My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2022
There is no way to value Bitcoin or other cryptocurrencies (since there are no cash flows from it) so we are in the realm of uncertainty, not risk. Gambling has known odds (more or less, depending on what you are betting on) and a negative expected return (house gets a cut). Investing has estimable odds (again, more or less) with a positive expected return for bearing risk. Bitcoin has no assessable odds at all, just guesses (and hype and wishes). That’s not to say it won’t skyrocket (sometimes gambles pay off), there’s just no way to know or even estimate any odds or values.
Interestingly, there is still no significant use case for it still (blockchain technology, perhaps; cryptocurrencies, not really) which I find telling given the enthusiasm and efforts to do so. It’s like tulips (1636-1637) or Beanie Babies (late 1990’s) – you are betting that someone else later will pay more for it despite the intrinsic value being roughly zero, aka the greater fool theory. There are a lot of fools out there so a buyer might make money. It’s essentially a pyramid scheme (without the cash flows) – as long as the pool of buyers increases it works. There are a lot of people who don’t own it yet, so it could go on, but there are a lot of people who don’t own most things in the world and that doesn’t automatically make them good investments.
The supply of dollars increases at about 3% per year. Bitcoin at about 1.8%. So there is a little scarcity difference, but not a material one. Cash is enormously more useful. Yet you don’t see people suggesting that squirreling away $100 bills in your sock drawer is a good way to get rich. The objection to that argument would be that there is fear that central bankers could debase the dollar. That’s fair, but the supply of Confederate dollars has been fixed for about 150 years and it isn’t skyrocketing in value despite having historical value and few people owning them. The global gold supply also increases at roughly the same rate as dollars or bitcoin (precise numbers are harder to get), and it’s useful (jewelry, electronics, dentistry, etc.), yet the expected return is the inflation rate.
Buying a little bit (very little) to avoid FOMO, indulge YOLO, or whatever is fine, but realize that it’s much closer to gambling than investing. It’s also interesting to me that we only get questions about it when it has hit a new high, never at the lows. People are mostly just buying the momentum rather than anything fundamental – because there isn’t anything fundamental. Again, there are no cash flows to value, ever.
I did a somewhat related blog post about five years ago comparing gambling, investing, and insurance. You can find that here if you are interested.
I did a post on decision-making years ago (here) but I wanted to share some more on it. As financial advisors, our “product” is really wisdom (as I’ve said before), and it turns out we are wiser about other people’s situations than we are our own. This has two implications, 1) our clients (even our very wise clients) need us, and 2) we need wise advisors ourselves (or strategies to get distance on our issues) no matter how wise we consider ourselves to be. (I’m blessed to have Anitha.) From Aeon:
… When inspecting the results, scholars observed a peculiar pattern: for most characteristics, there was more variability within the same person over time than there was between people. In short, wisdom was highly variable from one situation to the next. The variability also followed systematic rules. It heightened when participants focused on close others and work colleagues, compared with cases when participants focused solely on themselves.
These studies reveal a certain irony: in those situations where we might care the most about behaving wisely, we’re least likely to do so. Is there a way to use evidence-based insights to counter this tendency?
My team addressed this by altering the way we approach situations in which wisdom is heightened or suppressed. When a situation concerns you personally, you can imagine being a distant self. For instance, you can use third-person language (‘What does she/he think?’ instead of ‘What do I think?’), or mentally put some temporal space between yourself and the situation (how would I respond ‘a year from now’?). Studies show that such distancing strategies help people reflect on a range of social challenges in a wiser fashion. In fact, initial studies suggest that writing a daily diary in a distant-self mode not only boosts wisdom in the short term but can also lead to gains in wisdom over time. The holy grail of wisdom training appears one step closer today.
Related, here’s an excellent decision-making flowchart:
Also, you may be able to get the wisdom of crowds … without the crowd, as shown in this paper. Here’s the abstract:
Many decisions rest upon people’s ability to make estimates of some unknown quantities. In these judgments, the aggregate estimate of the group is often more accurate than most individual estimates. Remarkably, similar principles apply when aggregating multiple estimates made by the same person – a phenomenon known as the “wisdom of the inner crowd”. The potential contained in such an intervention is enormous and a key challenge is to identify strategies that improve the accuracy of people’s aggregate estimates. Here, we propose the following strategy: combine people’s first estimate with their second estimate made from the perspective of a person they often disagree with. In five pre-registered experiments (total N = 6425, with more than 53,000 estimates), we find that such a strategy produces highly accurate inner crowds (as compared to when people simply make a second guess, or when a second estimate is made from the perspective of someone they often agree with). In explaining its accuracy, we find that taking a disagreeing perspective prompts people to consider and adopt second estimates they normally would not consider as viable option, resulting in first- and second estimates that are highly diverse (and by extension more accurate when aggregated). However, this strategy backfires in situations where second estimates are likely to be made in the wrong direction. Our results suggest that disagreement, often highlighted for its negative impact, can be a powerful tool in producing accurate judgments.
Finally, from Annie Duke:
Investing is hard, because you need to answer these questions:
- Am I being disciplined or stubborn?
- Am I being foolish or staying ahead of the curve?
- How useful is market history?
- What if it really is different this time?
- Do I have enough?
- The Times that Try Stock-Pickers’ Souls
- How Much Conviction Do You Hold in Your Investment Views?
- Even Great Investments Experience Massive Drawdowns
- Negativity Is Not an Investment Strategy
As Voltaire observed, “Doubt is an uncomfortable condition, but certainty is a ridiculous one.”
My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Winter 2022
What should be the response to a low return environment (i.e. high prices on stocks and bonds)? I have touched on this before (here for example), but it seems like it might be time again.
If returns are lower than they were in the past, but risks are the same (i.e. the return per unit of risk is now lower), there are three perfectly rational responses:
- Keep your portfolio the same but realize you will not get the returns you once did with that portfolio.
- Decrease the risk in your portfolio. Since you are not getting paid as much for taking risk you decide to take less of it.
- Increase the risk in your portfolio. Since you desire a certain level of return the only way to get it is to increase risk.
Now, the problem is that although the options above are opposed to each other, they all make sense and are rational. But we have to pick one.
I don’t have a simple answer though. I think it depends on your resources compared to your needs. For example, if someone is wealthy (compared to their needs, not in absolute terms) the correct choice is probably different from someone who is not at all wealthy (again, relative to need). For example, suppose we have three families, each newly retired, and each need $120,000/year. Social Security/pensions/whatever are expected to provide $40,000. That means $80,000 must be provided by the portfolio. One client has an $1,600,000 portfolio; one has $2,000,000 portfolio; and one has a $2,400,000 portfolio.
- The family with the $1,600,000 should probably have a slightly more aggressive portfolio than they would have in a higher return environment.
- The family with the $2,000,000 should probably have the same portfolio they would have in a higher return environment.
- The family with the $2,400,000 should probably have a slightly less aggressive portfolio than they would have in a higher return environment.
I think. This answer is tentative, provisional, and preliminary!