Chapter 8

Principles

A stockbroker was hospitalized with a fever. When a nurse walked into the room and took his temperature, the stockbroker asked, “How much is it?”

“102, sir.” the nurse replied.

The stockbroker furrowed his eyebrows with intense focus.

After a moment of contemplation, he settled on a plan. “Sell it when it gets to 103.”

Stick with principles, not your gut. If our gut instinct was typically correct, we would all be millionaires. Returning to our investing creed (courtesy of Warren Buffett), “Only buy something that you’d be perfectly happy to hold if the market shut down for ten years.” Markets will always be full of chaos. This is why principles are so critical. Principles are what you can control. The following are the key principles investors control:

•Goals

•Balance

•Cost

•Discipline

Warren Buffett’s first televised interview back in 1985 speaks to these. “A short-term focus is not conducive to long-term profits.” Having lived through the cryptocurrency bubble of 2018, investing principles were lacking. The hype of where the price would be tomorrow seemed to loudly overpower any discussion about justification for where the price could be in five years. If I could rewind the clock, I would have sat myself and other investors down and asked some simple questions.

“What are your goals? Is your portfolio reasonably balanced between multiple different asset classes? Do you have a target exit price? Do you have the discipline to stick with your plan?”

I imagine an investor without principles feels on edge and wired up constantly. They are running at full speed, dodging any semblance of an obstacle that would “slow them down”—a type of madness intertwined with greed that refuses to confront the simple questions.

The hard truths—Investing principles are the truths your capital lives by. Respect what it means to establish principles. Give yourself the chance to slow down and establish your investing principles before a market turns chaotic, so when everything is in motion, you are standing still knowing precisely what your next move will be.

Goals

A goal consists of setting up measurable and obtainable investment benchmarks. The goal requires developing a process or set of steps to reach those benchmarks. The first piece of what encompasses an investment goal is the objective. Our crypto asset investment objectives can be anything, but defining your objective brings clarity. The following are examples of objectives you could have with cryptocurrency investing.

•Diversify a portfolio to include a high risk/high return asset class as a small percent of the portfolio’s composition

•Increase your portfolio’s alpha (return) in comparison to the S&P 500

•See an increase of percent from your initial capital investment

•Increase net position by $

•Buy a new car

•Retire two years sooner

Your objective does not necessarily need to be entirely covered by your investment into crypto. Maybe your objective is to have your investment in crypto pay for 50 percent of a new car, 20 percent of a new business, or help you retire two years early. Objective setting gives us the long-term vision of what we are trying to obtain. You can be aggressive or conservative with this objective.

The second element of a goal is the time horizon. How soon do we want to achieve our goal? It is important to give yourself an overarching timeline. Be realistic with your time horizon. Your time horizon and objective cannot be unachievable fantasies. Realism does not mean we are surrendering our goals—it means we understand that in order to achieve large goals you must execute realistic goals under realistic time frames. If we exceed beyond that, great!

The third element of a goal is the savings rate, or total entry point. In simplified terms, how much money are you willing to invest? If you have a portfolio of many different assets (real estate, stock, bonds, etc.), deciding on a percent of your portfolio that will include the new asset is a healthy practice. This gives you a target for how much you are willing to invest. A 2 percent asset allocation of an investor’s portfolio may mean they are willing to invest $60,000 or $200 into cryptocurrency. It all depends on how much capital you are working with.

Typically, as investors experience success, they will feel compelled to increase the amount of capital they have devoted to the investment. This is human nature. While this is not necessarily a bad thing, you need to be extremely cautious about overextending your position past what is considered safe and consistent investing. If you continue to overextend (suddenly your investment makes up 40 percent of your portfolio instead of 2 percent) then you are gambling—plain and simple.

A signal that you are overinvested into a risky asset and have not diversified your risk enough is if your everyday lifestyle and well-being is negatively altered because of the risks you are taking with your investment. Journaling, once again, is an excellent signal for spotting this.

How do we go about investing our capital once we have decided how much we are willing to allocate to an investment?

