I love bitcoin and believe that everyone should understand the reasons for growing interest in the revolutionary technology, if not own a piece of the ledger. I’m always looking for analogies to share the concepts with friends and family. When thinking about investing in bitcoin, I like to use venture capital as an example of the risk tolerance, return profile and due diligence.
Venture Capital (VC) is early stage investment into a company with a high probability of failure and vast returns, if successful. For example, two venture capital funds bought 15% of Facebook for $12.7mn in 2005, which was worth more than 1000 times more when it IPO’d for $15bn in 2012. Great returns but there are reams of failures – MySpace, Vine, YikYak, etc where investors lost capital. Most VC investments don’t return capital. So high potential return but high risk because they’re looking for diamond in the rough.
Valuing early stage companies in new markets is difficult. Think of Facebook in 2005, no revenues, very few assets, just ideas, and visionary people. All these risks require significant due diligence on the people, the ideas, the market and their finances. The average man on the street is unlikely to access venture capital investments due to the capital required to make a difference and the regulatory barriers to investment. But, even if you had the capital and access, the due diligence required to assess the investment implies that they’re are often unsuitable. A limited number of people have the time and know-how to determine whether Facebook would’ve been profitable in 2005.
Investors put asset classes onto a risk-return scatterplot like the one below to visual the spectrum. VC is on the top right side of the spectrum, with high risk and reward vs. more traditional asset classes. Risk is a notoriously difficult term to define so I avoid using one measure, but think of volatility, drawdowns in price, illiquidity, uncertainty and the risk of not doing due diligence are factors that should be considered.
Bitcoin has similarities to VC, in terms of risk, return and due diligence.
Competing with global payments networks and traditional store of valuable wealth is a massive task! Bitcoin is up against central banks, treasuries, banks and the monolithic state. Since bitcoin is a new and misunderstood technology, it’s not particularly well regulated. This is huge opportunity for innovation and growth but also a risk. There are many charlatans in the industry who could (if you’re not careful) steal your wealth.
Bitcoin is an audacious project and with VAST return potential if it is successful. Greater than 200% annualised returns since 2010 are eye-watering and attractive! But bitcoin’s price is also very volatile, which makes it a very uncomfortable and emotional experience. 50% declines in the price can take place in a few days! The most mundane measure of risk is volatility or standard deviation of returns. It’s got tones of weaknesses but it makes the point. Comparing the stylised graph above with a scatterplot of actual risk vs. standard deviation of monthly returns since 2010 shows that bitcoin dwarfs its traditional asset class peers.
As I’ve said, standard deviation of returns can be misleading. Some people don’t care much about the volatility of their investments. If you’ve got a long timeframe, should you care about short-term volatility of your investments? And in a portfolio construct, overall volatility is reduced through adding a volatile but uncorrelated asset class with the rest of the portfolio (very NB point that I’ll cover in another post). Volatility isn’t necessarily the enemy, but the scatter makes a sound point. At the extreme, does a granny in her 80s want to invest into bitcoin? Probably not – she doesn’t need the long-term returns and the extreme volatility is dangerous for someone who has no future income.
Considering VC and Bitcoin’s relative position on the risk-return spectrum, think about the due diligence. The average investor allocates capital to a fund manager or pension fund. Perhaps they’re a little more sophisticated and they buy an investment index, or an underlying company. Each step further down the spectrum requires a little more due diligence, a little more know-how. Now consider that fund managers, pension funds, indices and equities are still regulated so there are layers of oversight. Oversight doesn’t mitigate against fraudulent disasters like Steinhoff so don’t get complacent. Regulation and layers of oversight are also costly and could erode returns! But regulation provides investors with some degree of security that they have got someone looking after the investment on their behalf so that they don’t have to conduct the due diligence.
With bitcoin, the onus is on you. There are a few investment funds available but most people purchase bitcoin in their private capacity. That’s a great outcome but it has risks. People will benefit from learning more about the financial system, banking and the negative impact of the status quo on our society. Society needs a revolution in money and banking and bitcoin is certainly an element in that process. But don’t discount the due diligence required and the rabbit hole that you might fall into when you start this journey. I’m convinced that the bitcoin isn’t fraudulent, but I invested a lot of time before I was able to come to this conclusion.