Decoding Crypto

Time to Read: 9 Minutes

We have never seen an asset class quite like cryptocurrency. It’s confusing, it’s alluring, and for some people, it’s religion. As more and more investors flock to the decentralized world of crypto, more attention is being paid by those on the sidelines.  “Am I missing out on something?” you may be thinking to yourself.

While there are risks that need to be considered, it’s tough to deny the innovation taking place. Like the rise of the internet and dot-com stock craze, many investors are trying to win big by betting on the potential growth. However, it’s crucial to consider your financial situation and understand the risks at hand.

Stratos Private Wealth President Jeff Brown breaks down all the details in our 50-minute webinar, but if you are short on time you can read the highlights below.

Breaking Down the Basics

To understand how cryptocurrencies work, you first need to understand blockchain and its functionalities. A blockchain is a digital database that can store many kinds of data. It can be used as payment rails for worldwide transactions, and it can store complex data such as contracts. What makes blockchain unique is its decentralized nature. It allows for peer-to-peer financial transactions, and rather than the payments being routed and settled by a bank, the blockchain holds all the data, and people known as “miners” verify the transactions by solving a complex algorithm.

Every cryptocurrency is tied to its native blockchain. For example, Bitcoin is the native cryptocurrency of the Bitcoin blockchain. Bitcoin was created in 2008 and is the fastest asset to reach a $1 trillion market cap, hitting it in just twelve years. The next closest asset is Google stock, reaching the trillion-dollar mark in 21 years. Because there will only ever be 21 million Bitcoin, some of the value is driven by scarcity. It’s estimated that 46 million Americans own Bitcoin, and 29% of millennial parents have purchased cryptocurrency.

Ethereum is like Bitcoin because they’re both blockchains, and each has its native cryptocurrencies (ether and Bitcoin), but Ethereum has a few differentiating traits. First, it does not have a limited supply like Bitcoin does, which means different factors must drive its value. One of these factors is its utility. Rather than being used primarily for an exchange of value, it can be used to power decentralized applications and contracts. Right now, Ethereum is an essential piece of the decentralized finance and cryptocurrency environment.

What Differentiates the Blockchain?

“The whole point of using a blockchain is to let people — in particular, people who don’t trust one another — share valuable data in a secure, tamperproof way.”

The blockchain has unique attributes that make it critical to the next generation of internet commerce, and also widely usable today.

The Evolution of Crypto

Crypto has evolved from a decentralized asset held by true believers – the so-called “holders” to an accepted form of payment in many industries. As an exchange of value for goods, it is moving closer to the definition of a currency, although it may not truly be there yet. Still, the uptake by companies has already happened and is growing daily.

Visualizing a Crypto Transaction

There are two main reasons why transactions on the blockchain have a unique value proposition:

1. Blockchain creates a public ledger for all transaction, which can provide more transparency.
2. No intermediary is necessary. Transactions are direct and peer-to-peer, which lowers transactions costs and speeds up transaction time.

Understanding Tokens 

The two largest digital assets are Bitcoin (BTC), the digital asset tied to the Bitcoin blockchain, and Ether (ETH) tied to the Ethereum network. These are the most common payment tokens. Payments tokens are a means of payment for goods or services.

But that is not the only type of token. There are two other types of tokens that you may have heard of:

• Security Tokens may provide specific rights to the holder, including: the ownership of assets and entitlements to use them, profit sharing, and voting rights. DAOs have emerged as popular security tokens.
• Utility Tokens provide token holders with access to a function provided directly by the token issuer. NFTs (non-fungible tokens) are an example of this type of token and are often seen as the token of the future.

Integrating Cryptocurrencies in your Portfolio

Cryptocurrencies and digital assets can be viewed as risky, but they may also have a place in an overall investment strategy*. Historically, a traditional investment portfolio has primarily consisted of stocks and bonds. If you have a bigger appetite for risk, you will typically allocate more funds towards stocks instead of bonds and vice versa. With the introduction of more alternative and digital assets, that traditional portfolio framework is beginning to evolve.

Some investors are beginning to place 1% of their portfolio in cryptocurrencies such as Bitcoin, and while it sounds like a small amount, it can have a relatively significant impact given its price movement. An investor can capitalize on some of the upside and limit losses on the potential downside with a small allocation.

*Please see important disclaimers at the end of the article*

Case Study: The 1% Allocation to Bitcoin Scenario

When considering a 1% allocation, we can look back at potential outcomes in this hypothetical case study (used for illustrative purposes only, not a recommendation):

• 60/40 Benchmark Returns: Looking at 60% portfolio allocated to S&P 500 and 40% of the portfolio allocated to the US aggregate bond index.
• 59/40/1 Bitcoin to 0 in Yr 1: The first year performs worse than the benchmark as Bitcoin goes to 0, but all subsequent years closely match since the remaining portfolio is in line with a 60/40 allocation. The overall inception to date return performance is still fairly close to the benchmark.
• 59/40/1 Historical, No Rebalance: Demonstrates performance if you just invest 1% and never touch or rebalance the position again. The small Bitcoin allocation still has a large impact on the overall performance, yielding a higher overall inception to date performance versus the benchmark but adding more volatility throughout the years.
• 59/40/1 Historical, Annual Rebalancing: Demonstrates performance when investing 1% in Bitcoin and rebalancing the portfolio annually (taking profits when it does exceptionally well and adding to it when it performs poorly). The figures shows significantly outperforming the benchmark overall, but has less year-over-year volatility than the no rebalance scenario.

