Here is how you can make money of the next crypto bear market

Let’s construct a portfolio that benefits from a crypto crash without sacrificing the upside!

The next crypto bear market is coming

With bitcoin failing to hold its lows week over week and the smaller crypto caps failing to rise, the current market starts to look more and more like the onset of the last bear market in 2018.

Just have a look below at the monthly returns of the top 100 cryptos (stable coins excluded) by market cap until last month end. Draw your own conclusions, but to me this plot says “stack some wood and fix your roof, the winter is coming”.

Cryptocurrencies forward monthly returns by market cap

You don’t agree with me? You don’t have to. Simply remember this: during 2018 bitcoin lost 75% of its value, and the top 20 altcoins lost 95%. Now ask yourself this question: when that happens again, do I have the stomach to handle this loss?

People do stupid things when markets crash. On top of the list is getting out of the market at the worst possible time, thus materializing their losses and never recovering from them. I know, I have done it before. And unless you have been through this several times, trust me when I tell you that you just don’t know what you will do the day you see your assets down by 80%.

But there is a simple way to control your losses, to control yourself, and to actually make money out of this. Let me show you how.

A four regimes model for the crypto market

Change is the only constant. Markets regimes change all the time, and with it your asset performances. Some months your bitcoins outperform, others, altcoins take off “to the moon”, and sometimes, well, sometimes you tell yourself that should have stayed out of those markets all along, just to watch the bloodbath from the sidelines …

In the late 70’s a French fund manager called Charles Gave came up with the idea of using a four quadrants framework to describe four economic environments, that would have a tremendous impact in the world of wealth management. Since this model is brilliant at articulating a complex problem in a simple manner, I thought reusing the approach here.

Consider that, at any point in time, the crypto market is in one of the following quadrants:

A four market regimes model for crypto, with monthly statistics for the last height years.

There are four market regimes defined by the expansion or contraction of the overall market and the consolidation or disruption ongoing within:

1. In a winner-takes-all market the biggest projects become bigger. You want to weight your crypto portfolio according to the market caps, so the “winners” weight more and drive more profits. You would be happy holding Bitcoin alone!
2. In a challenger market (the most common regime so far), the smaller projects innovate and take market share from the larger ones. There, you want to extend your portfolio to more altcoins and make them contribute by giving them more weight in your portfolio than they have in the market.
3. In a crypto bear market, you only want to hold the most established and used cryptos, alongside plenty of stablecoins so you can buy the opportunities when the market turns back to profitable.
4. In a generalized panic mode, you don’t even want to be in the crypto markets at all. Capital is leaving the crypto space, and even the “value stores” are selling off. This threatens the existence of many projects and all crypto asset classes, you want to be off the crypto platforms, or at least to make sure you don’t need any of the assets you hold there in the next 3 to 12 months.

I know that some of you will argue that in a highly disrupted and overall contracting environment Bitcoin is precisely the store of value you need. But I disagree: the real risk in such environment is for liquidity to vanish, and when there is no liquidity, there is no bid for any risk asset (including bitcoin, gold, government bonds, etc…). Which is to say: you cannot sell your bitcoins, your gold bars or your stamp collection. At any price. In such environment, cash is king, and to whom has cash, everything is dirt cheap.

We have seen this type of event in most markets throughout history, I believe we are yet to see it in the crypto space.

It is now fairly easy to understand what market regime we are currently in. But it is still impossible to know which one we are entering next and when. All we know is that the more tuned our assets are to the current regime, the heavier the losses when it changes.

Optimisation for a specific market regime is neither possible nor desirable. This means that we need to prepare our portfolio for all eventualities. And this is what diversification is all about.

How to effectively diversify portfolio

We have four categories of assets that we know we need to hold at all times in order to preserve our capital. But how much of each we need to hold? Do we want to have 50% hard cash and split the rest equally? Or 60% in bitcoin and buy the dips by selling anything else?

Well, the answer is not as important as the fact that we need to diversify by holding all four categories of assets at all times, and that we need to stick to your diversification ratio by rebalancing your portfolio from times to times.

