Understanding Risk

Picture this.

Bob got into Bitcoin in October 2020 at a price of 11,483 USD. He just wanted to dabble in cryptocurrencies and invested a mere 1% of his net worth. He first learned about Bitcoin from one of his crypto friends, and there was increasing hype around it in the media and his social circle.

What followed were exciting months for Bob. Bitcoin climbed a staggering ~400% from his purchase price to 57,000 USD in February 2021. At this point, he was convinced of his own intellect and believed that Bitcoin was the asset that would turn his future around. Even though there was a 40% drop from March to June 2021, Bob was undeterred, believing it would bounce back. He thought that since Bitcoin is a finite resource, it would appreciate over time. He had faith in Bitcoin. Impressively, the price of BTC continued to rise, increasing sixfold since his purchase to around 65,000 USD in November 2021.

However, because he made his purchase purely based on faith, there was nothing substantial to back up his rationale for the investment. For one, Bitcoin is a non-productive asset. It doesn’t generate cash flows, and it’s incredibly difficult to value using standard valuation methods. Bitcoin’s value could only increase if someone else was willing to pay more for it.

Bob knew this, but having seen his money in Bitcoin grow sixfold, he couldn’t help but believe in it. He didn’t know why, but the value was going up, and that’s all that mattered. He was convinced of the following:

1. Bitcoin will always go up in value.
2. Buying the dip and holding no matter what is a safe strategy because of the first point.

After seeing the market value of BTC recover in November 2021, Bob thought that Bitcoin was in for yet another bull run. The momentum was strong, everyone was talking about it, and he was convinced that “the sucker’s going up.” So he brought out more of his life savings and put them into Bitcoin whenever it experienced a drop of 4% or more in price. Bob was confident in his investment strategy and began sharing his success with Bitcoin to his peers. In doing so, he subconsciously reinforced these ideas in his mind. Things he was unsure about began to sound like prophecy the more he shared (e.g., a simple extrapolation of the graph showed that Bitcoin would reach 100,000 USD by June 2022). His conviction increased the more he preached about Bitcoin, and he kept adding to his position. At times, he took on debt to finance his lifestyle, as most of his life savings were in Bitcoin. At the rate Bitcoin’s price was appreciating, he believed he could always make the money back in the future, and then some.

He fantasized about multi-million dollar mansions, fancy sports cars, expensive meals, and became ever more impatient in his pursuit of wealth. His greed led him to put as much of his wealth as he could into Bitcoin and simply wait for it to rise. He became even greedier and leveraged his position to increase his exposure to Bitcoin.

Traditional financial valuation became a myth.

Soon after, the collapse of FTX happened. The price of BTC contracted 73% to 16,841 USD in a year. Remember, it takes a 100% gain to recover from an initial 50% loss. Over time, he kept adding to his positions, thinking that buying the dip was the way to go (see point 2). The additional life savings he put into Bitcoin in November 2021 were now worth 27% of their original value. The amount lost in this incremental investment was more than the amount he had gained from his initial foray into Bitcoin. Thankfully, he didn’t leverage much, so even though he received margin calls, he didn’t lose everything. At this point, Bob had lost a substantial portion of his life savings, and his portfolio was still in the red.

With no way of valuing Bitcoin concretely, Bob was clueless as to whether it was safe to keep buying more Bitcoins or if it would keep dropping and he should close his positions. Would he continue to lose more of his life savings? Every day he checked his portfolio, and 9 out of 10 days, it was in the red. He was stressed, depressed, losing sleep, and his work performance had dropped. Nothing seemed to be going well for him.

After buying the dip with as much cash as he could afford, he continued to see his portfolio decline. He could no longer “buy the dip” and was watching helplessly as his life savings evaporated.

Later on, he started to sell some of his Bitcoins. This was in part to fund his daily necessities and also due to a loss of hope in the cryptocurrency. He began to think that investing was all a sham, that he got played by the “whales” or the “smart money,” that it was a pump-and-dump scheme and the game was rigged against him.

In January 2023, Bitcoin started to recover. By now, Bob had sold off nearly 80% of his Bitcoins. But his recent experience left him scared and wary. He was reluctant to let history repeat itself and stood idly by watching the price of Bitcoin rise. There was an anchoring effect at play. Having watched his portfolio suffer for so long, he was now convinced that Bitcoin would fall back to the low price of 16,841 USD. While he had accumulated some cash from selling most of his Bitcoins, he refused to “buy the dip” anymore.

