A roadmap for Wall Street suits exploring the DeFi space.
DeFi is on the rise — it introduced a new set of investment opportunities like yield farming that already made millionaires.
But it’s not that simple: creating a portfolio in DeFi is starkly different from the orthodox concepts known by asset managers from regular financial markets. People coming from a TradFi background may be setting themselves up for a huge risk without first learning the rules of the DeFi jungle.
TradFi vs. DeFi portfolio construction, let’s take a closer look at the main differences:
TradFi vs. DeFi Portfolios: Key Differences
1. Diversification
TradFi investors typically spread their investments across stocks, bonds, commodities, and real estate to mitigate risk and balance returns. For example, a typical investor allocates 50% of their portfolio to stocks, 30% to bonds, 10% to commodities, and 10% to real estate. They invest in a broad range of companies, industries, and geographic locations to achieve a well-diversified portfolio.
DeFi diversification, however, revolves around various tokens, pools, protocols, and blockchains. Yet, DeFi assets are often more correlated, making true diversification harder to achieve.
For example, a DeFi investor might allocate 40% of their portfolio to Ethereum, 30% to Aave pools for lending, 20% to provide liquidity on Uniswap pools, and 10% to Yearn Finance vaults. They aim to spread their risk across various DeFi platforms and chains but may face higher correlation among their investments.
Some DeFi investors use yield aggregators or portfolio management apps like One Click Crypto to assist them in creating portfolios according to their risk profile.
2. Risk Assessment & Due Diligence
While TradFi relies on credit ratings, financial statement analysis, macroeconomic indicators, and market sentiment, DeFi demands an assessment of smart contract vulnerabilities, platform security, regulatory changes, and liquidity. With limited historical data and standardized metrics, assessing DeFi risks becomes more challenging.
When doing due diligence in TradFi, for example, you analyze a company’s financial statements, credit rating, and market sentiment before buying its stock.
In contrast, a DeFi investor reviews a DeFi protocol’s smart contract audits, tokenomics, platform security, and community support to evaluate the risks associated with investing in the protocol.
3. Available Investment Products & Strategies
TradFi investors use strategies like value, growth, or income investing, tailored to their risk tolerance and objectives. In value investing, for example, investors focus mostly on undervalued stocks with strong fundamentals and potential for long-term growth.
In DeFi, however, there is such a huge variety of available investment instruments, that it would require a lot of learning (or assistance) in order to fully grasp its full potential and develop a proper strategy.
In addition to common types of DeFi strategies like lending, staking, and liquidity provision, there are other sources of generating yield through more sophisticated products like yield boosters, aggregators, or leveraged vaults.
4. Time Horizon
Traditional portfolios emphasize long-term stability, focusing on consistent returns over time. For instance, a TradFi investor might build a portfolio with a 20-year time horizon, focusing on blue-chip stocks, government bonds, and real estate investments.
In contrast, DeFi’s nascent nature and high volatility require a shorter-term, more proactive approach to portfolio management and rebalancing. Typical DeFi investor monitors market conditions and platform updates and rebalances assets monthly (sometimes weekly or even daily) to adapt to the rapidly changing DeFi landscape.
5. Passive vs. Active Management
TradFi offers a lot of passive options like index funds or ETFs like S&P500, by investing in which you can achieve a “set-and-forget” experience. In DeFi, however, due to its risks and market dynamics, there are not that many very passive options, and investors generally need a more hands-on approach with frequent monitoring and rebalancing.
Some tools like DeFi dashboards (Zapper, InstaDapp) and yield aggregators/robo-advisors (Beefy, One Click Crypto) aim to simplify ongoing management by providing easy-to-use portfolio creation and monitoring interfaces and often can save hours of manual work and hundreds of clicks.
6. Fees and Costs
Traditional finance fees include management, trading, and taxes, which can decrease potential returns. For example, a typical investor would pay a 1% management fee for their actively managed mutual fund and incur trading fees when buying and selling stocks.
DeFi investing generally has low or no management fees but often brings higher transaction costs (gas fees) for approving, depositing, and claiming funds when interacting with DeFi protocols.
7. Expertise and Knowledge
Building a TradFi portfolio demands an understanding of asset classes, financial markets, and macroeconomics. In DeFi, investors must be well-versed in blockchain technology, smart contracts, platform mechanics, and the rapidly evolving landscape.
— Okay, great, we talked about the TradFi and DeFi differences, so what’s next? — you might ask, — I still don’t understand where to start in DeFi.
As a traditional finance aficionado ready to embark on the DeFi journey, arm yourself with these essential tips:
7 Key Principles For DeFi Investing
1. Set Proper Expectations and Understand the Risks
A good mindset to start with in DeFi is to be willing to lose all your funds. Risks in DeFi are much higher than in traditional investing and include things like impermanent loss, smart contract exploits, and frequent encounters with scammers, which could potentially lead to losing all your assets.
It would be highly beneficial to study all the potential risks related to DeFi, a solid starting point would be websites like Exponential.
