Shiny new bitcoin or traditional stocks? Stick to proven fundamentals
Bitcoin has recovered a bit this past week, but has still lost over 40 per cent of its value in the past two months. This isn’t going to be an “I told you so” column; it is simply heart breaking watching so many people who invested in the cryptocurrency for fear of missing out, only to lose so much of their savings. What I’d like to do instead is to try to use this shock to look at how to build investment programmes that are more robust.
Looking at the bitcoin boom, what in the end was really driving it? It didn’t generate a yield, at least not one anywhere close to the growth in bitcoin’s price. It didn’t generate a profit from operations, as it has no operations. And as a currency it hasn’t been used for anything major, at least not yet.
The last point reveals bitcoin’s initial attraction: people could see how the cryptocurrency might be used on a large scale in the future. They subsequently discounted that demand back to today and invested, with the hope of reaping great future rewards.
But the astonishing rate at which the price of bitcoin appreciated eventually suggested a demand that quite possibly exceeded total global trade, an absurd notion. Investors that came to the party a little later were therefore not rationally discounting future demand anymore; rather they saw an asset going up in price and wanted to jump on the band wagon.
These two ideas can lead us to the basis of a solid investment programme. This is my programme, and it has worked for me. But it does not necessarily mean that it will work for you.
I am simply stimulating discussion and not giving investment advice.
The first point raised above revolves around an investment’s future prospects and expectations. In the end, the price that you pay for an asset today is based (rationally or otherwise) on the cashflows (dividends, sale of shares etc) of the future. Of course, when gazing into the future to see what it holds, one needs to be aware that accurately forecasting what is to come is never a sure bet. This is the basis of risk.
The past can be a guide though. It should in theory be able to more easily predict the future of a profitable company that has existed for 50 years in a mature market, compared with a technology start-up operating in a relatively new market. You could say that the first company is a less risky bet than the second company.
Notice that there are three dimensions here: length of historical data, maturity of market and maturity of product. Nine-year old bitcoin, operating in the new and constantly-changing world of cryptocurrencies – scores low on all three dimensions.
Of course there are plenty of disruptive companies in new markets – Google and Facebook immediately spring to mind – they have come to dominate their sector and the economy at large, and similar claims are made about bitcoin. Arguments made to me by proponents of the cryptocurrency have rested on some combination of anonymity, cryptography and de-centralisation of the trust system.
But what all these proponents seem to forget is that even if their arguments are all correct, it does not logically follow that bitcoin will emerge as top of the cryptocurrency pile.
Google and Facebook perfected rather than pioneered the search engine and social network experience, relegating early stars like Altavista and MySpace to the history books.
It’s like saying new boy bands will always have a market because older boy bands stopped being boys, the fans of current boy bands will, within a year or two, stop following boy bands, new fans will therefore want a new boy band. Makes sense to me.
But which boy band out of the dozens, hundreds or possibly thousands will get to the top? How can you tell who the next One Direction will be?
The other issue, making an investment simply because the price is going up, is actually often not that illogical. Often an asset will rise in price lifted less by hype than by an upward change in its fundamental value. Early investors may often have an insight into an asset’s worth. But the problem is when they get out, you’ll have nobody to sell to.
In conclusion, it’s worth remembering that risk and return are asymmetrical, and it’s therefore essential to try and minimise the downside completely. The old adage that a 50 per cent loss requires a 100 per cent gain to offset it is worth remembering.
So while new shiny investments with rocketing values will always be tempting, companies with a history of steady, believable returns will generally come up victorious
in the long run.