Dollar-cost averaging is a useful starting method. Instead of trying to time the market, you instead decide to have periodic payments (say, one hundred dollars every two weeks for an entire year) into an investment. This helps “cost average” your investment to a reasonable price point—toning down the effects of volatility.

Here is an example:

•Week 1: Purchase one hundred dollars’ worth of Bitcoin for the current price of $8,000 (0.0125 Bitcoin)

•Week 2: Purchase one hundred dollars’ worth of Bitcoin for the current price of $6,000 (0.016 Bitcoin)

•Week 3: Purchase one hundred dollars’ worth of Bitcoin for the current price of $2,000 (0.05 Bitcoin)

•Week 4: Purchase one hundred dollars’ worth of Bitcoin for the current price of $1,000 (0.1 Bitcoin)

When the price of an asset decreases with dollar-cost averaging, you end up purchasing more “shares” of the asset with your predetermined fixed sum of money. When the price increases, you end up purchasing fewer shares. With this example, your average purchasing cost and breakeven point is at $4,250 calculated with ($8,000 + $6,000 + $2,000 + $1,000)/4 or 0.1785 Bitcoin purchased in total. If the price goes above $4,250, you are making a profit. If the price goes below, you are at a loss.

Note how this is significantly different than the following:

•Week 1: Purchase $400 worth of Bitcoin for the current price of $8,000 (0.05 Bitcoin)

In this scenario, you will make money if the price of Bitcoin goes above $8,000. Because of your lump-sum purchase, you purchased 0.05 Bitcoin, which is 0.1285 less Bitcoin owned than if you had dollar-cost averaged over the course of four weeks (0.1785 Bitcoin).

With the single lump-sum purchase, you are operating at a loss if the price of Bitcoin goes below $8,000. This is why dollar-cost averaging as a strategy is amazing in contrast to a one-time entry—you don’t have to try to time the market. Instead, determine the amount of money you want to invest, and do it slowly over time. You reduce your overall risk and give yourself a chance for a safer return on investment.

Another effective method is value averaging. This strategy aims to invest more when the price of the investment falls, and less when the price of the asset rises. For example, we set an objective to increase our Bitcoin position by $500 every month using value averaging. Here is an illustration:

•Purchase 1 Bitcoin for $5,000

•Price increases to $5,100 so your position is now worth $5,100 at the end of month, $400 short of the target value

•Purchase 0.078 Bitcoin ($400 worth of Bitcoin) to achieve the goal position of $5,500 worth of Bitcoin at the end of the month (1.078 Bitcoin at a price of $5,100 is worth $5,500)

•Price decreases to $4,000 at the end of month two, so your 1.078 Bitcoin position is worth $4,312

•The net position is short $1,688 ($6,000–$4,312) of our additional $500 target position for this new month

•Purchase 0.422 Bitcoin for $1,688 at a price of $4,000 per Bitcoin

•Portfolio has 1.5 Bitcoin—net position is valued at $6,000 with the current price of $4,000

This pattern continues to be repeated in the following months. If the monthly growth of $500 is exceeded, you can be immensely happy and choose not to put in more capital at the end of the month because our preplanned growth goal was achieved.

The main goal of value averaging is to acquire more shares when prices are falling and fewer shares when prices are rising. This happens in dollar-cost averaging as well, but the effect is less pronounced. Several independent studies have shown that over multiple years, value averaging can produce slightly superior returns to dollar-cost averaging, although both will closely resemble the market’s returns over the same period. The weakness of the value averaging strategy is not having the funds to properly invest during significant shortfalls. This is why having a realistic view on potential returns in conjunction with smart budgeting with your investing is critical to the success of your goals.

The third and final entry point strategy is the lump entry strategy. This is the most common retail investor strategy. An investor decides they like an asset, and then decide to immediately purchase it without slowly scaling into the position. As you have seen in earlier examples, this can burn an investor. If you have the patience to set your savings rate with a reasonable time horizon using dollar-cost averaging or value averaging, you reduce your overall risk. At the same time, lump entry maximizes possible return if the price continues to go up after your purchase—you get the best possible bang for your buck at the cost of increasing your risk (probability of not achieving your goal rate of return).

