How To Allocate Capital for Newbies in Financial Markets?
There is always this saying in investing that, as long as you have capital, you are always in the game. It doesn’t matter if the market has gone against you. If there is still money in your trading account, chances are you can take advantage of any recovery and make back some of those losses.
It is based on this that capital management and allocation are key when trading crypto and other assets. In this post, we are going to look into capital allocation in more detail, how it works, and what you can do to get it right.
What is Capital Allocation?
As the name suggests, capital allocation refers to a deliberate process of subdividing your capital into a diversified pool of crypto assets. You see, the biggest mistake you can make as an investor is to place your money in one single trade, or one single asset.
Capital allocation simply prevents that. It allows you to identify various crypto assets, the risk involved, and allocate capital on each based on the risk profile. The primary goal of capital allocation is to diversify your investment and spread out the risk. This means that, even if one or more assets fail to perform as expected, you can still balance out those losses with gains made in other assets.
Why Is Capital Allocation Used by Investment Experts?
There are three main reasons why capital allocation is crucial in trading strategies. First, it is one of the most effective ways of managing risk. As noted above, having a diversified pool of crypto assets is the most effective way to reduce risk exposure. While this strategy can limit gains, it will go a long way in protecting your capital. In essence, capital allocation will allow you to risk a minimum amount of capital for steady small gains.
Secondly, capital allocation is done to help optimize trading. There is nothing more heart-breaking than waking up one morning only to realize a big chunk of your assets has been wiped out by volatile market movements. Capital allocation and portfolio diversification can however help you prevent this by simply hedging various positions against each other.
Finally, capital allocation is a great way to make your money work for you. You see, any investor will tell you that it is always nice to have broader exposure to as many assets as possible. By spreading out your money across various crypto opportunities, it is much easier to make more gains and limit losses.
Capital Allocation Strategies: The DCA Method
DCA stands for Dollar Cost Averaging. In essence, it is a capital management approach that allows you to invest small amounts of money incrementally during various intervals. Let’s say for example you plan to buy Ethereum. But because of high levels of market volatility, you are not sure how the price action will move.
So, with the DCA approach, you can start with a small investment. After that, you will watch the market to see the progress of ETH. If you are satisfied with the potential gains and prevailing risks, you can then decide to incrementally increase the size of your positions over time.
The biggest advantage of the DCA method is that it can help you take advantage of short-term price movements in the volatile crypto market without putting up too much capital at risk.
How Does the DCA Method Work?
To understand how the DCA method works, it is important to, first of all, explain what its objective is. DCA aims to limit capital exposure to risk. So, in a nutshell, it is a short-term trading strategy that allows you to profit from wild swings in the market. Ideally, with the DCA method, you would want to buy at lower lows and sell at higher highs.
Also, DCA is designed to ensure you have enough liquidity at any given time in the market. This means that there is enough cash flow in your trading account to invest any time you want. In its truest nature, the DCA method does not allow you to hold open positions for long.
Once you have hit a certain profit target, you are supposed to exit and maintain liquidity. The same also applies to losses. When the stop-loss is hit, exit and take a smaller loss while maintaining liquidity in your account.
With that said, here are the main basic steps to follow in Dollar cost averaging or DCA.
Decide How Much You Want to Invest
The first thing to do is to allocate the highest amount of money you would like to invest in crypto. Now, please keep in mind that the crypto market is highly volatile and fortunes can turn very fast. Only invest money that you are okay losing. It is also important to decide the duration of time you want to invest that capital. For example, you can allocate say $1000 over three months.
Identify The Assets You Want to Buy
Diversification is very important when trading crypto. This is why it is very important to identify at least three categories of crypto assets that you will be investing in. A good rule would be to have a clear record on a spreadsheet of which assets to buy.
Wait For the Perfect Entry Point
This is by far the hardest part of the DCA method. As noted above, the key to success in short-term DCA trading is to buy during lower lows and to sell during higher highs. But knowing exactly when the price action hits those targets is never that easy.
You also need a lot of patience. However, when an asset drops by more than 20%, the dip is always worth buying. Also, assets that surge by over 20% will likely pull back at some point.
Keep Track of Your Assets
Once you have entered positions with the various assets in your portfolio, you will need to keep track of the price action. Remember DCA involves small increments in your existing open positions. However, these increments are based on the movement of the market.
In that case, it is important to be up to date with the price action. This will help you make the right decision on whether to increase your position or to hold them as they are.
Limitations of Dollar Cost Averaging (DCA)
For all its success in managing risk, the DCA method also has several key limitations. First, you are likely to incur a lot of charges in trading fees since you will be executing a lot of trades within a short time.
Also, sometimes the trends in the market may fail to reverse in time. For example, it’s not uncommon to buy a 20% dip only for the crypto to keep falling further. Finally, DCA requires a lot of patience and discipline to execute.
For most beginner traders, it’s very hard to develop the required temperament to keep emotions out of trading decisions. But despite these challenges, the DCA method is still a great way to reduce exposure to risk while taking advantage of trading opportunities in crypto.
Capital Allocation Strategies: The Long-term skin in game Method
You can also focus on long-term investing through long term capital allocation. Here, you will dedicate your capital to long term opportunities with steady rewards. The best way to earn passive income in the long term is through staking.
Now, most staking programs allow you to lock in your crypto for a predetermined time and earn an annual yield from the trade. But some projects also allow you to stake short term, for as low as 7 days. But rewards earned from staking will be higher for long term staked assets. Best assets to stake right now include Crypto.com (CRO), Polkadot (DOT), Immutable X, and others.
Another way to earn long term yields from your crypto assets is through yield farming. Unlike staking, you do not need to lock in your assets with yield farms. Instead, you earn rewards by lending your crypto assets to DeFi platforms.
Compound Finance, Aave, and others are good options for this. Finally, you can consider buying NFTs as a store of value. NFTs are exploding right now and there is a lot of potential for further growth in the long term.
Capital Allocation Strategies: Short-term Method
It is also advisable to combine long term capital allocation with short term approaches.This allows you to take advantage of short term market movements and make decent returns. Here, you will simply buy certain crypto assets, hold them for a few days, and sell at a profit.
Short term trading is however risky since it can be very hard to predict short term market movements. A good rule however would be to watch out for decent dips or high impact news that may affect the direction of the market.
But remember, as long as you have capital, you are always in the game. That is why managing risk through savvy capital allocation is very important for any investor. There is nothing more devastating than losing all your capital in a flash. It will take you longer to regain it and you may end up feeling demoralized.
* We hope this information will help you in your investment process, but this is not investment advice. Every investment carries risk, especially in this industry, so DYOR before making a decision.