Effective Portfolio Construction & Risk Management – Your Saving Grace!

Foolishness Receives Little Sympathy

It never ceases to amaze me how “investors” make terrible decisions and then proceed to blame everyone else when things go south. Sure, being collateral damage in a situation such as UST, Celsius, or FTX is unfortunate. However, it should never be fatal, and yet for so many, it was. I saw countless people claiming to have lost their life savings as a consequence of being exposed to the abovementioned companies. In addressing risk, I have mentioned a number of times that investors should never place more than 10% to 20% of their portfolio in risky investment vehicles, or on exchanges. This is prudent risk management. I mean, who puts everything in a high-risk investment vehicle?

Unfortunately, once again, people pay attention to the reward and ignore the risk. Losing 10% of your portfolio is quite a blow, but nothing compared to being wiped out. What has transpired in the last six months or so is exactly why I have addressed the importance of risk management and portfolio construction over the years. Diversification is not necessarily, risk management. Picture a scenario where an investor spread out capital between Celsius, BlockFi, and FTX. This is diversification in terms of entities, but not in terms of risk profiling. Although the capital is not centralized around a single entity, it is centralized around a high-risk profile.

This, ultimately, defeats the point of risk management and portfolio construction. Diversification needs to take place in terms of risk profiles, and not merely “location”. This will strongly depend on each investor’s personal risk tolerance. This is why I offered such a broad parameter when it comes to risky investment vehicles. Conservative investors can think about a 10% allocation, perhaps even lowering that percentage in the case of very risk-averse portfolios. Those with a “healthier” risk appetite can consider a 20% allocation. I wouldn’t move beyond that level, as now you are becoming exposed to more significant potential losses.

The Exodus

The recent exodus of users from centralized exchanges is not risk management, but rather, damage control. An investor who has structured their portfolio and taken potential risks into account would have already been correctly positioned. However, extreme events can lead to restructuring and rebalancing. In May of this year, I published an article addressing portfolio construction in a bear market. I also addressed the rebalancing that I had done in May of 2021.

So, what happens to a well-hedged portfolio if the bullish scenario plays out? Quite simply, it pumps! If your holdings are perfectly balanced in that 50% is allocated to stablecoins or cash, then your portfolio will increase at half the speed of the market. A 30% rise would imply a 15% rise. If it does however decide to dump, a 30% drop would only imply a 15% drop. Appropriate portfolio construction is what removes the gambling aspect. Once a confirmed bull season is in play, investors can choose to disengage stablecoins and begin deploying.

This is what I did and went on to decrease exposure, as I saw the charts beginning to confirm much lower levels. This article is not me merely suggesting certain practices, but rather adhering to them, myself. I was already 40% in stablecoins since May of 2021 when BTC initially topped at $65K. I also began to reduce risky exposure during the first half of 2022. This included lending entities. The exchange exodus is simply reactionary, which reveals the lack of a predetermined strategy.

Things Need To Change

Unfortunately, the average “Crypto strategy” is simply to buy and then sell during face-melting pumps. A rather simple strategy with no real risk management. The irony is that this simple strategy is not even adhered to by those who apply it. How many are still sitting on their altcoin holdings? The good old saying “failing to plan is planning to fail” comes to mind. The important aspect to “lock onto” here is predetermination. If you have not predetermined and identified levels, price targets, and time into your strategy, you don’t have a strategy. A strategy has very particular “points of execution”.

Getting serious about risk management and portfolio construction will simultaneously increase your efficiency and success rate. I really hope to see some solid “strategists” in the next bull market. I will leave you with one last important point: Portfolios need to be rebalanced as certain phases mature. For example; I began rebalancing in 2021 in anticipation of the next bear market and I am currently preparing to begin rebalancing for the next bull market.

I am still however preparing and not executing. An important distinction. That’s it for this one! See you next time!

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