Making A Return When The Dow is Down
The Base Code strategy for the other half of your Personal Hedge Fund
I. Setting the Stage
As we’ve mentioned in previous installments of The Base Code, the goal is to use small amounts of cash from each paycheck, invest in companies with good fundamentals, and pay no fees using free apps like Robinhood.
But you might be scratching your head because if you’ve spent any time reading about Hedge Funds, what you’ve already realized is we haven’t given much information about that hedging part. Said differently, what happens when the market crashes for no other reason than fear? Do you lose all of your money even though nothing has changed fundamentally about the companies you’ve invested in?
What if you’re worried about your retirement savings when you’re getting closer to the big day and want something less risky? What if you don’t have that much disposable income and every little bit matters?
All of these feelings are the basis for why Hedge Funds were created in the first place. It’s so when one part of your portfolio tanks, the rest of the portfolio doesn’t go down with it.
In the world of mathematics, we call this concept correlation.
II. Defining Correlation
Think of it this way. Positive correlation means that when one thing increases, so does this other thing. Negative correlation, on the other hand is about opposites. It means as one thing goes up, the other goes down.
This is important when you start investing because if you invest in a stock, and there’s a market crash, you don’t want your stock’s price to crash as well. That would be a positive correlation. What you really want is some kind of hedge. Some kind of negative correlation.
So when the market tanks, your stock goes up. How is that possible, you might be asking? Well, it’s a bit tricky. And as you might have guessed, it means you’re going to retard your returns as well. If you’re invested in two different assets that move in opposite directions, then while one goes up, the other goes down and your returns get offset.
So, what you really want is something that is uncorrelated with losses. Two assets that don’t move in similar directions but also doesn’t cancel out your gains.
So, we can’t stay within the standard equity market trading stocks with company fundamentals if we truly want to hedge our risk against macroeconomic forces.
We need to move into a different asset class. We need to find something with near-zero correlation. When something happens over here, there is nothing that happens over there. And vice-versa. That’s the true essence of a hedge.
III. Introducing Bitcoin
There’s a rad newsletter that I suggest you subscribe to by Ark Invest. They also recently updated their whitepaper on Bitcoin as this new asset class. Which brings up another critical term that you should spend some quality time this weekend getting to know: the Sharpe Ratio. They mention it in the whitepaper but it’s an old business school metric that describes your return per unit of risk.
Ideally you want to invest in things that have low risk, but high returns. That’s like the holy grail of investing. You can put your money in a savings account and it’s perfectly safe unless the entire banking system and nation goes under (but then you’ve got other problems), but you’re going to get a return around 1%. At that level, you’re not beating inflation of about 3%, so it makes practically no sense. You may as well just hold liquid cash.
Stocks are just as liquid, you can buy or sell at any time, but they are much riskier. One piece of bad news about the company or the economy and it could crash. What we really want to get at is something that’s liquid, has a high return profile, but isn’t correlated to the market at large, thereby reducing our risk.
That means, we’re looking for an asset class with a higher Sharpe Ratio than stocks.
That’s where Bitcoin comes in as a potential alternative. But first, we need to see how correlated it is to other asset classes (note: green is good, white is okay, and red is bad):
As you can see from the above, Bitcoin is performing quite well in terms of being uncorrelated to other asset classes. It has near-zero correlations between stocks, bonds, gold, real estate, oil, and emerging market currencies.
So there you have it. Less correlated to the market at large, regardless of security. But does it have less risk, as measured by price volatility? Below is a chart showing Bitcoin’s daily price change over the last 6 years.
As you can see, the new security is getting less volatile over time as the market and price settles. But what about the Sharpe Ratio compared to other asset classes (higher number is better)?
Bitcoin has consistently produced the highest risk-adjusted return over various holding periods as compared to other asset classes. Except for that one tricky place. If you bought in 3 years ago at it’s all time market high you didn’t do so hot, but that’s to be expected, no?
So, what can we learn from this:
- Bitcoin is not correlated with other securities (good)
- Bitcoin has a higher risk-adjusted return (good)
- Don’t buy Bitcoin at it’s all-time high (duh, just like stocks)
Now, this is all historical and as we know, past results are not indicative of future performance.
IV. Should You Invest in Bitcoin?
Bitcoin is just one cryptocurrency. There’s also Ethereum, which is more of a platform than a currency, and a few others that are beginning to emerge. So, it’s early days yet, but in terms of liquidity, it’s just as large as other major marketplaces so you’re safe from that perspective.
It’s also not correlated to other securities so it could be a nice offset to protect your downside risk from investing purely in stocks.
That said, it’s a bit harder to understand what drives the price of Bitcoin as it’s not backed by a gold standard and doesn’t represent the success of company operations. Based on our preliminary view, it really just results from human emotion. Confidence and fear make it go up and down. When the rest of the world is a bit chaotic and more news stories come out about investing in Bitcoin, more people become aware of it and go invest in it.
And because the supply of Bitcoin is basically static (it will take another 95 years for the additional supply of Bitcoin to get into the market), the only real risk you have is if a large early holder (like the founder) decides to dump all his/her Bitcoin onto the market. It’s unlikely because they end up losing as well and they invested so early it’s like dumping shares of Uber or Facebook halfway to the IPO.
As a portfolio strategy, we believe it makes a lot of sense, especially for your Personal Hedge Fund. If you’re using Robinhood’s app to invest in stocks, then use Coinbase’s app to invest in Bitcoin.
The only consideration about buying in right now is that Bitcoin’s at it’s all-time high (about $1100 USD), so the probability of it going up up up is a bit risky than it correcting a bit first. In general, because we’re dealing with humans, there is some organizing principle to this chaos. Expect it to behave in isolation at least somewhat like other markets that humans trade on.
If you do invest, let us know, we’re curious how members of The Base Code are faring with their own personal investing strategies.
Your Recommended Reading
- Transforming the Stock Market into a Game
- The Real Truth Hidden in Snap’s S1
- Picking Your Next Investment
- A Primer on How To Value A Public Company
- 12 Tech Theses of the 2030s
from Stories by Sean Everett on Medium http://ift.tt/2kVxoq3