Our edge at Apollo Capital is our experience in both traditional financial markets and crypto markets. On a daily basis, Henrik and I draw upon our experience from traditional markets to construct a portfolio of crypto assets. Combined with our knowledge of crypto assets, we are the best in the country, if not further afield, at managing a crypto portfolio.
While I don’t pretend to know as much about crypto or financial markets as Henrik, my experience* is different and has undoubtedly shaped the way I approach crypto funds management. I thought it timely to share a few thoughts on investing in crypto, in particular volatility, opportunity & position sizing.
(*for more information on my background, please feel free to visit my LinkedIn page.)
A number of traditional financial ratios and models use volatility as a measure of risk. Modern Portfolio Theory (MPT), developed by Harry Markowitz in 1952, is used to optimise portfolios based on their expected returns and observed risk. The standard deviation of an asset’s returns is used as standardised measure of risk. MPT, CAPM, Sharpe Ratio, Sortino Ratios, nearly every ratio I have come across uses volatility as a unit of risk.
The general theory is that the more volatile the asset, the higher the standard deviation of returns, the riskier the asset. The words volatile and risky have almost become interchangeable in financial markets.
If we put crypto through these models, I suspect the models would spontaneously combust. Crypto is extremely volatile. I usually check crypto prices a couple of times a day and it is common to see 24hr price swings of greater than 10%. Imagine if that were the case in equity markets! Throughout the 16 months since inception, the Apollo Capital Fund has already delivered monthly returns ranging from +45% to -34%.
In Berkshire Hathaway's 2007 annual meeting, Warren Buffett said the following about volatility and risk:
“It's nice, it's mathematical, and wrong. Volatility is not risk. Those who have written about risk don't know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn't riskier because it's more volatile.”
Instead, Buffett prefers the dictionary definition of risk: “risk is the possibility of loss or injury.”
Why is crypto risky?
It is clear that investing in crypto is risky: there is a possibility of loss (hopefully not injury!) and that possibility exists because crypto is young and the future is uncertain. Any groundbreaking technology is going to be met by opposing camps of skepticism and fervour. Crypto is a complex topic and it’s future is anything but clear. It is easy to forget, but many people thought the same about internet stocks in the mid 90s - they were risky investments.
Why is crypto volatile?
Crypto is volatile for two reasons: it is risky and prices are retail driven.
Crypto prices are predominantly retail driven. Retail investors are more easily caught up in the waves of greed and fear that drive financial markets, especially crypto markets. While the equities that represented the internet hysteria were certainly volatile, they were not as retail driven as crypto markets. Crypto assets are more accessible to the world’s population than equities on listed stock exchanges and equity markets are largely driven by institutional capital.
The distinction between risk and volatility is important:
“Crypto is not risky because it is volatile. Crypto is volatile because it is risky”
Once we accept this important distinction, the solution to deal with the risk is clear: position sizing.
Position sizing refers to allocation of capital to a particular investment in the context of the overall portfolio. For us as managers of the Fund, we discuss the size of positions such as Bitcoin and Ethereum. Do we invest 10%, 20% or 40% of the portfolio in Bitcoin? For the individual investor, position sizing refers to the amount of capital allocated to crypto relative to the overall portfolio.
Although we do not provide advice to investors in the Fund, we certainly do not advocate investing 50% of a portfolio in crypto, it’s too risky. The possibility of loss is too great and the consequences of any loss too severe. Many of the greatest thinkers in crypto suggest allocating an amount of capital that the investor is prepared to lose. Studies of institutional investors in crypto suggest starting allocations of 0.2% to 0.3%. Crypto is risky and for any investment in crypto there is a possibility of loss of capital.
I used to work at a funds management company that managed more than $500m of client funds in Australian equities. My former boss, a veteran investor with more than 30 years experience across a range of markets, taught me a number of lessons about investing. One of the key lessons that stuck with me is “the best returns often come from the ones you feel uneasy about.” I didn’t realise it at the time, but I now understand why.
“Risk creates opportunity”
When a company’s future is uncertain, when the risk feels high, other investors often reach similar conclusions, many choosing to avoid that risk by either selling or not investing. Risk can create opportunities to buy assets that are cheap. It is the job of the investor to discern from risky opportunities that are worth investing in, compared to those that are doomed to fail.
I see similar circumstances to crypto assets. There are numerous reasons why crypto assets may not succeed. Investing in crypto is risky. This creates opportunity. One of the main reasons for this uncertainty is a lack of understanding. The vast majority of people have not or will not spend a little time trying to understand crypto. This is a missed opportunity to learn about a technology with enormous disruptive and innovative potential.
This creates opportunity for those that have a keener understanding of crypto. It is interesting at this point to stop and consider, “how much do I need to understand to make an investment in crypto?” An investor doesn’t need a comprehensive understanding of the intricacies of crypto assets to make an investment. Just as we don’t need to understand the code behind Google’s search algorithms, we don’t need to understand the of code that powers the Bitcoin network. A more relevant understanding is the power of Google’s search algorithms to its users, the power of the Bitcoin network to its users and why both are better than the alternatives.
“Investors need to understand the three forces driving crypto innovation.”
First, it is a groundbreaking technology. We have written at length how crypto removes the need for trusted intermediaries and the resulting waves of disruptive innovation. Second, it has attracted huge amounts of capital. Third, the world’s best computer software engineers are flocking to work on challenging crypto projects. Understanding the power of innovation that is likely to come from these forces is more important than knowing the details of the Ethereum code.
For those that see the potential, for those that read Apollo Capital’s weekly newsletter and understand why crypto shows promise, investing a small amount in crypto is obvious. Investors realise the inherent risks in these investments, but they accept these risks and in doing so, give themselves a chance of capturing the upside.
Again, we come back to position sizing. The future of crypto is uncertain and accordingly, it makes most sense to only invest a small percentage of the portfolio in crypto assets. Despite working in crypto and understanding crypto assets better than most, I only have a small percentage of my net worth in crypto. I have a far, far greater percentage in my house, despite having greater conviction in crypto than the property market in Australia.
An unfounded fear of volatility and a lack of understanding is causing the majority of investors to miss out on the crypto opportunity. Many are waiting to understand crypto in full, or for there to be greater understanding from their peers and the media. They are missing the point. By the time this happens, the market capitalisation of crypto assets will be in the trillions.
Once crypto becomes mainstream and well understood, the opportunity will be long gone, leaving many investors to regret the omission of a small allocation in their portfolio.
**please note this article does not constitute financial advice. My thoughts are my own.