Only invest what you’re willing to lose and at first lean towards established protocols with big brand names and proven track records.
2. Start Small
Dip your toes into DeFi by allocating only a modest portion of your portfolio. Modern blockchain scaling solutions like Arbitrum have very low gas fees which allows you to get started with as little as $100.
Gain hands-on experience, and as you become more comfortable, adjust your exposure to align with your risk tolerance and objectives.
3. Diversify
Spread your DeFi investments across various assets, protocols, and chains to mitigate concentrated risk. Keep in mind, though, that DeFi investments are generally more correlated than traditional investments, which may constrain overall diversification benefits.
Tools like One Click Crypto can help to create a diversified portfolio tailored to your individual risk profile in under 2 minutes.
4. Keep Secure Self-Custody
Maintaining your assets in web3 non-custodial wallets is a must-have in DeFi, as you don’t want to expose yourself to additional counterparty risk for storing your assets (see FTX).
Safeguard your crypto with well-known self-custodial wallets (e.g., Metamask, Trust Wallet), two-factor authentication (2FA), and hardware wallets when appropriate. Don’t connect your wallet to unknown websites, don’t approve suspicious transactions, and never share private keys or seed phrases.
5. Do Proper Due Diligence
Before investing in a new DeFi protocol, a typical DeFi investor reviews its smart contract audits, security measures, development team, and community support. This helps them avoid potential scams or high-risk projects.
Some DeFi aggregator tools like Beefy or One Click Crypto help to assess the risk of each DeFi pool by providing a certain risk score that is either calculated programmatically or assigned by the project’s research team.
Nevertheless, it wouldn’t harm to do your personal DD on the side. It will help you sidestep scams or high-risk projects.
6. Monitor and Rebalance
By nature, yields in DeFi are not fixed. They are variable and keep changing all the time. And more often than not, yields are trending downwards than upwards.
So some pools and protocols where you’d been farming 30–50% APY a month ago, today may only deliver 5–10%.
For example, the popular perpetual trading exchange on Arbitrum GMX.io has a yield-bearing token GMX, which upon staking delivers a passive return. As we can see from the DeFiLlama analytics dashboard below, GMX yield (pink line) has been only trending downwards over the last 6 months.
Usually, the same happens with most of the DeFi platforms: as liquidity and protocol TVL increase, the rewards tend to dilute and decrease. To avoid “underutilizing” their positions, DeFi investors tend to be in a constant search mode for new and more profitable farming opportunities (which could often backfire). But in general, active rebalancing is a much more relevant strategy in DeFi compared to TradFi.
Additionally, proactive monitoring can protect you from a lot of risks.
For example, back in May 2022 UST investors farming yield on Anchor protocol had a short time window to withdraw their assets before the UST stablecoin collapsed to zero. If you stay informed about important market developments and act quickly, you can potentially save yourself from a lot of trouble.
DeFi evolves on a monthly basis. So to keep up with its high volatility and rapid evolution, you may want to actively track and adjust your investments to match your risk tolerance and goals.
Tools that can help with monitoring:
Tools that can help with rebalancing:
7. Be Patient, Agile, and Keep Learning
The last and probably the most important one: never stop learning.
DeFi is a fast-growing and ever-evolving ecosystem brimming with a lot of potential, but also volatility and risks.
Begin with the basics — blockchain, cryptocurrencies, and DeFi platforms. Master key concepts like smart contracts, decentralized exchanges (DEXs), lending and borrowing protocols, yield farming, and staking.
Before diving into action, you might also want to read a few dozen of whitepapers of popular DeFi platforms (e.g. Aave, Uniswap, and Curve), subscribe to DeFi newsletters, and follow relevant influencers on Twitter to stay updated on the latest trends and narratives in the space.
Don’t forget to network and learn from others. You may want to join a few DeFi-focused forums, Telegram groups, and Discord channels and chat with experienced DeFi investors and developers, learn from their insights, and keep up-to-date with the latest narratives in the space.
Here are some of the useful sources to start with:
Articles:
Newsletters:
Twitter accounts to follow:
Approach DeFi with patience and be ready to adapt to new developments, challenges, and opportunities as they appear.
Summary
To sum it up, venturing from TradFi to DeFi is like stepping into a whole new financial universe. You must learn the ropes, get a handle on new tech, and adapt your strategies to stay ahead. By embracing the key differences explained in this post and navigating the dynamic DeFi landscape, you can potentially reap the rewards of this game-changing financial frontier.
With these tips in your toolkit, you’ll be better equipped to navigate the DeFi landscape and make well-informed decisions about your DeFi investments. Happy exploring and stay safe!
Disclaimer: This article is not intended to serve as financial advice. The sole objective is to provide an educational perspective on the DeFi vs TradFi investment landscape. Investing in products, tokens, or company shares associated with these trends will not necessarily result in financial gain. Always conduct your own research and seek the advice of a financial professional.
Secret hashtag: #DeFiTips
