Category: Investing Insight

Investing insight to make you a better investor.

define: bitcoin

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an infinitely divisible digital collectible

The Problem

When faced with a cash-crunch, whether due to wars or natural calamities, the first instinct of governments since time immemorial has been to debase their currency.

Take the Roman empire, for example. The major silver coin used during the first 220 years of the empire was the denarius. During the first days of the Empire, these coins were of high purity, holding about 4.5 grams of pure silver.

However, with a finite supply of silver and gold entering the empire, Roman spending was limited by the amount of denarii that could be minted.

This made financing the pet-projects of emperors challenging. How was the newest war, thermae, palace, or circus to be paid for?

Roman officials found a way to work around this. By decreasing the purity of their coinage, they were able to make more “silver” coins with the same face value. With more coins in circulation, the government could spend more. And so, the content of silver dropped over the years.

By the time of Marcus Aurelius, the denarius was only about 75% silver. Caracalla tried a different method of debasement. He introduced the “double denarius”, which was worth 2x the denarius in face value. However, it had only the weight of 1.5 denarii. By the time of Gallienus, the coins had barely 5% silver. Each coin was a bronze core with a thin coating of silver. The shine quickly wore off to reveal the poor quality underneath.

By 265 AD, when there was only 0.5% silver left in a denarius, prices skyrocketed 1,000% across the Roman Empire.

Traditionally, citizens of a country have limited options to escape a government hell bent on debasing their own currency. They could buy gold, but the government can find ways to restrict how much gold one could own. For instance, the US restricted gold ownership for over 40 years claiming that “hoarding” of gold was stalling economic growth and worsened the depression. In some left-leaning countries, people default to using the US Dollar as a store of value. But often, like in the case of Argentina in 2001, the government can freeze bank accounts and restrict withdrawal of hard currency. One could try to accumulate hard assets, like land, for example. However, real-estate is not portable and can always be sized by the government, like India in the 1950’s and South Africa in the mid-2000’s.

Each of these traditional assets have trade-offs.

  • Gold: cannot be used for electronic payments. But everybody knows its price and is a trusted store of value.

  • US Dollar: centralized clearing either through SWIFT or ACH means the US Government can shut you off at any time. But it is a widely accepted medium of exchange (world trade is denominated in it.)

  • Hard assets: not portable, one-of-a-kind, tough to value and transact with a high liquidity premium. But is known to hold its value through inflationary environments.

Bitcoin was designed to overcome most of these problems.

The Solution

Bitcoin is meant to be a decentralized, fixed-supply, infinitely divisible, digital currency.

Decentralized: there is no central ledger or clearing-house for bitcoin transactions. All bitcoin transactions are written on a blockchain. To win the right to write to the blockchain, miners compete and if they win, are awarded bitcoins. Anyone can become a miner, so transactions are settled by a distributed network of miners that does not require a central authority.

Fixed-supply: there can be only 21 million bitcoins in total. This makes it impossible to be debased like regular currencies.

Infinitely divisible: bitcoin’s smallest unit is called a “satoshi.” It represents one hundred millionth of a bitcoin, or 0.00000001 BTC ($0.00035 USD, at current price.)

Digital: you access your bitcoins through a unique 34-character key. There is no other identifier tying you to your bitcoins. You can use many such keys to send, accept, and store your bitcoins anywhere in the world.

A shared illusion

As far as I can tell, money is a shared illusion. We have a lot of beliefs in various systems, whether it’s the universe or government or organized religion, that serve more of an existential function to give us a sense that there is some order in the world. A big part of money’s function is the ability to help us measure things in an understandable way. – Adam Waytz, Kellogg School of Management

Money is whatever a group of people can agree on that is

  1. a store of value

  2. a medium of exchange

  3. a unit of account

It is not necessary to use a government-issued currency (fiat) to achieve these ends. However, since taxes can only be paid in fiat and the government can use violence to extract the taxes owed, it is often convenient to keep using it.