Think about our four asset categories as communicating vessels:

Think of a diversified portfolio as communicating vessels

When your selection of disruptive altcoins soars faster than bitcoin, you take out some profits and invest them in bitcoin. When cryptos drops, you “buy the dips” with your cash in stable coins, and when those three categories do well overall, you take some gains out in cash.

…And when sh!t hits the fan, well, you sleep at night, and carry on with your life until the casino re-opens and everything is for sale. That’ when you take your cash and go shopping!

A strategy we will take as a baseline is to simply allocate 25% of our portfolio to each category, that is:

1. 25% in Bitcoin (and possibly Ethereum if you like).
2. 25% in a basket of altcoins: either selecting a handful projects you really believe in or using a more systematic approach such as “top 10” or “top 20” by market cap. You may want to have a look at my previous post on this topic.
3. 25% in stablecoins on a high-dividend account (some examples next section). Here again, we want to diversify across available categories of stable coins (e.g. build a mixed basket of DAI and USDC).
4. 25% in cash in a regular bank account or under your mattress (the interest rates are about the same either way). Again, you do not have to stick to USD or EUR, meaningful diversification is your friend.

You can of course slightly deviate from this allocation if you are convinced that an asset class is going to continue to outperform, but you need to remind yourself that you know nothing for sure, so you need to fix yourself rules. The easiest way to do so is to set yourself a threshold at which you will rebalance. For example: never let any asset weight more than 35% or less than 15% of your portfolio. When that happens, rebalance so everything weights 25%.

Note: I have tested this “10% threshold” strategy versus rebalancing at the end of every month, and there is no significant difference in the portfolio performance.

Nice talk, but show me the money

Here is how such strategy would have performed over the last 5 years:

Performance of our portfolio versus main asset classes over the last height years

Equal-weighted portfolio performance

The “Equal-weighted” strategy in green is our baseline strategy above, simply allocating 25% to each asset class (Bitcoin, “Challengers” Altcoins*, Stablecoins on interest account**, and cash) and rebalancing every month end.

Implementation notes:

* The “Challengers” are the coins ranking from 11 to 20 in terms of market capitalization, we hold an equal-weighted basket of those and rebalance every month. This is the strategy I call “Small 10” in my previous post, have a look there for more details.

** I am assuming a conservative 8% per annum interest rate on stable coin. I will share in the next section of this post how you can achieve better than this.

With this simple equal-weight portfolio strategy, you would have made a bit over 33 times your original investment in 8 years (275% per annum, not too bad!), and you would have performed better than Bitcoin until September 2020.

Understanding drawdown

Over 2021 bitcoin performed really well and ended up performing better than our strategy. But remember that only half of our portfolio is in risky assets and a fourth is just sitting on a regular bank account, so we are taking considerably less risk.

If you want to get a sense of what risk mitigation does, have a look at the drawdown below, that is how much your investments can lose at any point in time:

Maximum drawdown of our baseline portfolio versus main asset classes

Our diversified portfolio mitigates our losses because it captures the gains of our riskiest assets and transfers it to safer ones. And the direct consequence of having a fourth of your money in your bank account, accessible at all times, is that you won’t panic. I don’t know about you, but I personally don’t have the stomach to handle a 75% loss, leave alone 95%.

Remember: The first function of diversification is to let you sleep at night!

Frequency-weighted portfolio performance

Now what is this second “Frequency-weighted” strategy about?

There, I wanted to show how we could further optimize the weighting of asset classes. This strategy uses the frequency of market regimes (i.e. how many months did we spend in each regime, as indicated in the four-quadrants plot) in order to weight our portfolio allocation to each asset class. The idea is that if we know that one regime is more prevalent than the others, we want to overweight the assets that will perform well during this regime.

Aligning to the regime frequencies observed over the last 8 years (96 months), we allocate 9/96 to Bitcoin, 47/96 to our altcoins basket, 31/96 to stable coins and 9/96 to cash.

