Managing Risk in a World Gone Mad

Today I'd like to talk to you about managing risk in a world gone mad. Have you ever noticed that life is what happens when you make other plans?

Today’s newsletter is the printed transcript of my first YouTube video! If you like video, go watch it. If you prefer written content, you get all the same information here in the newsletter.

You can be going about your life, everything is amazing. The rent gets paid on time, the electric bill is paid automatically out of your checking account, and then suddenly your electricity app decides to charge you $14,000 for a month of electricity. Is there something we could do about that?

Okay, that was an actual situation that happened to utility customers in Texas because they didn't understand the financial risks that they were taking. They signed up for something that would give them "cheaper" electricity. And they didn't understand the implications of that. And to be honest, I haven't seen any evidence that the people that made the app understood the risk that they were requiring their customers to take.

So we definitely want to manage risk or have a risk framework that makes it so that risk management removes risk from our life, instead of adding risk to your life. So, to me, finance is all about risk management. I wanted to start out with managing risk, understanding risk, because understanding risks is the cornerstone of Finance. Everything else that happens in finance is around tools that better facilitate the management of risk.

For me, that broad risk framework starts with fundamentals. So you've heard the fundamentals, this isn't a fundamentals channel. Build a budget, pay off your credit cards, etc. At a certain point, you begin investing. And when you invest, you're flipping the framework over because you are taking on risk instead of removing risk. So if finance is all about managing risk and removing risk in your life, then why are we investing? Why are we taking on additional risks and bringing that uncertainty into our lives?

And the short answer to that is we're doing that because that helps us better manage a broader tier or category of uncertainties, which you could think of as career risk or job risk. If something happens, if you lose your fingers, for example, can you still do your job? Would your employer be patient with you learning to use Excel with a pointer and not with your hands? And yes, I realize that there are legal protections if you have an accident, but employers can and will find ways of getting around that, "Oh, your performance has degraded and we don't think that it's because of your whatever, blah, blah, blah", I don't want to get too far down that rabbit hole.

The rabbit hole that I want to get down into is when we are adding risk, adding uncertainty in our life by investing, can we have a life-changing outcome without bringing devastating downside risk into our lives? This is an important question. You hear a lot, the phrase, "don't risk money that you can't afford to lose". Okay, that's great. How do you know if you can't afford to lose any? How do you know how much money you can't afford to lose?

When we approach that from a broad risk framework, we can say okay, these uncertainties are met; I have life insurance, I have renter's insurance or homeowners insurance, I pay down my credit cards. I have that buffer, I have maybe a little bit of savings cushion. I'm ready to start investing, but I don't know how much I can afford to lose. Or maybe I'm in a situation where I have never had the extra resources to do any of that. But I want to start learning about some of these financial tools because if I bring those skills into my toolbox, it can actually increase my earning potential.

Can I do that in a way that doesn't have a major downside risk on my personal financial situation? All the things that we're talking about:  How much are you risking? What is the potential benefit? Can I have life-changing outcomes, where it's life-changing on the positive side without being life-changing on the negative side? I don't want to raise my toddlers on a street corner, just because I bought too much Bitcoin, or whatever the situation is.

So I want to make sure that the basic framework of my life is covered. I have a minimum lifestyle requirement. I know that I wouldn't be happy, I would be very upset, if my lifestyle drops below a certain level. So I want to settle my lifestyle to that level, and I want to put a lid on it, and try to keep my expenses at that level. And then as soon as my income rises even a little bit above the level required for my minimum acceptable lifestyle, that little bit extra, that's money that I can afford to lose. And I know that I can afford to lose it, because if I do, the rest of my life is not in Cataclysm, the shock is not too great. Depending on the level of uncertainty in other aspects of my life, I may need a bit more of a cushion. If I know that things aren't going great at work, I should have a bigger cushion. Because if I invest this money, and I lose it, and I'm stressed out about that, and it causes my performance at work to degrade a little bit more, and I lose my job. Now suddenly, I've lost my cushion. I've lost my job that I needed the cushion for. And I have a cataclysmic lifestyle shock.

So I want to frame everything in my life around these minimum acceptable levels, minimum lifestyle, minimum viable product, minimum investable criteria, right?

Then when I'm looking at investments, I'm thinking about what I call asymmetric outcomes. An asymmetric outcome would be a life-changing outcome, positive reward without life-changing, negative risk. And there are various ways of doing that. But asymmetric outcomes are one of the things that are most attractive about the crypto space from an investor perspective. I can risk a little bit, I can take a little bit of this cushion, and I can choose a new project that I think has incredible potential and I can invest into that project. And maybe if I don't have very much investable money, I can invest time into that project. Instead, I can get engaged with a DAO. I can test out protocols, I can start getting some airdrops and those airdrops give me a little bit more resources to work with. I can leverage my time and energy and the small amount of financial cushion that I have, and build toward an asymmetric outcome. If it all goes to pieces, my lifestyle risk is minimal. I still have a decent job. I'm still hitting my performance goals at work, my babies are fed. Things not working out with a small Bitcoin investment or a small Defi protocol investment doesn't have a negative outcome in my life in the sense of my whole life changes. Even if it has a negative outcome in the sense of, well, I thought I'd be driving a Lamborghini and now I'm not.

That's a key component in terms of investing time and money and finances. What does your potential payoff look like compared to your downside? We're looking for asymmetric opportunity outcomes or asymmetric outcome opportunities. I sometimes hear it described as asymmetric risk because risk can be positive or negative. I'm risking amazing potential; I'm risking a little bit of downside. That's asymmetric risk. So then that cushion, that how much you can afford to lose, pair that with asymmetric risk and we start looking at fabulous opportunities.