It is no wonder that even though the technical pieces of bitcoin have been around since the mid 90’s, it took the shock of the 2008 Global Financial Crisis to breathe life into it. With widespread panic, bank runs, countries at the brink of default, and evaporating faith in the global financial system, the time was ripe for an alternative to emerge.

An elegant solution to a well defined problem… with trade-offs

From a technical point of view, bitcoin does what it says on the tin. And the code that drives all of it is public. There are no surprises. But every solution has tradeoffs. Bitcoin’s biggest trade-off is that settling transactions is extremely slow and expensive.

There is no hard limit to how long bitcoin transactions can take to be confirmed. It can take anywhere between 10 minutes and over a day. The two biggest influences on the confirmation time are the amount of transaction fees and the activity on the network. This is not something that can be used for micro-payments, like buying a cup of coffee. But this is only one part of the problem.

New bitcoins enter circulation as block rewards, produced by miners who use expensive electronic equipment to earn or mine them. Every 210,000 blocks, or roughly every four years, the total number of bitcoin that miners can potentially win is halved. But the consequence of this dropping block reward is that eventually, it will dwindle to nothing.

In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume. – Nakamoto

When you learn that the total annual energy consumption of the Bitcoin network is comparable to the power consumption of Chile, you’ll immediately understand why this is a problem.

This makes #2 of what makes something money questionable in the context of bitcoin. If you can’t use something to transact for everyday needs, is it really money?

Volatility kills accountants

The volatility of Bitcoin is roughly three times higher than that of most country currencies. Compared to a currency pair like USDCAD or USDEUR, which barely breaches 2% (10-Day) volatility even during the Great Financial Crisis, Bitcoin at its lowest volatility is lucky to be below 2%. And this is true even if you compare it with other least-developed country currencies.

The problem with this kind of volatility is that if you own bitcoin denominated assets, what is it worth? This makes the #3 reason of using something as money questionable in the context of bitcoin.

Bitcoin is more like art, less like money

Picasso’s Les femmes d’Alger was sold for $179.4 million in May 2015.

What makes a piece of art valuable? It just sits there and does nothing. So, like bitcoin, it obviously has no intrinsic value. And, like bitcoin, supply is usually capped because the artist is usually long gone. Also, like bitcoin, there is an ecosystem around art comprising of auction houses, galleries and museums that promote a shared myth.

The #2 and #3 use-cases of money is barely met by bitcoin. But bitcoin fits nicely into the art metaphor. With two big differences.

  1. Art, unlike bitcoin, is not divisible. This means that the price of a piece of art is capped by how much someone is willing and able to pay for it. Bitcoin has no such constraint. If someone with $10 buys a fraction of bitcoin for $50,000, then that price gets printed.

  2. Bitcoin is completely digital. Bitcoin represents digital scarcity, which, before Bitcoin, had almost no solutions. Before bitcoin, only things in the real-world were not “copy-pasteable.”

This makes bitcoin an infinitely divisible digital collectible.

We leave you, dear reader, with these thoughts and a recording of our fascinating conversation with someone who is working on a PhD in crypto-currencies and who also happens to be a dear friend of mine. Enjoy!

Sources:

Currency and the Collapse of the Roman Empire

Executive Order 6102

Corralito

Zamindar

Land reform in South Africa

Money: The myth we all believe in

Crypto Assets

How Long Do Bitcoin Transactions Take?

Bitcoin Halving, Explained

Bitcoin Energy Consumption Index

Why Bitcoin Has a Volatile Value

Evolution of bitcoin: Volatility comparisons with least developed countries’ currencies

The Value of Art: Money, Power, Beauty

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Cross-Asset Time-series Momentum

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Trend-following systems typically use the past performance of a particular asset to trigger a buy or a sell on that asset. A research paper that came out in 2019 looked at whether the historical performance of multiple assets can be used to trade them.

Pitkäjärvi, Aleksi and Suominen, Matti and Vaittinen, Lauri Tapani, Cross-Asset Signals and Time Series Momentum (January 6, 2019). Available at SSRN: https://ssrn.com/abstract=2891434

From the abstract:

We document a new phenomenon in bond and equity markets that we call cross-asset time series momentum. Using data from 20 countries, we show that past bond market returns are positive predictors of future equity market returns, and past equity market returns are negative predictors of future bond market returns.

