How to Invest in DeFi
Some people are making mountains of money in the new world of DeFi. Others are losing their life savings.
You’ll hear plenty of stories of the first group. You’ll read about overnight millionaires, with astounding 3,000 percent returns for those who got in early (meaning $1,000 invested turned into $30,000 in just a few days).
You won’t hear so much about the second group, because people don’t brag about losing money.
I’ve spent the past few months deep diving into DeFi. My goal is to help you make money in DeFi, not lose it. I wanted simple investing principles that can be applied to this new space, so busy blockchain investors can make money without spending all day moving money around.
I’ve come up with five investing principles that can be applied to DeFi. (Full disclosure: I’ve invested in UNI, BAL, AAVE, LINK, and REN. I tell you this up front so you can adjust for my bias — and tell me if you disagree.)
If you’re new to Decentralized Finance, I highly recommend watching this excellent intro from Carolyn Reckhow and Maggie Love, courtesy of the Women in Blockchain Boston Meetup.
Principle 1: More Users = More Value
I want to shout it from the rooftops: BLOCKCHAINS ARE ABOUT PEOPLE.
If more people are using your blockchain, it grows more valuable. More users = more value. But because blockchains have network effects, the value doesn’t grow in a linear fashion (like most things we experience), the value grows quadratically, which looks like this:
The most important metric for investing in any blockchain project is active users. Think of this like customers of a traditional company. If a company was bringing in new customers at the rate in the top chart above, you’d probably want to invest in it.
With blockchain projects, this growth is intensified, because blockchains are networks. Like network companies (Facebook, Twitter), the more people who join, the more valuable the network becomes.
Unlike network companies, however, blockchain users can be seen in real time. Real-time user reporting is the blockchain investor’s secret weapon. This is not like investing in Facebook, where you have to wait for quarterly earnings reports, when Facebook’s user data is already stale and old.
With blockchain projects — at least those on Ethereum, which is where most DeFi projects are built — we’ve got real-time reporting, using tools like Etherscan.io (raw data) or Dune Analytics (user-friendly reports). Here’s a link to my favorite Dune Analytics report: I watch this daily.
We’re looking for two things: total users, and growth in users. Ideally we want to see a classic growth curve like this (in my investing book I call it the “Rocket Ship Rule,” because it looks like a rocket ship taking off over time):
What we don’t want is something like this:
Ideally we want sustained growth that’s accelerating. But also pay attention to the number of users. It’s tempting to look at a small project with hypergrowth — but keep in mind the scale of the Y-axis.
Before you invest in anything DeFi, check the users. You want to see real people using these protocols. (Be sure they’re not gaming the numbers — beware of giveaway gimmicks or throwaway accounts.) If there are a lot of quality users, and they’re growing quadratically (the Rocket Ship Rule), it’s a good bet the project is a good bet.
Principle 2: Invest in protocols, not in the platform
This is counterintuitive. In fact, it’s the opposite of everything you’ll hear about DeFi.
Most DeFi strategies are ways of moving money around between protocols and platforms. It’s called “yield farming,” which means moving your tokens around wherever they’ll get the most interest.
Reject this approach.
As an analogy, imagine you had $10,000 and you were constantly moving it between various banks, opening and closing savings accounts, chasing those with the best daily interest. You’d call it “interest farming,” and you’d be wasting your time.
Most of us just don’t have the time or the money to waste. At Bitcoin Market Journal, our philosophy is to look for long-term investments in protocols that will drive long-term value. So instead, look for the protocols or projects that people are using.
Think of buying DeFi tokens like buying stock in the company.
Buying the UNI token is not the same thing as buying stock in the Uniswap company (it’s decentralized, so there is no company). This is not obvious, because DeFi projects will tell you they’re “governance tokens,” meaning you get to vote on proposed changes to the project … which is like a shareholder vote.
So even though they’re not stocks, I think of them like stocks. If Uniswap is gaining users, at a rapid clip, and the product is great (which I think it is, because I’ve used it), then I invest.
This means I stay away from “yield farming,” or “locking up” assets in protocols like Compound or Balancer. I’d rather invest in COMP and BAL directly.
Instead of investing in the protocol (lowercase), I invest IN the protocol (uppercase).
Here’s another analogy: you could put your money in a typical savings account, OR you could buy stock in the bank. Which would you rather own: a banking account, or the bank itself?