I can’t express this enough: enter slowly over the course of time—you will save yourself a world of pain. And if the asset is truly undervalued, you will still come out extremely profitable with much less risk incurred.

To summarize, the Goal principle is about having clear, appropriate investing objectives. This means establishing a healthy time frame with a predetermined amount of capital or growth you are willing to invest towards.

Balance

The Balance principle is the system of selecting and deciding on asset allocation using a diverse set of investments. Balance is both a mindset and a strategy that you must adopt and practice. At the forefront of balanced investing is diversification and asset allocation—the hallmarks of professional investors.

Asset allocation as defined by James Chen, former head of research at GAIN Capital, is as follows: “The rigorous implementation of an investment strategy that balances risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals, and investment time frame.”

In layman’s terms, it’s about how much capital we devote to any given asset class over a certain time frame. Because cryptocurrency is its own asset class, the principle of balance must be applied to it as an investment—same as any other asset.

I cannot emphasize enough how important it is to diversify between multiple asset classes.

Diversification is central to the balance principle and is the most important principle in investing. Other asset classes separate from cryptocurrency have proven to be consistently valuable over time, and to gamble all your capital into any one asset class is foolish. You can reduce your overall level of risk by diversifying your investment capital into multiple investment vehicles. This divergence is not only healthy, but imperative to your investment portfolio’s well-being.

Here are the primary asset classes a portfolio can consist of:

•Cash

•Stock

•Bonds

•Real estate

•Gold

•Precious metals and commodities

•Alternative investments

Diversification across multiple asset classes works because a diversified portfolio has exposure to multiple different key markets—safeguarding against weak performance in any one area. For you opportunists, some portfolio styles have a high risk/reward. Before I discuss simple portfolio setups, I want to briefly touch on a cryptocurrency classification misnomer.

A common misconception is that cryptocurrency falls under the category of an alternative investment. Certain cryptocurrencies can be classified as precious metals, stock, or even real estate (tokenized assets). This is a powerful potential future reality of the blockchain space that I assume will become more fleshed out as the market regulators and blockchain developers continue to advance and define the technology.

As of right now, even behemoth entities such as the Securities and Exchange Commission in the United States don’t know how to consistently classify certain cryptocurrencies! It is best to view cryptocurrency as an alternative investment that in the future may be categorized as its own asset class with a separate set of regulations and laws.

When discussing portfolio composition, the asset class allocation percentage is the bread and butter of a portfolio. How much you commit to any given asset class (separate from which investments you choose within the asset class) is what largely determines your overall risk and return.

Each asset class has thousands of different investments you can choose from. Within cryptocurrency are two categories: small market cap and large market cap cryptocurrencies. Market capitalization is a rough representation of how much the market values a cryptocurrency with the total supply accounted for.

As an example, Bitcoin’s market capitalization (price of Bitcoin times the supply of Bitcoin) is $117,810,000,000 at the time of writing this. Bitcoin has the largest market capitalization of any cryptocurrency. This contrasts with the ninety-seventh cryptocurrency, HyperCash, whose market capitalization of $43 million. Notice how significantly smaller this market capitalization is compared to Bitcoin. There is significantly more risk in investing in a cryptocurrency with a smaller market capitalization for reasons discussed in Chapter 9: Qualitative Analysis—Risk.

This is why having a portfolio that is balanced is so important. Going 100 percent all in on an alternative investment asset class such as cryptocurrency while simultaneously placing 100 percent of your capital into a relatively unknown high-risk cryptocurrency (below the top twenty largest cryptocurrencies) is plain lunacy. Spread your risk! Do not gamble away your financial security into a dead-end investment just for the one-off chance to significantly grow your wealth.

“Do not put all your eggs in one basket.”

—Warren Buffett

Simple Portfolios

An infinite number of portfolio compositions exists. This section will cover two: aggressive and defensive portfolios. These are illustrations designed to give you a picture of what diversifying means. Because the process of designing your portfolio is the primary component of achieving excellent return, I recommend investing a significant amount of time researching this topic.