Unfortunately, the paper did not look at Indian markets to check if this worked. So, we rigged up a simple backtest to see for ourselves.

Rules

A simplified equity-bond cross-asset trading strategy at the beginning of month t can be constructed as follows: Compute the past 12-month equity return (E past) and the past 12-month bond return (B past). If:

a) E past is positive and B past is positive: Buy equity
b) E past is negative and B past is negative: Sell equity
c) E past is negative and B past is positive: Buy bonds
d) E past is positive and B past is negative: Sell bonds
e) Otherwise, invest in the risk-free rate.
Hold the portfolio for one month and then repeat the same procedure in month t+1 (source.)

Backtest

We used the NIFTY 50 TR index to represent equities, NIFTY GS 10YR index for bonds and the CCIL Index 0-5 TRI for risk-free rate.

Since our risk-free index starts only from 2004, our backtest only goes back 16 years. However, the markets have been through a lot since then, so it is unlikely we are losing much by not being able to go back much earlier.

The 12-month look-back approach massively under-performs the NIFTY 50 TR buy-and-hold. We shortened the look-back to 3-months to see if we could make the strategy more responsive to trend reversals.

To our dismay, we saw only marginal improvements in overall returns but the draw-down profile of the long-only portfolio was much better.

Conclusion

While the approach outlined in the paper might be valid for the selected subset of markets, it fails a simple backtest on Indian market indices.

Code for the backtest can be found on github.

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Moats are for never

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Be wary of #neversell

When Buffett-heads are asked about when they are likely to sell a stock, they often bring out this quote from the Master:

A common-sense parsing of the actual quote would over-weight the “outstanding businesses” bit over “forever.” However, the quote has been deliberately misinterpreted by asset-managers (who are paid as a percentage of AUM) to keep investors tied into their funds in spite of extended periods of underperformance.

Corporate history is replete with examples of companies that once had the widest of moats but withered nonetheless. The most recent posterchild is Intel.

Over the last decade, Intel (INTC) trailed the broader S&P 500 and Nasdaq indices with the final death-blow being dealt by Nvidia.

Twenty years ago, could you imagine a world without Intel? Now you can. Apple, Samsung, Amazon, Google and Microsoft are all in the process of developing or have already developed processors to run their operating systems and power their data centers. For a deeper dive, read this excellent piece by James Allworth.

And it is not just hardware. Twenty years ago, could you have imagined that Infosys would beat IBM and the S&P 500? Yet, it did.

Oh! But that is tech, you might say. What about the “real” economy stocks?

Remember GE? Their six-sigma blackbelts were supposed to be cream-of-the-crop problem-solvers who could be parachuted into any situation.

While you can argue that the above companies were cherry-picked, the base-rates are more shocking

A recent study by McKinsey found that the average life-span of companies listed in Standard & Poor’s 500 was 61 years in 1958. Today, it is less than 18 years. McKinsey believes that, in 2027, 75% of the companies currently quoted on the S&P 500 will have disappeared. (IMD)

table 1 companies exiting and entering_smaller454

Often, experienced managers are experts at solving problems for an old world order. The “best” managements often miss creative destruction happening in their own backyard, like Kodak. Incentives typically are setup to reward reaching local maximas. So, it is entirely possible to hit every single quarterly number while steadily marching toward bankruptcy.

The Coca-Cola Company is an example where initial high expectations were merely met (and not exceeded) to the dismay of common-stock holders.

And what is true about individual companies it true about the broader market as well. A visit to Japan will blow your mind. But as an investment?

In fact, a simulation of historical country-index returns show that only DENMARK, USA and SWITZERLAND had an extremely small chance of posting negative buy-and-hold returns. Out of the 43 Country specific MSCI indices we analyzed, half had more than a 10% chance of giving negative returns to buy-and-hold investors. India had a 6% chance (The Buy and Hold Bet.)

No company lasts forever. No market will always remain the best one to be in. No investment strategy will always deliver market-beating returns. No investor can consistently beat the market year-in/year-out.

