mind, these are some things to keep in mind when generating yields with your tokens:

  • Generate yield from several different sources to diversify your risk
  • Avoid yield opportunities that includes tokens which you wouldn’t hold otherwise
  • The higher yield you are targeting, the more actively it needs to be managed

Principle 3: Diversify Your Portfolio

While it is fairly easy to predict that the crypto space as a whole will continue growing in the future, it is much harder to predict exactly which tokens will lead that change, and what tokens will disappear.

With this in mind, it is important to diversify your crypto portfolio across many different tokens and yield opportunities. 

Without this diversification, your portfolio will be vulnerable to potential issues with single tokens or yield opportunities, and if your portfolio consists of only a few positions you run the risk of losing a large portion of it if something goes wrong with one of those projects.

By diversifying your portfolio across several positions you can get the benefits of a higher potential return without exposing yourself to large potential losses as the result of one bad decision. 

If you do not have the time to research enough tokens to build a highly diversified portfolio, it might be worthwhile to consider investing in managed index portfolios such as MVI, GMI, or JPG.

While there are several ways of diversifying your portfolio, a simple but effective approach is to establish a certain percentage allocation to each component of your portfolio, and then re-balance over time to maintain that percentage allocation. 

With this approach, you will automatically capture some profits when a certain position in your portfolio outperforms other positions in your portfolio, as well as increase your exposure to tokens that become discounted in relation to your other tokens.

These are some things to keep in mind when diversifying your portfolio:

  • Try to match your level of conviction in positions with your intended allocation
  • Ensure that no one position ends up making up too much of your portfolio value
  • Set a schedule to re-balance your positions periodically

Principle 4: Hedge Crypto Market Cycles with Stablecoins

The crypto markets go through market cycles much more rapidly than traditional financial markets, and the swings of the market are often significant. 

While this can seem scary, it is also an opportunity to improve your results, if you handle the market cycles correctly. 

One way of doing this, without depending too much on timing, is to always keep a portion of your portfolio allocated towards stablecoins like USDC, USDT, and BUSD. 

As stablecoins are pegged to fiat currencies, they will (in theory) not decline in value when the rest of the crypto market declines.

Thus, by having stablecoins as a part of your portfolio, you will experience less loss in market declines, and will have more funds to invest when the market is trading at a discount. 

In light of recent events with the collapse of the stablecoin UST, it is important to also remember that any stablecoins you hold should be well researched, and that you should diversify across several stablecoins and several yield opportunities.

Although this strategy is hard to execute perfectly, it can be very effective to help you capture profits in a bull market and seize buying opportunities in a bear market.

In theory, your allocation to stablecoins should become higher as the market is reaching a top, and lower as the market is reaching a bottom.

To help you better understand crypto market cycles it is helpful to understand that the market as a whole is currently largely driven by the price of BTC and ETH, so if you can understand when these tokens are overpriced or underpriced it will help you estimate the general market cycle. 

Beyond just following the general market sentiment, other data points that could help you make this judgment from time to time are indicators like the crypto fear and greed index and the bitcoin rainbow chart.

These are some things to keep in mind when hedging with stablecoins:

  • Use also your stablecoins to generate yield
  • Only invest in stablecoins that you have researched and trust will keep their value
  • Diversify your stablecoin holdings across several stablecoins

Principle 5: Hold Off-Chain Buffer Assets

While the world of crypto is undoubtedly thrilling, it is important to remember that no matter how exciting it is, it holds many risks that you can only avoid with assets outside of the crypto ecosystem.

Thus, it is important to not only decrease your risk with stablecoins within the ecosystem, but also to always keep at least some portion of your portfolio in traditional assets.

While crypto can help you build a fortune, no great fortune should stand on one leg alone, which is why it is important to stabilize your portfolio with traditional buffer assets.

If you are focusing on crypto for making high returns, then you don’t need a traditional asset to provide you with the highest possible returns, but rather the most dependable returns.  

One of the best traditional buffer assets to use for this purpose is cash value life insurance, which features downside protected growth, attractive tax-advantages, and other risk minimizing features.

The best insurance carriers offering cash value life insurance have delivered secure growth ever since the 1800s, and are unlike crypto well-proven to continue performing through depressions, world wars, and more.

To get started with cash value life insurance in the simplest and best way possible, you can use White Swan’s online brokerage which features a combination of smart technology and unbiased industry experts to make it simple for you to get started with a policy from one of America’s top insurers.

With a traditional buffer asset like cash value life insurance complementing your crypto portfolio you can rest assured that no matter what happens with crypto, you are always going to have a part of your net worth fully secured and effectively working for you.

Beyond that, cash value life insurance is the Swiss army knife of financial instruments, and can be used for many other purposes such as providing tax-free retirement income, protecting your family, and more. 

These are some of the things to consider with off-chain buffer assets:

  • Cash value life insurance is one of the most dependable buffer assets 
  • The easiest way to get started with cash value life insurance is through White Swan
  • Prioritize dependable returns that on aggregate outperforms inflation

Principle 6: Don’t Take Security For Granted

No matter whether you are keeping your crypto portfolio with a centralized exchange or in a decentralized wallet, you can’t take your security for granted.

With decentralized wallets people regularly get hacked, losing access to everything in their wallets.

Even with centralized exchanges the security of your funds could be compromised, such as with the infamous Canadian exchange QuadrigaCX which lost clients hundreds of millions of dollars.

To handle this risk associated with crypto assets, it is important that you establish a secure infrastructure for your crypto holdings.

For centralized exchanges, it makes sense to only use the most established actors, and if your holdings grow large enough, to spread it out amongst several exchanges.

For decentralized wallets, there are several considerations that goes into ensuring that your wallet is kept secure:

  1. Use a hardware wallet such as Ledger or Trezor
  2. Store your seed phrase to the wallet on paper, without ever saving it digitally, and keep that paper in a safe or bank valve
  3. Only connect your wallet to sites which you trust and which have gone through an audit from a reputable blockchain code auditor such as Certik

Additionally, as your holdings become larger, it might make sense to keep several wallets with different seed phrases to spread your holdings, or use a multi-signature wallet such as Gnosis to provide an additional layer of security to your holdings. 

Conclusion

While the crypto space is ripe with opportunity, the winners in the space are going to be those who can properly handle their risk, which we have learnt more about in this article.

A few principles to keep in mind for handling risk in crypto are:

  1. Having a long term perspective
  2. Using your portfolio to generate yield
  3. Diversifying your portfolio
  4. Hedging against market cycles with stablecoins
  5. Holding off-chain buffer assets
  6. Not taking security for granted

With these principles in mind, you will be better set for success than many others in the space, and will be able to sleep better at night, knowing that you have an active strategy to minimize your financial risk and maximize your long term results.