Of course, this period of time was a good time to be invested in Bitcoin which does impact the case study results and not always the case.  We use this case study to inform our individual and client-specific recommendations on a one-on-one basis.

Source: Ycharts.  60 or 59 represent 60% or 59% in the S&P 500 index.  40 represents 40% in the US Aggregate Bond Index.  1 represents 1% in the Bitcoin index.  The returns numbers start on 1/1/2017 and end on 3/7/2022.  ‘Bitcoin to 0 in year 1’ assumes that Bitcoin loses 100% of its value in 2017 and does not come back.  The portfolio is then rebalanced to the 60/40 from that point forward.  This is for illustrative purposes only.  Performance data quoted presents past performance; past performance does not guarantee future results; the investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than quoted performance data and can be accessed at https://go.ycharts.com/fund_contact_info (See Important Disclosures for standardized returns information).

Investing with Strategy

Due to the high-risk nature of digital assets, building a sound investment plan and strategy is critical. This would include taking into account the risk profiles of your current investments, defining your investment purpose, and establishing an exit plan. Traditional investing principles still apply in crypto, and rebalancing and dollar-cost averaging can help investors maximize the long-term risk and reward metrics.

Additionally, becoming educated about crypto is one of the best ways to protect yourself. With so many ways to gain exposure to the asset class, investors should work with their advisors to understand the trade-offs and create a plan that fits overall investment objectives.

If you have thought it through and you want to invest, consider this process:

1. Assume your digital asset can go to zero.
2. Test your current equity/bond/digital asset (DA) allocation to understand what the long-term return would have been if your allocation to DA lost everything in year one.
3. If volatility is something you can tolerate and in line with your investment objectives, add digital assets to the portfolio. *
4. Use Dollar-Cost Averaging and Rebalancing to reduce risks long-term.

Dollar-Cost Averaging: A Quantitative, Confidence-Level Approach to Risk Management

Getting tactical about steps three and four above is the key to implementing and maintaining a crypto allocation. Just like any other asset, an investment rationale and process are critical. At Stratos Private Wealth, we’ve developed an approach based on a technical analysis of the data coupled with an implied confidence level as signals on when and how much to invest. Using a tried-and-true investment strategy like dollar-cost averaging, but customizing it with objective indicators, can lead to a more successful result.

At Stratos Private Wealth, we believe objective indicators can enhance our strategies.  For example, looking at the chart below, we can modify our dollar cost averaging to attempt to be tactical on determining the amount to invest.  This will help us identify if Bitcoin is in a bullish, neutral, or bearish zone. We then apply that to our investing strategy by increasing or decreasing the amount we would automatically invest.

For example, if the data showed that Bitcoin was in a neutral zone, and our pre-determined dollar-cost averaging investment amount was $5,000, we would stick at $5,000. If it is in a bullish zone, we might double the investment amount. If the data points to bearish, our decision would be to cut the investment to $2,500. So, we are still getting invested, but we’re weighting the amount of the investment based on what the objective indicators are showing, aiming to lower the risk of when we invest.

The Takeaway

Digital assets and cryptocurrencies should be approached with caution and guidance. Investors who take the time to think through their investment decisions and build a plan around them can effectively reduce their risk while still participating in the asset class.  Stratos Private Wealth  can help you better understand the benefits and drawbacks and ultimately help you make the best decision for your financial future.

Cryptocurrency is decentralized digitized money that allows individuals or entities to transfer funds on line without the need for a bank or credit card company. Cryptocurrency typically relies on blockchain technology, a network of computers running open-source code, to manage and track these transactions. Unlike the U.S. Dollar, there is no central authority that manages and maintains the value of this currency. Instead, the value is determined by supply and demand in addition to market factors. Therefore, since cryptocurrency-related products purchase and custody cryptocurrency, they are highly speculative and extremely volatile investments. And because these products list shares in the secondary market, investors could lose their entire investment.

Cryptocurrency-related products may involve a high degree of risk. risk considerations include, but are not limited to, the following:

Emerging Asset and Complexity. Cryptocurrencies and crypto-related products are part of a new and evolving industry, and the value of shares depend on their development and adoption of its network.  True price discovery and best execution remain a challenge, as a result. Certain technical issues might be uncovered as the network continues to develop and the resolution of these issues requires the attention of cryptocurrencies global development community. Cryptocurrencies were not designed to be investments. They were designed to be mediums of exchange and seen as an alternative to traditional sovereign currencies.

Current Lack of Regulations. Due to the unregulated nature and lack of transparency surrounding the operations of crypto exchanges, they may experience fraud, market manipulation, security failures or operational problems, which may adversely affect the value of cryptocurrencies and, consequently, the value of the shares of cryptocurrency-related products.

SEC Actions. The Securities and Exchange Commission (SEC) has stated certain digital currencies could be considered “registered securities” at some point. Because of this, the SEC might introduce additional regulation and make it harder to trade, clear and custody compared to other digital currencies not designated as securities.

If designated as a security, these securities could be subject to register under the Investment Company Act of 1940, at which point, products structured as grantor trusts, would need to terminate the trust per its terms. This would involve liquidating the trust at a time that could be disadvantageous to you as a shareholder.

Competing Cryptocurrencies. Certain cryptocurrencies could experience a “hard fork,” meaning a change in blockchain coding that can create a permanent, new cryptocurrency which could then compete with the existing cryptocurrency. In the event of a hard fork, the sponsor will use its discretion to determine which digital asset network is the most appropriate for the product. Doing so may adversely affect the value of shares