Figure 11: Aggressive Portfolio

This is an example of an aggressive portfolio. The aggressive portfolio has a high growth potential, with 10 percent being the largest percentage of allocation any investor should be willing to put into cryptocurrency. Note that even with the most aggressive portfolio, only 2.5 percent of allocation is devoted to small cap cryptocurrency—the highest risk investments (and highest potential return) assets you can possibly invest into.

Figure 12: Defensive Portfolio

The defensive portfolio is the absolute inverse of the aggressive portfolio. The defensive portfolio is a great portfolio setup for a beginner investor that wants to get their feet wet safely and smartly in the crypto markets. Not only that, but this is a great portfolio in general, and I would recommend this style of portfolio for risk-averse individuals. The defensive portfolio’s goal is to be resistant to market recessions and downturns. This is done by heavily investing into value-retaining assets (bonds and precious metals) as well as investing into companies that provide necessities to the economy.

I will pause here and address the doubters. “Five percent into crypto with a defensive portfolio? Is this guy insane?” I am a firm believer that crypto has huge growth potential, and with the rest of the defensive portfolio being extremely safe, having a percentage of the portfolio in a speculative investment is a very strong hedge against the low level of risk within the portfolio. If the 5 percent crypto asset allocation performs well, your portfolio will outperform many other defensive portfolio setups that don’t include cryptocurrency. If your crypto assets do not perform well, you are worse off. But with 95 percent of the portfolio dedicated to value retention, perhaps it is a risk you are willing to take.

You have so many options for portfolio composition—planning how you want to allocate is, in my humble opinion, extremely fun! The general consensus is that the younger you are, the more risk you can take on and be fine in the long run, as your portfolio will recover from market downturns more easily and still grow. As always, I would encourage you to err on the side of caution. As long as you diversify and don’t invest too much of your investment portfolio into high-risk assets such as cryptocurrency, you put yourself in a great position to grow your wealth.

Balance in investing is king, so don’t go chasing queens.

Cost

The third principle we can control is cost. When we talk about the cost principle, the foremost variable that you fully control is your expenses. Entry and exit points also fall under this category, but you do not have control over the price (in stark contrast to fees). Thus, controlling fees incurred falls under the principle of cost because you have control over this variable. Fees are incurred for buying, selling, and moving cryptocurrency.

Simply put, if you are putting in $100,000 over the course of two years, you want to aim for the cheapest fees for on-ramp fiat exchanges, trading platforms, and crypto brokers. This seems like a no-brainer, but often people do not hunt for better exchanges/brokers because they are intimidated by the search. Higher fees are usually associated with ease of entry. Exchanges that make it easy to deposit fiat and immediately purchase crypto with USD will often have higher fees. This could also be related to the fact that exchanges with flashy user interfaces, customer service, and simple registration processes have a larger clientele and therefore get away with charging higher fees.

Coinbase is the easiest exchange for anyone to use to purchase cryptocurrency with USD. If you are a beginning investor, this is the go-to exchange. Coinbase has a simple user interface, great customer support, and excellent banking relations. At the point you start investing more frequently, it would be best to look for an exchange with a cheaper fee structure than Coinbase (aligning with the cost principle). Some alternative on-fiat ramps are Gemini, Kraken, and Binance.

In summary, always look to cut costs where you can. It is one of the few things you can truly control.

Discipline

The fourth and final principle of investing is discipline. Unfortunately, every single self-improvement guru and fitness magazine spams this word in our faces all the time. Here is the truth: real discipline doesn’t pick and choose. Discipline does not choose to follow a solid game plan one day, only to ditch it when it gets slow or boring.

You need to embrace the fact that real discipline is cold, relentless, and unforgiving. Real discipline is the antithesis of the twenty-first century attention span. Discipline is the never-ending process of steadily committing yourself to a plan by taking the right small steps over the course of the marathon that is your long-term goals. Of all the principles, discipline is the one that is the most vital to your investing success.