Principle 3: Keep it simple
Warren Buffett famously invests in companies that he actually understands, which is why his company often buys “boring” stocks like candy, railroads, and furniture. He’s relaxed this standard a bit in recent years, but the principle is a good one.
If we’re investing in a medical device manufacturer, for example, we don’t need to have the knowledge of a surgeon. But it helps if we can roughly explain what the devices do. (“They produce heart stents, which help people with blocked arteries.”)
The world of DeFi is extremely complex, so strive to understand before you invest. I can explain what Uniswap does: it allows you to easily change one blockchain token to another. Better yet, I’ve used the product, and I know it works. (Warren Buffett invested in Dairy Queen partly because he liked the ice cream.)
The principle of keeping it simple also applies to the number of investments you make. Again, we’re trying to move our money in the places where it can do the most good. Avoid chasing every project you think may pay off. Remember the 20-Slot Rule.
KISS: Keep It Simple, Silly.
Principle 4: DeFi as a slice of the pie
Our principle for blockchain investing is to keep it a fraction of your overall investment pie (between 2.5%-10% of your total investments, depending on your risk tolerance). In other words, the majority of your investing (90% or more) is in well-diversified stocks and bonds, and only a slice — your “mad money” — is in crypto.
DeFi is a slice of that.
Let’s say you have 10% of your overall investments in blockchain. Think about your DeFi investments as 10% of that. In other words, blockchain is a slice of the pie, and DeFi is a slice of that slice.
To be absolutely clear on the approach:
- The majority of investments (90% or more) in traditional stocks, bonds, and real estate
- 10% or less in blockchain investments
- 50% or more of your blockchain investments in BTC
- 25% or more of your blockchain investments in ETH
- The remainder in DeFi (if you choose)
If the whole DeFi market suddenly crashes and burns, you’ve only lost a maximum of 2.5% (or 25% of 10%). And if the whole blockchain market crashes and burns, you’ve only lost 10% of your overall investments. As with all investments, decide what you’re comfortable risking.
Principle 5: Watch for fees
Fees are the silent killer.
You’ll see these show up as “gas fees,” which is like a service charge for using the Ethereum network (the platform that runs most DeFi projects). If you are buying $1,000 in tokens, but paying $50 in fees, you’ve just lost 5%. Poof!
Gas fees are highest when the most people are using the network. This is a doubly bad thing: first, you’re paying more to make the same transaction; second, it’s a huge sign that you’re following the crowd.
When Ethereum gas fees are high, it’s like Uber “surge pricing” when everyone is leaving a football game: you’re paying more for the same service, because you’re competing with everyone else. Usually, you are literally following the crowd, rushing with the herd.
It’s easy to ignore fees, because many DeFi services don’t denominate your fee in dollars, they denominate in ETH. So your fee is real, but it doesn’t look real because there’s no reference to your everyday life (quick quiz: how many eggs could you buy with .005 ETH)?
The simple rule of thumb is if your transaction is not going through because the Ethereum network is overloaded, step back and take a breather. It probably means that you’re falling into the vortex of our two great enemies, FOMO and FUD.
Higher FOMO = higher fees. Higher FUD = higher fees. One means people are trying to buy, one means people are trying to sell. Either way, you’ll pay (literally) for investing during these times. Avoid FOMO and FUD, and you avoid the fees.
But the opposite is more important: avoid investing when there are high fees, and you avoid FOMO and FUD.
In summary, this method of investing in DeFi is completely different from how most people are investing in DeFi.
- Look for projects with real users.
- Invest in the underlying token (instead of “locking up” money in the platform).
- Watch for fees. (High fees = high FOMO and FUD.)
- Consider DeFi a “slice of the slice” of the investment pie.
- Keep It Simple, Silly.
We don’t chase the news every day. We don’t constantly move money around between bank accounts, trying to get a percentage point of profit. We’ve got more important things to do.
Ultimately, we’re moving our money to where it can do the most good. When we approach investing in this way — serving the projects that are best serving their users, not just “stacking sats” (a.k.a. chasing returns or hoarding pennies) — we are more likely to be successful long-term investors.
At the end of the day, DeFi is about building the “open financial system” that we all dream about. When we align ourselves with the companies, projects, and protocols that are building this open system — and then open our wallets as well — we are more likely to open our lives to great things.
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