How does risk and reward work in cryptocurrency?
Regardless of the type of investment, there will always be some risk involved. Otherwise, it would be hard to get a hefty reward, right?
Today I aim at looking at strategies, issues and solutions to some risk/reward conundrums. Understanding the relationship between risk and reward is a crucial piece in building your investment philosophy. Investments—such as flipping cryptocurrencies, staking or mining—each have their own risk profile. Understanding the differences can help you more effectively diversify and protect your investment portfolio.
As I said so many times before, diversifying is key to spreading your risk. Without the right strategy for diversification and understanding what types of risks are there, associated to each type of investment, you’re likely to lose ROI.
Hence, I take my altcoin price and fundamental analysis so seriously.
Usually people say “the higher the risk, the higher the potential return”. Perhaps a more accurate statement is, “the higher the risk, the higher the potential return, and the less likely it will achieve the higher return”.
To understand this relationship completely, you must know what your risk tolerance is and be able to gauge the relative risk of a particular investment correctly. When you choose to put your money into altcoins that are riskier than Bitcoin or Ethereum, you run the possibility of experiencing any or all of the following to some degree:
Losing your principal: any cryptoucurrency could literally go to zero value.
Not keeping pace with inflation: Your investments could rise in value slower than actual prices. In other words, you might lose versus the U.S. Dollar or Bitcoin.
Paying high fees or other costs: Expensive fees on trading and staking, or hidden costs (discussed below), could severely diminish your ROI.
To fully comprehend how to measure risk, let’s discuss the Risk/Reward ratio and why it is useful.
Understanding the risk/reward ratio
According to Investopedia, “the risk/reward ratio marks the prospective reward an investor can earn, for every dollar he or she risks on an investment”.
Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Consider the following example: an investment with a risk-reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to invest $1, for the prospect of earning $3 on his investment.
Traders often use this approach to plan which trades to take, and the ratio is calculated by dividing the amount a trader stands to lose if the price of an asset moves in an unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward).
Hence, the risk/reward ratio is a key indicator of how well you’ve allocated your funds.
In the case of Bitcoin and some other key altcoins, such as Ethereum or XRP, this ratio is absolutely insane.
Before I conclude this piece, I should underline there is a difference between dirty risk and clean risk. To explain how these concepts differ, I’ll compare two lending mechanics: Salt and Lendroid.
Dirty risk is hidden risk. Essentially, it’s risk not fully understood by the borrower. In Salt, you could take out a loan and pay a fixed monthly interest. What isn’t properly explained is the hidden risk, in this case what happens if your collateral’s price falls to a certain threshold. In sum, you would simply get liquidated if the price of ETH falls below a certain level.
That represents Dirty risk because borrowers may not be aware of this, as it is not cleared explained on the website.
Clean risk, on the other hand, is transparent risk. Essentially, borrowers are fully aware of hidden fees or liquidation prices.
To better understand the difference, let me use the case of Lendroid, a lending platform. What Lendroid created is an alternative mechanism to avoid getting borrowers liquidated.
In Lendroind, there are two kinds of risk liquidity pools you can get involved in. One is the ‘Harbour Pool’, which is risk free by design. Worst case scenario, you get back the money you put in it. Much like the brand new smart contract lotteries built on Ethereum. You pool funds with other users, stake those funds, and use the interest to bet. This way, you may never lose (or keep losses to less than 1%).
The other kind of pool in Lendroid is the ‘High Water Pool’, where risk is made very clear. It advertises the currency and collateral combination it supports, so the user can make an informed decision. This way, the chances of getting liquidated greatly diminish.
With clear risk and a differentiation between “risk pools”, it’s possible for borrowers to avoid hidden risks.
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