Fully-developed discipline is like breathing—you don’t have to think about it. Discipline in its purest form is in and of itself not fun. What you derive because of discipline is fun. Investment journaling weekly takes discipline. Not jumping ship every other week takes discipline. Not switching up your asset allocation after a month takes discipline. The grass is always greener on the other side, so have conviction about your decisions and stick with them. That is how you develop discipline.

Discipline in investing primarily manifests itself in three ways:

1.Refusing to “chase” gains

2.Rebalancing an investment portfolio when one part over-performs or under-performs beyond a preplanned percent

3.Sticking to your money allocation plan (no impulse purchases after already purchasing x amount with a predetermined sum of money)

Sounds simple enough right? If only it were so easy.

Rebalancing a portfolio is done far too infrequently by the average investor. Here is what it looks like to rebalance. Our starting portfolio is worth $1,000 with all our asset classes’ value adding up to 100 percent of the portfolio worth. Six months went by. Our large cap crypto currency exploded in value during this time.

Figure 13: Starting Portfolio

When we viewed our portfolio at the end of the six months (listed below), all our assets’ net values stayed the same except large cap crypto. It went from $250 to $600. That is amazing growth! Notice how different the allocation graph looks compared to where the portfolio started six months ago. This is because the large cap crypto position now holds a larger percentage of the total portfolio allocation. Even though the other assets did not gain/lose value, their percentage of allocation decreased because of large-cap crypto.

Figure 14: Portfolio After Six Months

A lot of new investors will forget to rebalance their portfolio back to their initial asset allocation composition. Because riskier assets do not retain value as well (because of greater volatility), if you do not rebalance your portfolio then you are at risk of not truly locking in your gains. The best way to move forward would be to sell $262 of the large cap crypto position and simultaneously purchase larger positions in all the other asset classes until we return to an allocation composition for each asset class roughly similar to where we started.

Figure 15: Rebalanced Portfolio

After rebalancing, the structure of the portfolio is back to our original asset allocation percentages and simultaneously our total net position total value has grown to $1,350 from $1,’000! This is what it means to rebalance.

The trade-off to rebalancing is it conflicts with the cost principle. The more often you rebalance, the greater the fees incurred from buying and selling fees. Professional investors set a percentage of tolerance they are willing to allow their portfolio composition to change before rebalancing. The greater the flexibility, the fewer fees incurred. The trade-off to more flexibility is that greater risk is incurred, assuming a deviation from your original portfolio composition represents risk.

Constantly rebalancing based on goal portfolio distribution can kill net position growth potential. Instead, have a disciplined mindset about not letting an asset class of your portfolio exceed plus or minus 3 to 10 percent from its original allocation. Ideally, you want the changes in your portfolio composition to guide your decisions. Portfolio composition changes should prompt questions in your investment journal; valuable insight can be gained by digging into the “why” of significant portfolio changes.

Rebalancing requires the discipline to consistently face your investment reality and to make changes even in the face of overwhelming success. Rebalancing is the discipline of not getting too caught up in what could be a temporary success of any single asset class. The discipline to safeguard your investment portfolio by consistently rebalancing will increase your total net worth in the long run as you reallocate growth to safe value holding assets through the act of rebalancing.

Finally, sticking to your spending plan is the ultimate act of discipline. I have been in the room with people who under-planned, under-researched, and were ill-advised to purchase stock and crypto after having put in their “limit” for the month during the previous week. They do this again and again until their everyday life is suddenly affected by not having enough fiat in their bank account.

Overinvested, they are emotionally affected and proceed to make even more significant unplanned financial actions. This is terrible and can lead to life-changing financial instability.

Principles are the building blocks of our investment decision-making. Embrace them. Strive to understand and improve your long-term plan, asset allocation strategy (balance), cost minimization, and your investment discipline.

By now, you are probably itching for cold, hard numerical strategies. Abstraction is important and allocation is essential, but identifying excellent investments within any asset class (in this case cryptocurrency) through qualitative analysis is the bread and butter many investors are familiar with. Now is the time to talk about the fun part of investing.

You’re in a room with two hundred people of whom you know nothing about. Ten of these people will make you rich, and most of the room will make you poor. How do we go about sleuthing our way to success? What questions do we ask? This is the art of qualitative analysis.

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