Bitcoin Bubble

Our office has been closed the last two days because of the winter cyclone that hit the East Coast. I’ve spent this unexpected time off reading and thinking about Bitcoin. I’m putting together a white paper that will pull my thoughts together in long format, but I think it may be useful to get a few tentative conclusions out there quickly, just in case things fall apart in the near future.

The nature of bubbles is that inexperienced investors think they are making huge money because they are smarter than everyone else. This illusion is self-reinforcing. It is why bubble pricing goes parabolic before it crashes. The reality is always that the late stage of a bubble is when the greedy and inexperienced make big profits, while the expert and experienced stand on the sidelines shaking their heads. And then it all falls apart, and perhaps one of twenty of the peak-era traders has actually gotten out with substantial wealth intact.

My opinion, as someone who has been running investments since 1978, and has seen bubbles in gambling stocks, precious metals, oil services stocks, tech stocks, shore real estate, residential real estate, tech stocks, shore real estate, tech stocks, residential real estate, tech stocks, and cryptocurrencies, and has correctly identified the last five or more of them, is that we are in the blow-off phase of the cryptocurrency bubble. I’ll develop this thesis further in the coming white paper.

So this blog post is aimed at Bitcoin hodlers (a deliberate misspelling with meaning to Bitcoin enthusiasts) who are sitting on significant wealth, and who are open to the possibility that they might, just possibly, maybe perhaps, be making a mistake by holding a large portion of their net worth in Bitcoin and/or other cryptocurrencies.

I have come to three semi-firm conclusions about Bitcoin and its variants (including Bitcoin Cash, Bitcoin Gold, Bitcoin Diamond et al) and competitors (including Litecoin, Ripple, et al):

  1. Blockchain is a powerful new technology, which is likely to have huge impact going forward, especially in those parts of the economy (brokerage, real estate, insurance) where assets are bought and sold, and their ownership tracked.
  2. Bitcoin innovated blockchain, but has no priority claim on using it. People can design their own novel blockchain applications and Bitcoin does not benefit. Indeed, competitors or would-be successors can duplicate Bitcoin’s software in every respect, make a few tweaks, and launch their own competing cryptocurrencies.
  3. We can’t know the future. Even you, Mr. Bitcoin Hodler. In one possible future, Bitcoin becomes as valuable as Netflix, Google/Alphabet, Amazon, or Facebook. In another, a different crypto makes it big and replaces Bitcoin. And a third possibility is that all cryptos become worthless, while the big money from blockchain applications will be earned based on another use-case entirely.

Which leads to one simple suggestion. If you are sitting on big money in Bitcoin, especially if you got in early and your net worth has exploded, even more especially if Bitcoin and other cryptos represent most or all of your portfolio, do two things:

  1. Sell half your holdings right away. Take the proceeds, hold back enough to pay the capital gains taxes, and invest equal amounts in three things: an S&P 500 Index, a global stock index, and a money market fund.
  2. With the remaining holdings, consider diversifying, again into three equal buckets: Bitcoin, a “portfolio” of three to five credible crypto alternatives, and a portfolio of public companies that are doing important work in the crypto space.

If Bitcoin is gonna be Google, and cryptocurrencies as valuable as the Internet, you’ll still get filthy rich, but not quite as rich as you might have. A billionaire, perhaps, instead of a multibillionaire. If some other crypto replaces Bitcoin as the future Google, you’ve still got a shot at owning it, and getting much richer than if you stay concentrated in what might end up a loser. And if the whole digital currency thing is not the second coming of electricity, the internal combustion engine, and the internet rolled into one can’t-miss digital asset, you’ve still got a chance for profits owning real companies that derive economic advantage from blockchain innovation.

If Bitcoin is in a stupid bubble, and loses 90% or more of its value, you will have changed your life, and you will be the envy of your techie friends who didn’t get out, even a little bit.

Either way you win. Fail to diversify, and there is a non-zero possibility you end up with nothing, or something close.

This is going to be real interesting to watch.

 

Vaccinate Your Portfolio

Faith in institutions is near all-time lows. Americans don’t trust the mass media. We certainly don’t trust politicians. The internet allows each of us to construct a comfortable cocoon of congenial opinions. It appears we are each allowed to select our preferred set of “alternative facts.” Absent trusted sources of data, confirmation bias runs rampant.

Yet there remains an objective reality out there. In many disciplines there are recognized best practices that define how well-informed and prudent individuals and institutions should act; failure to follow those best practices risks adverse consequences.

Consider vaccination.

My wife is an epidemiologist trained at Johns Hopkins School of Public Health. Some of my closest friends, and many of my clients, are physicians. None of them have any doubt whatsoever that vaccination is safe and effective. All recognize the absolutely central role of vaccines in improving public health.

We no longer have thousands of children and adults confined to iron lungs because of polio. I don’t know anyone whose brother, sister, son, or daughter died of measles, mumps or whooping cough as a child. Unless the Iranians or Russians have retained live smallpox cultures, a disease that has killed millions over the centuries is gone from Planet Earth.

All because of vaccinations. Yet vaccination has become controversial because of misinformation spread on the internet. Even intelligent people, when struggling with a personal tragedy, can be led astray into believing in the non-existent dangers of vaccination.

Vaccination remains a sensible, indeed essential, best practice for the protection of something precious–the lives and health of people we love. Bad information about vaccination puts unvaccinated individuals at risk, but it also harms all of society as we lose the important protection of “herd immunity.”

A recognized best practice also exists in investment management. Diversification is the proven, sensible, documented best practice for managing investment portfolios. All professional investors, charged with managing entire portfolios for individuals or institutions with long-term goals, diversify.

Period. Hard stop. No capable investment professional ever fails to diversify, regardless of the temptations of today’s “hot” speculative opportunity. No sensibly-run college endowment ever puts all its money in one asset class. No foundation decides to bet it all on a single hot stock, fund or manager. No pension plan abandons diversification to go entirely into cash, stocks, venture capital, pork belly futures or Bitcoins.

All of these professional investors recognize that diversification is the key strategy to manage risk and deal with the intrinsic uncertainty of the financial markets. The intellectual foundations for diversification are simply too robust, well-documented, and mathematically compelling to be ignored.

That doesn’t mean institutions never make mistakes. As behavioral finance demonstrates, we humans are all potentially subject to information-processing and decision-making errors. At market extremes, many tend to over-weight the best-performing asset classes, confusing recent price trends with long-term economic advantages. (For a great summary of the thought process that leads investment committees astray, here is a recent piece from the smart folks at GMO, one of the world’s premier asset-allocation firms.)

Despite the abundant evidence in favor of diversification, we’ve recently observed a small number of investors choosing more focused portfolios. They believe they have identified the specific assets that will perform best in the near future–as at prior market highs, usually those assets that have performed best in the recent past. Right now, some smart people are inclined toward investing all of their money in U.S. large-cap stocks, believing that the “Trump trade” will continue to drive domestic stock markets to new highs.

I doubt that any of these folks would consider not vaccinating their children. But they may be in danger of making a tactical blunder with important consequences for the health of their portfolios. We’d hate to see that result.

Be smart. Vaccinate your portfolio. Stay diversified.

J