Today, the price of Bitcoin is at 97,513 USD. It has risen another 5.7x since its low in November 2022. Bob watched his friends earn money on this new bull run of Bitcoin, and he blames himself for not having jumped on this new opportunity sooner.

It might be interesting to point out that at this point — the spectacular gains that Bob has initially generated from Bitcoin has mostly been wiped out. Recall that success in investing is the accumulation of long-term wealth. Bob is in not much of a better state now than when he just started, but people only ever heard about his gains and not his losses.

At this point, some of you might think — why not just sell at the top and buy at the lows? The answer is in the sentence itself. “Top” implies that you have seen a reversal of the bullish trend, with the benefit of hindsight. Few are able to time the market successfully, consistently. The same goes for “lows.” Don’t get overly complacent in your ability to predict the future. What’s more, in the moment, greed may compel you to hold on to a clearly overvalued asset, and fear may compel you to sell an undervalued one. The market is a cruel teacher.

Even if you make a lot in the short term, there’s no point if you lose it all in the end.

So. Do you think Bob should buy back in?

History doesn’t repeat itself, but it often rhymes.

— Mark Twain

Sir Isaac Newton, one of the brightest minds in human history, lost a fortune in the South Sea Bubble in a similar fashion to Bob. One can also look up the Tulip Mania and the Dotcom Bubble as real-life examples of this story.

There is a pattern here. While the exact details of the hypothetical story about Bob don’t exactly match many past cycles, the greed, fear, and hope that Bob experienced are common for many investors.

Circling back to the topic of this article, risk in investing should be measured by an educated estimate of how much money you can lose in an investment. If you don’t understand an investment and base your decisions on hopes and prayers, you might as well throw your money into a bottomless pit.

Traditional finance theory disagrees with this definition of risk, but it doesn’t make much sense to me. Investing is a game of building wealth; hence, don’t lose money. How is it that higher returns beget higher risk? Sure, you can get into the formulas of finance theory, but the definition of risk that those formulas are based on deserves some questioning.

A company that offers high returns and is valued at a discount to its intrinsic value is a low-risk investment. A company that offers low returns and is valued at a premium to its intrinsic value is a high-risk investment. Heck, a company that offers high returns but is valued way above its intrinsic value is also a high-risk investment. Recall that risk is the probability of losing money. One misstep from the company, and if investors’ expectations grow pessimistic, the stock price tanks. That’s risky! Thinking from first principles, isn’t this a better way to consider risk?

There’s a saying that “Hindsight is always 20/20.” Seeing that the price has appreciated significantly in the past does not automatically imply it will continue to do so. In the past, you also wouldn’t have known what you know now with the same degree of certainty. Making an investment without knowing or trying to understand its underlying value is a fool’s errand—you simply have no idea how much you can lose, which could have guided your investment decisions and offered you a good night’s sleep.

Almost everyone in the financial market knows about Bitcoin. Many think that one can make life-changing money with Bitcoin and continue to pile their life savings into it. However, unbeknownst to most who refuse to look beyond their standard echo chambers, there are many small-cap companies that have appreciated as much or more than Bitcoin, backed by real value (i.e., they generate actual cash flows and are productive assets). From 1st January 2024 to today, 10th December 2024, Bitcoin appreciated by a “mere” 124%. On the other hand, TSS, Inc., a micro-cap, has appreciated by an incredible 3100%. That’s 31 times your initial investment in TSSI compared to 1.24 times in Bitcoin. There are many more opportunities than what’s hyped up in the media, and it’s up to us to find them. As Peter Lynch aptly put it, “The person that turns over the most rocks wins the game.”

P.S. In hindsight, perhaps I should have used NFTs as the example instead of Bitcoin. There are increasing practical uses of Bitcoin with a newly elected Trump administration that’s likely supportive of cryptocurrencies, but I simply don’t know how to value it, so I’m staying away. By considering the consequences, I’ve written this article to remind myself of what makes sense to me, lest I start being emotional with my investments. Greed is a difficult emotion to control, but it’s a necessary one to master in investing. The ideas presented may prove wrong in the future, and it serves more as a journal than an informative post, so take it with a grain of salt.