A beginners guide to building a cryptocurrency portfolio

The “cryptosphere” is crammed with thousands of digital currencies, while new coins continue to join the fray.

On the one hand are well-established heavyweights such as Bitcoin, Ethereum and Cardano. On the other are the smaller coins of questionable functionality and provenance, including meme coins such as Shiba Inu and Dogecoin that are worth a fraction of a penny.

Deciding which cryptocurrencies to buy can be tricky. Here is a guide to help you navigate the rollercoaster world of digital assets and what to look for when building your portfolio.

Where to begin

A good place to start is to assess whether to pick an established cryptocurrency — a blue-chip coin, if you will — or newer, relatively untested assets that may carry higher risk but could be spectacularly rewarding.

Invest in projects or tokens that you fundamentally understand, says Adam Haeems, chief executive of UK-based investment firm Alphachain Capital.

“Investing in the latest hype going around social media is a sure way to lose money over the longer term,” he cautions. “By investing in something that you truly understand and believe in, you will be able to withstand the volatility of the asset class more easily and less likely to panic sell during market downdrafts.”

Cryptocurrency newbies are advised to do their due diligence and know the risks inherent in some alt-coins — tokens other than Bitcoin — floating in the market.

There is also the issue of custodial complications to consider. Currently, investors can gain exposure to Bitcoin and Ether through exchange-traded funds, which eliminates the risk and challenges of custody. However, newer assets must be bought directly and may require storage arrangements, a tricky undertaking for inexperienced investors.

What matters while structuring a cryptocurrency portfolio?

It depends on what the investor wants in a cryptocurrency portfolio. In most cases, the size of the reward could be tied to the level of risk. There are more than 10,000 alt-coins from projects ranging from dog-themed meme coins to decentralised finance (DeFi) protocols looking to disrupt industries.

“Just like in traditional markets, investors need to do their homework about the project and if they choose to buy the coin — especially a new alt-coin — they need to understand the risks involved and where the founding team is taking the project,” says Yuri Cataldo, a cryptocurrency specialist and co-founder of investment company Athenian Capital.

Investing money in some crypto projects is as good as gambling, he says, citing Squid Coin, which is based on the popular South Korea-produced Netflix series Squid Game.

The coin rose 28 million per cent, from $0.01 to $2,861 per coin in a few days. But the story ended in tears for its investors. The entire project turned out to be a “rug pull” worth $3.3 million. A rug pull is industry parlance for a fraudulent cryptocurrency project where the founders suddenly shut down the site and make off with investors’ money.

A key component of due diligence is understanding the “tokenomics”, says Mr Haeems. By that, he means finding out the supply schedule of the token and its largest holders, as well as their incentives to hold versus sell.

“Any large concentration of tokens held by any single individual should be a concern, particularly if there are no concrete lockups to stop them selling on to investors,” he says.

As is the case with traditional investment assets, having a long-term horizon is paramount for cryptocurrency investing. This is a developing market and the technology is still in its early days. New projects are at risk of bugs, hacks and thefts, which can quickly erode an investment.

“The most money has been made by those who buy and hold higher quality cryptocurrency assets, but that means withstanding more than 90 per cent sell-offs from time to time,” Haeems warns.

Do cryptocurrencies belong in a balanced portfolio?

Some exposure to this asset class is prudent as part of a wider portfolio. The question is what percentage is reasonable. It comes down to risk tolerance. The younger you are, the higher allocation you could have, Mr Haeems says.

“The idea is that younger investors should be able to take more risk than someone approaching retirement,” he says.

Cryptocurrency assets also make sense as a strategy to counter the effects of inflation.

“Crypto has proved to be a good inflation hedge in 2021, and thus a great contribution to a balanced portfolio of diversified assets,” Mr Haeems says.

Increasingly, millennials and Generation Z investors are treating some cryptocurrencies as a replacement for traditional assets such as gold to blunt inflationary damage.

“The current generation has Bitcoin [protection], which has been called ‘digital gold’,” says Mr Cataldo, pointing out that unlike physical gold, Bitcoin’s supply is finite.

Bitcoin’s supply is capped at 21 million. “No one will suddenly unearth new Bitcoin in the future,” he says.

As an asset class, cryptocurrencies are prone to greater volatility than traditional assets. The fluctuations are more frequent and fiercer among smaller cap digital assets. In a bull market, these assets could outperform their bigger peers but underperform them in a bear market.

How much to allocate?

Given their volatile nature, the size of your cryptocurrency allocation is determined by your risk tolerance. Whether a conservative, a high-risk investor or somewhere in between, each investor must decide for themselves what feels right.

As a rule, the more conservative an investor, the smaller the cryptocurrency allocation.

“Those who are conservative should consider a 1 per cent to 5 per cent allocation to the asset class within a wider diversified portfolio,” says Mr Haeems.

Over time, their small allocation may grow to a larger percentage of their overall portfolio. When that happens, they can rebalance the profits into other assets to bring their cryptocurrency allocation back in line, says Mr Haeems.

Those with a moderate-risk tolerance could allocate between 5 per cent and 10 per cent over a long investment horizon. This allocation “will see the performance of the cryptocurrency market impact portfolio performance somewhat, [yet] a significant sell-off will not have a devastating affect on their overall performance”, he notes.

A high-risk portfolio would have a cryptocurrency allocation of between 10 per cent and 25 per cent.

“These people will certainly see the performance of the crypto asset class in their overall portfolio,” Mr Haeems says. “While downside moves will be much more noticeable in the overall portfolio performance, the same goes for upside.”

Which cryptocurrencies to buy?

There is no shortage of the types of coins to buy. However, as an overall strategy, it is a good idea to buy coins with different attributes.

“Diversification is known as the only free lunch in investing and hugely benefits the long-term performance of portfolios by spreading risk across asset classes that behave differently and are largely non-correlated to each other,” Mr Haeems says.

However, he recommends sticking to top-tier tokens. These are native tokens of an underlying blockchain. Most notable examples are Bitcoin (BTC), Ether (ETH) and Solana (SOL). “I believe these will have better long-term performance than some of the tier-two tokens, which are built on top of the tier-one blockchains,” he says.

Mr Cataldo favours Bitcoin, Litecoin, Monero for currency; Ethereum, Cardano and Polkadot for platforms; and DreamsCoin, Axie Infinity and Wax for games.

Understand the risks

As with any asset class, there are risks associated with cryptocurrency investing. One of the key risks is that many of the companies behind cryptocurrencies are not established enterprises. “These are start-ups that are still finding out their business models, coin governance and market fit,” says Mr Cataldo.

Often, projects do not take off as expected and businesses collapse.

Another risk is government regulation — the risk of being banned by certain jurisdictions. The recent Chinese crackdown on cryptocurrencies market and the outright ban of crypto assets in several countries show that government could be a significant source of risk.

“Keeping up to date with global macro news is a big part of crypto investing,” says Mr Haeems.

Also, beware the “pump and dump schemes” involving overhyped coins, many of which are pitched to investors as “Bitcoin killers”.

As with any new technology, some kinks will be ironed out over time, but some risks may have to be weighed carefully and managed with knowledge and common-sense practices.

Updated: February 4th 2022, 5:00 AM