Technology Stocks

Do I Invest in Bitcoin?

by

Quiz!

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold
  4. Stocks
  5. Real estate

Do I Invest in Bitcoin?

Bitcoin was invented in 2009 as a digital currency, and exhibited phenomenal growth so far, raising the question: what growth can we expect moving forward? While it is easy to extrapolate recent growth into the future, it is not always correct. History is full of such examples. Below is an analysis of bitcoin as an investment.

Potential intrinsic long-term growth:

  1. Ongoing value creation: bitcoin doesn’t offer any product or service (unlike companies), or a place to live in (unlike real estate). It is tough to identify value creation in the long run.
  1. Ongoing value destruction: bitcoin cannot lose value through a sharp increase in supply, so not expected to lose value to inflation, unlike the dollar.

Conclusion: There is a potential for 0% very long-term growth beyond inflation.

Today’s pricing: 0% growth beyond inflation assumes that bitcoin is priced correctly today. While there are no useful measures to give it any specific value greater than $0 (it doesn’t produce anything), there is some useful information:

  1. Bitcoin is a software product, and its returns have been correlated with tech stocks (but more volatile). If this correlation sustains, we may be able to draw potential information about bitcoin’s pricing (valuations) using tech stocks.
  1. Bitcoin existed only during the current up-cycle of US tech stocks (since 2009, 15 years). This makes it risky to assume that its past returns will continue. US tech stocks have become extremely overpriced. They have extreme prices relative to intrinsic values (Price/Book). The S&P 500 developed an unusual concentration in tech stocks, as it did before prior crashes. Mid-last month, it reached record overpricing beyond the extreme of year 2000 (potentially, an all-time historic record overpricing). While tech stocks (as presented by the Nasdaq) declined by 78% after that peak, the excess volatility of bitcoin could imply a greater decline.

The future: One of the biggest stated appeals of bitcoin is the ability to avoid losing value to the high inflation created by governments, similar to the stated benefit of gold. Both aim to achieve this benefit through their limited supply (with a hard cap on the supply for bitcoin). This commonality allows us to put the benefit to the test of a very long history of gold.

  1. Recessions: History had more severe recessions under the gold standard, including The Great Depression. With inability to print more money easily, the Federal Reserve (the “Fed”) could not stimulate the economy. In contrast, without the gold standard, the Fed and government were able to stimulate the economy during recessions. As an extreme example, it helped prevent the 2008 recession from turning into a depression. Central bankers and economists are largely unanimous against the idea of returning to a gold standard. If bitcoin becomes too prevalent, the government could set regulations to make bitcoin uncompetitive, or even illegal (as China & Saudi Arabia did).
  1. Spreading recessions: The gold standard linked countries through fixed exchange rates. If a country struggled, people wanted to stop holding its currency. This would lead to a depleting stock of gold for the country. To prevent that, the country raised its interest rate, to make its currency more appealing to hold. Higher interest rates led to reduced economic activity, magnifying the country’s economic struggles.

More topics:

  1. Environmental Impact: Bitcoin mining uses an enormous amount of energy (over 100 terawatt hours last year). While it seeks to use energy at times of low demand, it is a true waste when compared to storage in batteries for later use. Until the world operates on 100% abundant renewable energy (we are far from that), bitcoin has a negative environmental impact.
  1. Limited supply is not a benefit: Bitcoin is designed to have limited supply. This does not imply any rate of growth, if it does not come along with an appeal. For example, if I can find a small rock of an uncommon shape or size, it won’t likely have much value, no matter how rare it is.

Summary: I don’t see bitcoin as an appealing investment in terms of expected returns (inflation + 0%) or risk-adjusted returns (extreme volatility, with very low expected returns). It doesn’t have theoretical reasoning as an investment – it doesn’t generate anything. It also doesn’t have a history of a full cycle, so past returns are still between irrelevant and offering a hint at a potential sharp reversal.

There are plenty of productive investments that generate value beyond inflation, including companies (stocks) & real estate. Their viability is rooted in basic human needs: the desire to get things done cheaply and efficiently (e.g. buying a car from a company instead of building it at home), and the need to have a place to live in (real estate). Of these assets, there are plenty that are priced very reasonably (including value & international stocks).

To answer the question of the title, I do not invest any of my money in bitcoin.

Quiz Answer:

What asset is bitcoin most similar to, and why?

  1. Dollars
  2. Bonds
  3. Gold [The Correct Answer]
  4. Stocks
  5. Real estate

Explanation:

  • Both bitcoin and gold are used as an inflation hedge – the ability to store money without seeing it decline with inflation.
  • Both don’t generate anything on an ongoing basis (though gold has intrinsic value, such as for jewelry, and bitcoin doesn’t).
Disclosures Including Backtested Performance Data

My Personal Experience with the Recency Bias

by

Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data

Will Technology Stocks be the Leaders of the 2020s?

by

Quiz!

8 of the 10 largest companies in the world in 1990 had something in common: what was it?

  1. They were all American.
  2. They were all technology stocks.
  3. They were all Japanese.
  4. They were all energy stocks.

Will Technology Stocks be the Leaders of the 2020s?

In 2021, the 10 largest companies in the world were technology stocks. Technology changed our lives, and the companies on the top 10 list are prominent names including Apple, Microsoft, Alphabet (Google’s parent company), Amazon, Facebook and Tesla. Investing in such a prominent sector seems like a no-brainer – they are the future, and should stay dominant. While they declined more than the general stock market in 2021, it may seem reasonable to expect them to recover fast and continue their dominance.

It turns out that every decade or so, the top 10 most valuable companies in the world were dominated by a group that people fell in love with. In 1980 it was oil stocks, 1990: Japanese stocks, 2000: tech stocks, 2010: Chinese & energy stocks, 2021: tech stocks. (See the well-written article: https://mcusercontent.com/6750faf5c6091bc898da154ff/files/8a56f057-ed95-f5a2-56e2-cc7a5b72247d/GKDailyComment221206.pdf.)

Every time, there was a rational explanation for the dominance of the companies, and the continued dominance. While the story always sounded convincing, it never worked out. The world’s production isn’t driven by one sector. By the next decade, the favorite group underperformed, sometimes with decade-long declines, and got replaced by the next favorite.

Here are several tools to identify these situations:

  1. A group of stocks dominated the largest 10 companies in the world (by market cap = investment value).
  2. The valuations of this group of stocks were extremely high (measured by Price/Book Value, or P/B).
  3. The bubble popped, and the group of stocks underperformed the rest of the market for a number of months.

Once all 3 happened, the initial declines were not followed by a return to dominance in the following decade. Can you guess how many of these 3 applied to technology stocks in 2021? All 3! Seeing the dominant groups of stocks in each of the recent decades, can you guess the dominant group in the 2020’s?

Note that this article discussed investments, not intrinsic values of companies. To understand better, Price = book x price/book. The book value (or intrinsic value) of a company can grow nicely, but if the price/book starts very high and corrects itself, the price can still decline or grow much more slowly. This is how some great dominant companies in each decade end up being poor performers as investments.

Quiz Answer:

8 of the 10 largest companies in the world in 1990 had something in common: what was it?

  1. They were all American.
  2. They were all technology stocks.
  3. They were all Japanese. [Correct Answer]
  4. They were all energy stocks.

Explanation: Read this month’s article for more.

Disclosures Including Backtested Performance Data