Heuristics are not an investment strategy

Christopher Brookins , 15 Apr 2018 - CryptocurrencyInvestmentOpinion

A heuristic strategy for problem solving might otherwise be described as a ‘rule of thumb’ or ‘best guess’ approach. It’s fine for some things — like pumping up your tyres or watering plants — but it’s arguable that it has no place in cryptocurrency investing

Anecdotally, today’s crypto market appears to be primarily comprised of two types of individuals. Perma-bulls aka HODLers who expect the market to reach unspeakable heights in perpetuity, and Perma-bears who think this market is the largest bubble of all time and will burst horrifically sooner rather than later.

We tend to subscribe to a mixture of the aforementioned doctrines, specifically:

  • Yes: cryptocurrencies, decentralized economics, and blockchain technology will leave a lasting, positive impression on the world.
  • Yes: cryptocurrencies and digital assets are in a speculative, frothy frenzy which draws high similarities to some of the greatest bubbles of recent history.
  • Yes: the bubble conditions have cooled a bit given the ~50% decrease in prices the market has experienced in 2018.

Most importantly, though, we think crypto investors need a more robust risk management process than “I’m in it for the long run.”

The new Avant Garde of crypto — passive investing

The crypto ethos appears to be moving from HODLing at all costs to HODLing a diversified basket of digital assets via a passive investment instrument. And everybody’s getting in on it. This great opinion article by the Financial Times dissects Coinbase’s introduction of its first Index Fund, while it seems Grayscale is releasing a couple of new investment trusts a month. The reasons why institutions are creating these instruments probably include:

  • Over the long term, passive investment strategies have regularly outperformed active investment strategies for a variety of reasons.
  • Passive strategies are a pain-free way to get the institutional money into the crypto market via investment instruments that are familiar, regulated, and more liquid.

Although it makes sense on paper, investors need to be realistic about the risks. For example, most passive pitch decks tout their huge historical returns. However, what should be painfully obvious is that this infant market has experienced remarkable growth over the past few years which will inflate “since inception” returns for at least another year. The chart below shows the MVIS Top 10 Index whereby the “since inception” portion of the chart goes up until the peak while the “year to date” section is the downtrend from said peak.

 BNC Pugilist1

*mvis-indices.com/indices/digital-assets/mvis-cryptocompare-digital-assets-10

Heuristics always work until they don’t. So, the real questions investors should be asking themselves are:

  • Is it appropriate to assume that the future return of these passive assets will resemble their past unheralded gains in perpetuity?
  • If not, what risk management is in place beyond periodic re-weighting of the index?

Why the unnecessary risk?

Crypto investing rhymes with venture capital, but requires a different skill set for managing the risks of highly speculative, liquid assets that no one really knows how to value properly. For example, the markets in 2018 are down ~50%, but there are many spectators distributing charts showing how bitcoin and crypto markets typically sell off in Q1, then rally. Again, that heuristic works until it doesn’t. 

BNC Pugilist2

“Alpha” Protection => “Alpha” Generation

Investors should be able to manage short term risks while still being bullish long term. The methodology that my firm ascribes to (which may not be appropriate for everyone) is:

  • Leverage statistics and fundamental analysis to capture asymmetric return opportunities, i.e. white swans of crypto.
  • Stay nimble and liquid to avoid when the market’s heuristics change in order to give an investor’s capital the best chance to compound over the long term by minimizing losses.

Conclusion

This year’s fall of ~50% provides a great illustration of the principles listed above. If so many people expected the decline to happen, why didn’t they shield their personal or client portfolios? Why not lock-in some profits or take out a derivative hedge on their portfolio? Better yet, why aren’t they making money this year by having a net short portfolio with an overweight short derivatives hedge and periodically buying and selling the extremely oversold dips of the market for a quick 30% — 50% pop?

I realize a lot of these recommendations are easier said than done, but they are not impossible to execute. It simply requires a more pragmatic and risk management heavy lens in which to view the markets and investor portfolios.

Disclaimer: Information provided is for educational purposes only and does not constitute investment, financial, or legal advice.