Hi! It’s George from Investorama.
Thank you for joining me in the exploration of the future of investing. In this newsletter, I’ll be looking at alternative assets, blockchain, investment technology and trends - without the hype.
gm,
Bridging traditional finance and crypto is a critical area of modern finance and one that fascinates me. It keeps coming back as a topic in the conversation with my podcast guests, for example:
Here I will take a different approach to building bridges, one that doesn’t require any tech: through the mind.
You have heard about our “lizard brain”, or limbic system. It is responsible for our fight or flight response. That’s still useful, but we often have to inhibit it in modern-day life.
As I’ve been experimenting with crypto, I feel my ‘traditional finance’ brain has pushed me to make costly mistakes. They are part of the learning process and it was fun and relatively painless. However, I could have avoided them in hindsight, and it would be just as fun.
Many of you know me from YouTube, so I’ll use a movie metaphor: Avatar.
You’re arriving in Pandora. You’re linking with your synthetic avatar. There are exciting things you couldn’t do before. It’s a fascinating place, but also a dangerous one. Here are a few things you should know first.
I’ll share the mistakes, lessons learnt, and rules I’ve set up for myself around three pillars: market moves, fees and dopamine. I use “back of the envelope” calculations, so my process is rather analytical, but the rules are intuitive.
I’m sharing my journey as an investor, not a trader, in the hope that it will help others, but remember this is NOT INVESTMENT ADVICE.
Market moves
You need to trade once, even if you plan to HODL forever. And considering the daily moves in crypto, that entry point matters. As I write this on 25 Feb 2022, in the last 24 hours, Bitcoin went from $39K to $34K and up again, roughly a 15% move in both directions.
A personal note about technical analysis:
My first job was in FX sales in Singapore. One of my daily tasks as a junior was to come up with some recommendations based on charts, or technical analysis. I’d indicate buy and sell levels. I got quite good at it. Not at predicting the ‘right’ levels, but at coming up with something every day. Did the ‘analysis’ ever work? It didn’t matter. It was about having a talking point to share with clients.Good ol'times, but let’s go back to crypto today.
Mistake:
Not taking into account the volatility of crypto compared to equities and using the same order of magnitude for orders.
Analysis:
Historically the volatility of Bitcoin or Ethereum is around 70% compared to 15% for equity indices. I’ll skip the details here: it varies based on the level and the timeframe. 70% is my benchmark. However, that figure is not very useful to understand what it means in terms of price action.
The Normal Distribution, pictured below, gives us a theoretical tool.
Before I dive in: I’m NOT using it by the book (I ignore μ, time horizons and more), I’m rounding up and taking shortcuts. I just needed a practical guide. And it’s just theory. The reality can be totally different.
Volatility = Standard Deviation = σ
The curve shows the probability to stay within a range of [-σ;+σ] = 68%
So if Bitcoin is at $40,000 and σ= 70% there’s a 68% chance of staying between [$12,000; $68,000]. Feels wide? The last time we saw 12K was 18 months ago; 68 K was 3 months ago.
Applied to the S&P 500 at 4,300, σ=14% gives a range of roughly [3700; 4900].
I find it helpful to keep that order of magnitude in mind as I shift from equity to crypto. By the way, it’s not just me, ‘algorithms’ think this way too, according to SBF.
In practice:
The distribution curve is the basis for Value at Risk or VaR (discussed in this Billions video) used in risk management.
It’s also helpful for placing your orders instead of applying the same approach as equities as I was doing by default.
For example, let’s say I want to add more Bitcoin gradually. I will place buy orders on the downside. If I leave them outside the 1 σ range, there’s a less than 32% chance of getting my order executed (in theory).
I’d personally see how I feel about owning Bitcoin and adjust my order accordingly.
For example, The probability of staying within a range of 0.5 σ is 38%, and that number feels about the right balance of conservatism and FOMO. Applied to Bitcoin 0.5 σ is 35%. So if we are at 40K today, the range is [28K;52K]. Maybe I would put my order around 30K if I am not in a rush to get in?
Personal rule:
Expect moves of 30% on either side for crypto (NB: I insist on PERSONAL and FEELINGS). Always use limit orders rather than market prices.