From there, the next question in my risk framework is:

How do you allocate risk across a portfolio? How should I manage risk in position sizing?

If your allocation is your time instead of your money; if you're getting involved in DAOs and looking to capture asymmetric risk by getting deeply involved with the DAO and capturing more value from that DAO, then again you want a narrower opportunity set. You want to find your top two or three DAOs and focus in on those, or maybe even your number one DAO and focus in on that, so that people within that start to recognize you. They know your face, they know your skillset, and after a certain point in time, you can ask yourself, are they giving me the opportunity that I'm looking for within this DAO? Am I getting the level of rewards that I'm looking for, after having put in 60 or 90 days of effort into this DAO? If I am, that's amazing! I've built an income stream with an asymmetric opportunity set. If I'm not, then maybe it's time to move on. If I've spent 90 days putting 10 or 20, or 40 or 50 hours a week of effort in something, and I'm not being rewarded for that, then either my efforts aren't as good as I think they are, or that DAO is not well-positioned to recognize and reward the value of my efforts. And in either case, it's time to move on. Maybe it's time to move on to building new skill sets, maybe it's time to move on to find another DAO that recognizes the skill sets that I actually have. If I have done that three or four times, and I'm never capturing any value after 90 days, you know, maybe it's me. And if it is me, then I need to get a better feel for what skill sets these groups are looking for and whether I can build those skill sets.

There are basically two schools of thought around portfolio management or risk management. One is diversification is key! You should diversify across a lot of things so that if one of them doesn't work out, one of the other ones will perform well, this tends to be the cornerstone or basis of venture capitalists investing go invest in 20, or 30 projects. 15 or 20 of them may end up not working out and one of them hits a home run and the total performance of the portfolio ends up being really, really good, right. That kind of diversification is a focus for venture capitalists.

Unless you're really good at identifying asymmetric outcomes, it's really hard to diversify across multiple opportunities in a way that actually moves the needle; in a way that the one that has that amazing outcome isn't actually compensated by all of the rest going to zero, doing nothing.

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From that context, if you take on more opportunities and have some minimum risk (or minimum investable threshold) so certain criteria that have to be met, there's a lot of opportunities out there, some of them are amazing, some of them are terrible. You can have a short checklist:

I want to know who the team members are; at least I want to know what their backgrounds are so that I can evaluate whether they have the expertise to manage the security of this protocol.

I want a project to have decent tokenomics. It has to have a token, and I have to be able to look up and understand the tokenomics. Those have to be consistent and not subject to change, or if they are subject to change, the process to change those is clearly defined.

That might be a minimum investable criteria. You follow that and you evaluate the project space, and that gets you down to a few dozen or maybe a few hundred, depending on how strict your criteria are. From there, you can then take small positions across a lot of different opportunities. If you're using some of the cheaper transaction cost blockchains, you can take very small positions. That's a $10 position and maybe it goes to 1000, or it's a $1,000 position, and maybe it goes to $100,000. If you're looking in the Defi space on Ethereum, for example, you probably want to be taking a little bit larger position sizes, just because of the gas costs. You don't want a $100 position, maybe a $1,000 position, maybe a $10,000 position. Or take a $1,000 position that you plan to hold for long term and look for the cheapest gas possible. There are ways of finding cheap gas prices; if it's a Sunday afternoon when the markets aren't going crazy.

Once you have an understanding of how much you can afford to lose, and some capability of evaluating what could potentially be asymmetric outcomes, and then you're allocating your risk across that portfolio, you start thinking about things like position sizing. Your position sizing really comes down to your level of confidence in the way that you are allocating risk across your portfolio.

If you're doing full-on deep dive long-term positions, and you're using a risk moat: What are the fundamentals of this protocol? What are the drivers that I see for it to actually be adopted and continue to grow? Do I think that it has a product-market fit? The more in-depth that you're able to build your knowledge on a protocol or token or project, the more consolidated you can get.

If you're trading on price action and technical analysis, then what you're trading really is about is a statistical edge or statistical arbitrage. 54% of tokens that exhibit this price action go on to get a 100% increase over the next 90 days, right? I don't have that Holy Grail! But if I did, then I'm looking at what is my Risk of Ruin? What size of position allows me to be wrong, whatever percentage of the time I'm going to be wrong, and still result in a positive outcome over my entire trade set. 

Diversification - Lots of smaller positions, if my approach is statistical or technical analysis based, 

Focus - A few larger positions, if my approach is fundamentals-based, built on confidence and understanding of the protocols. 

That is how I then allocate the money I can afford to lose across the position set.

We'll dive more deeply into basically everything that I've talked about today at some point in the future, but I wanted to start with a broad risk framework. Establish the fundamentals, minimize lifestyle risk, and then build a cushion that becomes your basis for what can I afford to lose? Look for asymmetric opportunities so that I can turn that narrow cushion into a much broader cushion. And then if it gets broad enough, then I can begin raising my lifestyle.

I hope that you enjoyed this. I enjoyed making it.

If you have a question or comment, please message me. Please comment below. I'm very interested in hearing what you have to say. I love having conversations about finance and crypto. That's why I started this newsletter. They're topics that bring me joy that I spent a lot of time studying. I love to hear perspectives that are different than I've already heard. I like to have my own perspective challenged.

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