No investment is forever.

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Volatility and Allocation

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Think in terms of volatility buckets, not assets

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. The Permanent Portfolio

  3. Sequence Risk and Asset Allocation

  4. Static vs. Tactical Allocation

  5. Tactical Allocation

The thrust of our previous posts on allocation was that Indian investors shouldn’t blindly copy strategies that worked well in the US. There are a lot of qualitative arguments to be made to support a India-dominant view for allocation strategies. In this post, we introduce a quantitative aspect to the discussion.

It is Volatility, Stupid!

In finance, more than any other field, it is very easy to get correlation and causation mixed up.

A man goes to the doctor and says, “Doctor, wherever I touch, it hurts.”
The doctor asks, “What do you mean?”
The man says, “When I touch my shoulder, it really hurts. When I touch my knee – OUCH! When I touch my forehead, it really, really hurts.”
The doctor says, “I know what’s wrong with you. You’ve broken your finger!”

There are no universal laws for an asset class that holds across geographies and economic systems. The reason why a 60/40 Portfolio “works” in the US has more to with the quantitative aspects of the assets being mixed than what they are called. US bonds have benefitted greatly from a 30 year slide in yields, benign inflation and a flight-to-safety bid. None of these hold true for Indian bonds. So, expecting a 60/40 Indian portfolio to behave like a 60/40 US portfolio just because you mixed the same assets together is idiotic.

The most import aspect while considering assets for diversification are their volatilities. Specifically, the correlation of their volatilities at their left tails.

To keep things simple, consider a 2 asset portfolio: Eq and X. Eq has some average return that will be held constant during this analysis. What changes is its standard deviation (aka, volatility.) X is a stable asset with zero volatility (think of it as a fixed deposit.) How does different allocations to Eq change portfolio returns and volatility?

  1. Low volatility is supportive of higher allocations

  2. Higher allocations to the higher volatility asset progressively reduces the predictability of portfolio returns

Volatility is Volatile

Asset return volatility is itself volatile.

The past performance of a diversified portfolio is based on the realized volatility of its components. However, volatility itself is unpredictable over long periods of time.

Take-away

While considering assets to diversify into, look at the volatility of the asset rather than what it is called.

Don’t expect the quantitative aspect of an asset class to transcend economic systems – different markets need different treatments.

All investing is forecasting. And all allocation is forecasting volatilities.

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The Permanent Portfolio

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Pain is eternal

This post is part of our series on diversification and asset allocation. Previously:

  1. Diversification and its Malcontents

  2. Sequence Risk and Asset Allocation

  3. Static vs. Tactical Allocation

  4. Tactical Allocation

The Permanent Portfolio – an equal weighted allocation to stocks, bonds, gold, and cash – was devised by free-market investment analyst, Harry Browne, in the 1980s. The basic idea is that no matter what the macro environment, the portfolio will not totally crash and burn.

The American Experience

Turns out, the theory largely worked for US investors.

If you look at the rolling 3-year annualized returns of the Permanent Portfolio, never has it given negative returns. In sharp contrast to equities and gold, US bonds have been spectacularly stable. So naturally, an equal weighted allocation to all for assets delivered decent returns with low drawdowns.

Did it work for Indian Investors?

Indian investors need to be careful with their bond allocations.

The Permanent Portfolio allocates 50% towards fixed income. This is a problem for Indian investors because unlike US bonds, Indian bonds do not have a “flight to safety” bid – they tank along with stocks during market panics.

A density plot of annualized 3-year rolling returns highlights the left-tail problem with the Indian Permanent Portfolio:

Take-away

Beware of people preaching simple solutions to complex problems. If the answer was easy someone more intelligent would have thought of it a long time ago – complex problems invariably require complex and difficult solutions. – Steve Herbert

This is another instance of a “copy-paste” solution disappointing Indian investors.

The common thread connecting the misfiring of the 60/40 and the Permanent portfolios is the vastly different paths taken by Indian bonds. Is there a better way to crack this nut? Stay tuned.

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