Fees
Mistake:
Ignoring transaction fees
Analysis:
When you consider an asset that can quickly move by 30% (see above), it’s easy to dismiss transaction costs even if they are considerable (3.8% if you pay by debit card on Coinbase).
But fees are certain. If you incur 3% transaction costs on either side and enter a trade with 70% chance of a 15% upside and 30% chance of a 15% downside, your expectation is 0%. Just saying.
As a beginner, you will incur two types of fees:
Gas Fees: the transaction fees that users pay to miners on a blockchain protocol to have their transactions included in the block. Gas fees vary by protocol, transaction type and time of the day (it’s a supply and demand mechanism). The primary protocol, Ethereum, is also the most expensive one in terms of gas. Lately, fees hover around $20.
Platform fees: that’s the cost to transact on centralized platforms like Kraken and Coinbase. They internalize the transaction and therefore don’t trade on-chain for every request.
Brokerage fees for card payments: typically high (3% on Kraken)
Brokerage fees for transactions from bank deposits: usually low (0.2% on Kraken)
Withdrawal fees: variable (fixed up to $20 on Kraken, a % on Coinbase)
In practice:
Crypto is a place where you learn as you invest. Spending some gas fees on experiments can bring great educational returns, but you soon want to rationalize the process.
Fees are a limiting factor in the democratization of crypto:
If you’re dealing with tens of thousands of dollars or more, then you should transact on-chain, as the gas fees will represent an insignificant amount of 0.2% or less. But the rest of us need to be more careful.
For small amounts, it’s usually better to pay a % of your notional as fees on platforms like Kraken, Coinbase, but that’s very limiting.
There’s a potential arbitrage between Platform fees (centralized and as % of the amount) and Gas (fixed by transaction). It’s also worth exploring different platforms to find a fee structure that suits you.
Think of the workflow and how you can limit the number of transactions. When possible, transact on-chain in lump sums.
Don’t buy crypto with bank cards!
Personal rule:
Think of the workflow and limit the number of transactions. Transact on-chain in lump sums >$4,000 so the gas represents less than 0.5% (approx.).
Don’t buy crypto with bank cards!
Dopamine
Mistake:
Overtrading (or over-activity, crypto is not always about trading).
Analysis:
Another difference between crypto and other asset classes is that it’s 24/7 and almost instantaneous. Although well-known, the consequences can be unexpected. It’s easy to check continuously, and if you’re not used to the amplitude of crypto, feel like you need to act.
It’s also a much more frictionless experience than traditional markets. You’ve seen the Web3 memes:
And there’s entertainment. The gamification and storytelling are effortless. The communities are strong.
Take Babylon finance, a lightweight investment DAO (I’ve invested and will discuss it in another post). It’s all ‘Babylon-themed’. There are Gardens, Prophets and a Heart and 3D garden NFTs.
As a comparison: Imagine investing in Vanguard’s Admiral shares, and there’s a nautical-theme website. Fund managers are called Captains, and investors are all Sailors or something like that. And you can chat with other ‘Sailors’ and vote on strategies.
Great fun, right?
In practice:
The brain seeks the release of “feel good” neurochemicals such as dopamine and serotonin. But it’s not the best for wealth creation. The most significant risk is to overtrade (see fees above).
Sharp market moves and dopamine can make an intoxicating cocktail for investors. Let’s not be prudish; intoxication could be a goal in itself in real life. But only if you don’t drive. And in crypto too? But only if you don’t pay high fees and don’t care about wealth building.
Personal rule:
Ignore FOMO. Get the bigger picture first. Define how much time and money you allocate to the asset class and each token or project.
To sum it up, here’s the crypto equivalent of the notes I’d write on the palm of my avatar’s hand if I was about to explore Pandora.
My crypto cheatsheet:
Expect 30% moves. Only trade with limit orders.
For fiat to crypto, use small amounts via Kraken. For on-chain, ERC20 transactions, a minimum amount of $4000.
Calm, cool and collected. Learn as much as possible without transacting.
The above is just a step in my crypto-investment journey. I hope it can help in yours, but do your research, invest in yourself first and seek diversification.
See you soon for more crypto adventures.
PS: I’m back on YouTube with a video about The art of data manipulation, featuring Masterworks