This strategy returns twice as much as our equal-weight baseline with a maximum drawdown of 68%. While this looks very good, remember that we have very little data here and that crypto is a rapidly evolving market, if the odds were to change completely, you would be severely underperforming a simple equal-weight.

A simple and secure way to put our strategy to work

So, you like this strategy and would like to implement it? What about starting with a small amount today and scaling up as you get comfortable with it?

Here is fuss-free, three steps method to get you started today.

Any major crypto lending platform are a good place to start small and quick:

• They give you single, user-friendly, entry-point (typically a mobile app) to buy, exchange, track and manage your crypto, whether it’s Bitcoin and Ethereum, popular altcoins, or stable coins.
• They give you a high interest rate of 4–8% per annum on the cryptos you hold there, and up to 12% on stablecoins. Exchange rates are acceptable, so the cost of deploying and rebalancing our portfolio is largely covered.
• There are enough well established, tried and audited, platforms to choose from.
• They hold your crypto with professional custody service providers for you.

Yes, there are risks inherent to the use of those lending platforms (counterparty, insolvency, custody), ultimately you need to decide whether to trust any platform managing risks for you or manage it yourself.

1. Chose a crypto holding platform

I personally use the two platforms below, they have more than a billion USD asset under management, were both founded in 2017.

1. Nexo — Simplest to use, best overall interest rate for our use case at the time of writing. Signup with my referral link here for a $25 bonus.
2. Binance — Largest variety of assets and one of the best established and used crypto platforms for all type of use case. But there are so many products that it may take some time to get your head around it. “Binance Earn” is the section you are looking for. Signup with my referral link and we split the commission 50–50.

2. Deploy your portfolio

Remember never to invest more than you are ready to lose. Once you have figured this out, define the size your portfolio, split it into four equal parts, open an account on any of those platforms and purchase:

1. A basket of Bitcoin and (optionally) Ethereum. In the simulations and model above, we stick to Bitcoin alone, which is what I personally do and recommend.
2. A basket of altcoins (I would recommend 5 to 10 max). If you want some ideas to build up your altcoins holding, please have a look at my last post. I personally like to look for candidates in the lower half of the top 20–30 coins by market cap, this filters projects that have gained sufficient inertia not to collapse next month, and still have enough potential for a tenfold increase.
3. A basket stablecoins. Again, please diversify, it’s free! For example, hold both UDSC and DAI.

And, 4, use any regular bank account to hold your cash allocation, but please remember that this needs to be off crypto and off the DeFi platforms. A stablecoin is not cash!

If you are new to this, please remember to get in slowly, dedicate a small part of your savings every month, split it in four parts, invest three in crypto and do not forget to keep the fourth on your bank account!

3. Rebalance your portfolio

Every month, redistribute your assets by selling some of what performed well and buying more of what didn’t, so you are back to your 25% allocation (or whatever you think is better) in each category. You do not have to be religious about it (it’s OK if some assets wander a few % off), but you must set hard limits, for example, set a rule that if any asset category weights more than 35% you will immediately rebalance everything back to 25% in each.

Do not underestimate the importance and psychological difficulty of rebalancing your portfolio. The importance because it is the mechanism by which you make actual money. The psychological difficulty because you will find it tempting to let winners run forever and difficult to keep investing in losers.

Bear markets happen when we expect them least, we have been there before

Remember that bear markets, and complete meltdowns, serve a function: they shake off the weakest, unveil the dodgiest, and sometimes send crooks behind the bars. They bring us a new generation, a better market, into which investing is more effective.

All you need to do is to make sure that you hold the right portfolio to navigate through difficult times, so you are still around after the flood, and ready to invest when greater opportunities arise.

Today, we explored the very basics of the techniques that will keep you afloat and make you prosper in turbulent times.

Disclaimer

Everything discussed here is provided for information only and should not be considered a financial advice.

While I sincerely I hope you will find this content insightful, and hopefully entertaining, please consider your own situation first, do your own research, think for yourself.

“I don’t want you to think like I do. I just want you to think.” — Frida Kahlo