An Investor’s Guide to Cryptocurrencies

Feb 9, 2018

There are a lot of resources available for investors to research traditional currencies or securities, ranging from financial statements to analyst reports, but when it comes to cryptocurrencies, there are very few reliable sources of information on which to base informed market views. Many investors also lack a full understanding of how cryptocurrencies work, which can make it difficult to conduct research of their own.

Cryptocurrencies may seem like a complex asset class but they share many similarities with typical assets and securities. For example, precious metals like gold are mined at ever increasing difficulty and cost, while most cryptocurrencies are mined in a process that involves expending computational power at ever increasing difficulty and cost. Cryptocurrencies also tend to have a limited supply of coins, much like the limited supply of minerals and precious metals.

Let’s take a look at how to assess an initial investment in cryptocurrencies and monitor existing holdings for changes.

Assessing an Initial Investment?

Most investors start by looking at a traditional investment’s prospectus to get an idea of its goals and how it works. In the case of cryptocurrencies, the founding document is often a whitepaper that discusses why the cryptocurrency exists, what problem(s) it intends to solve, and how. Bitcoin’s original whitepaper and Ethereum’s wiki whitepaper are examples that discuss why the cryptocurrencies were developed and how they’re designed to work on a technical level.

The next step for investors is often looking deeper into a company’s operations. For cryptocurrencies, roughly equivalent counterpart would be its network quality. A cryptocurrency with few miners, validators, or daily transactions on its blockchain indicates that market participants aren’t actually using it, inciting less confidence about its future. Some analysts use ratios like the network value to transaction volume ratio as a way to analyze a cryptocurrency network’s value relative to other networks (see Figure 1 below), although investors should be careful to compare protocols that differ radically in functionality based on equal metrics.

Figure 1 – Network Value to Transaction Volume Ratio Comparing Asset ‘j’ to Asset ‘i’

Some key questions to ask about the cryptocurrency and network include:

  • Who is mining the cryptocurrency right now?
  • What is the cumulative hash power of its miners? And how much cumulative work is contained in its blockchain?
  • How big is the network (e.g. how many nodes are there)?
  • How diverse is the network?
  • What hardware or technical requirements are there (e.g. is it scalable)?
  • Who are the developers? What is the governance model?
  • What type of cryptography is used?
  • Are there benefits other than value transfer?
  • How does the network fund itself?
  • Who is using the network? Are any established institutions involved?

The final step for many traditional investors is looking at the stock’s trading characteristics, such as its liquidity, volume, or bid/ask spreads. For cryptocurrencies, this means looking at fund flows on various exchanges to see how they’re being traded. Investors should note where capital inflows are coming from (e.g. other cryptocurrencies or fiat currency) and whether there’s enough liquidity to enter and exit positions without materially influencing the price.

 

Choosing the Right Exchange

The good news is that some mainstream financial institutions have started to embrace cryptocurrencies, which could lead to greater stability and more traditional exchange-traded products. With these in hand, investors can simply add cryptocurrencies to an existing portfolio without worrying about exchanges and other factors.

Some key questions to ask when evaluating an exchange include:

  • What currency pairs are offered?
  • What are their banking relationships?
  • Do they have a long track record of credibility?
  • Do they abide by self-imposed regulations (e.g. KYC and AML)?
  • Who are the key personnel and what are their histories?
  • What are the fees involved (keeping in mind that no fees isn’t always better)?
  • What is their funding model (e.g. coins or fiat currencies as well)?

The good news is that some mainstream financial institutions have started to embrace cryptocurrencies, which could lead to greater stability and more traditional exchange-traded products. With these in hand, investors can simply add cryptocurrencies to an existing portfolio without worrying about exchanges and other factors.

Monitoring Positions Over Time

Most investors track traditional investment portfolios using a variety of tools, ranging from online portals to paper statements each month. Financial advisors often recommend playing the long game and holding assets through any major volatility. Since most people are familiar with these assets, it’s not that difficult to adhere to the advice and stick to their guns – except when an occasional crisis hits and some investors run for the exits.

The fast-moving world of cryptocurrencies is a lot less certain. Over the past year, Bitcoin and Ethereum prices have soared around 1,000% and it’s not uncommon for major 10% to 20% corrections to occur within days. Traditional investors aren’t accustomed to this much volatility and it can lead to a lot of fear, uncertainty, and doubt (FUD). Without the reassurance of financial advisors or traditional analysts, it can be difficult to remain disciplined.

There are a few strategies that could be employed for dealing with these issues:

  • Portfolio Diversification – Many investors maintain a diversified portfolio of investments to maximize their risk-adjusted returns. For more on diversification – Investopedia has a detailed overview.
  • Cryptocurrency Diversification – Many investors consider diversifying into different cryptocurrencies rather than allocating their crypto investment in a single coin.
  • Rebalance Your Portfolio – Many investors maintain the balance of their asset allocations over time through aptly named – ‘rebalancing.’ For more on rebalancing – Investopedia has a detailed overview.

There are also active trading strategies that can be used to help limit risk. Often times, these strategies are based on technical analysis and involve identifying areas of support and resistance for the price of a cryptocurrency. Many investors have started to apply traditional technical analysis techniques to cryptocurrencies since many financial assets have similar underlying psychological behaviour.

The Bottom Line

Cryptocurrencies may be challenging to understand for traditional investors, but that should not preclude them for consideration when building a portfolio. Sporting low correlations with other financial assets, they could be a valuable part of any diversified portfolio and help improve risk-adjusted returns over the long-term. The key is understanding how to analyze cryptocurrencies to make initial investment decisions and then manage those positions over time. At CoinShares we strive to provide the necessary information with which investors can build educated views on this rapidly developing industry.

Disclaimer

Coinshares (UK) Limited is an appointed representative of Sapia Partners LLP, which is authorised and regulated by the UK Financial Conduct Authority (FRN: 550103). This document has been prepared and issued by Coinshares (UK) Limited and is being provided for information purposes only and does not constitute investment advice. It is not intended as an offer or solicitation to enter into any proposed transaction or investment.  Investors’ capital is at risk, and investors should only invest if they are able to afford the loss of all capital invested. There is no guarantee that the investment objectives will be achieved and past performance should not be construed as an indicator of future performance.

Crypto-currencies can be extremely volatile and subject to rapid fluctuations in price, positively or negatively. Investment in one or more crypto-currencies may not be suitable for even a relatively experienced and affluent investor. Each potential investor must make their own informed decision in connection with any such investment (after having sought independent financial advice thereon).

care for more depth? read the H2 2017 Crypto Report:

care for more depth? read the H2 2017 Crypto Report:  

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