Bitcoin, Volatility and Investment Risk, 14/05/2021
In a week when Elon Musk told us that we can’t buy a Tesla with Bitcoin, the Baxter household finished the immersive, binge watchable Medici’s on Netflix and volatility returned to markets.
Two questions from conversations with clients in the last week made me revisit the concept of investment risk and how we view it at Tideway:
· A learned friend of mine said we should be holding 15% of our portfolios in crypto currencies, what do you think?
· The high yield bond funds have delivered good returns but they have been as volatile as equities and I have had better returns in the equity funds, it seems I’m taking as much risk for a lower return on the basis that volatility is a good proxy for investment risk, that’s right, isn’t it?
It turns out that inventing new currencies, or ‘fungible’ assets which you can exchange for goods and services or other fungible assets is nothing new. By first cancelling off their reciprocal trade debts and interest payments with their trading partners and only settling the differences in physical coins, the 15th Century Florentine bankers and art patrons the Medici family and their contemporaries turned loans into fungible assets. The precursor to the modern bond market.
But just how fungible will crypto currencies become? Will they always appreciate in value and why are there so many? Are they just online betting around social media celebrity hype? Answers on a post card please.
What is clear is that the level of price volatility they have displayed and continue to display both short term and longer term tells you that nobody knew historically what they would be worth, no one knows today what they are worth, nor does anyone know what their future value will be. Without any underpinning intrinsic value, right now they are purely speculative bets, with huge propensity for capital losses. The only investment thesis I can see is that they have gone up in value so far.
Which brings me back to the questions above. What is investment risk? Is price volatility a good proxy for risk? And what do Tideway do about risk?
The best definition I can give for investment risk and how we think about risk at Tideway has three core elements:
2. Time horizon
In words, it is the probability of failing to make an expected investment return over a planned time horizon combined with the extent to which any failure might be.
If I’m investing £100,000 for ten years say and hope to make an investment return net fees of inflation plus 2% p.a. to have £122,000 in today’s money at the end, how can I make that return as certainly as possible? If I miss, how do I make sure I don’t miss by much? How do I reduce the chances of ending up with £60,000 in today’s money?
In short, the bigger the probability of failure and the bigger the potential for losses the higher the investment risk of an investment asset or portfolio. In early 2007 just before the Great Financial Crisis I listened to a talk by Andy Haldane now Chief economist of the Bank of England. In the Q&As that followed and to the question “what happens if interest rates fall?” He replied – “investment assets will go up in value and the ones we know least about will go up the most”. This one neat sentence succinctly explains Bitcoin’s meteoric price rise and its propensity to do damage if the speculators are wrong about its real value. When money is cheap people will speculate more and the best things to speculate on are those where nobody knows the true value. Make no mistake crypto currencies are high risk investments, they may deliver stellar and possibly the best returns over the coming months and years but their potential for doing damage to capital values and target investment returns are huge.
So, what about the bond fund volatility in 2020. It is true that it was equally as bad as equities when looked at on a daily priced basis, the peak to trough drawdown was pretty much the same as the equity funds. But when we look longer term over say 5 years, we can see fairly consistent returns from the bond funds which tend towards the yields on the underlying bonds, plus a premium earned from active management less fees. Looking forward today on our high yield bond funds we can still see a net of costs return of inflation plus 1-3% with pretty good certainty.
We understand these investments well and we know the short-term price volatility in 2020 was caused by very poor liquidity in bond markets which was fixed by central banks pretty quickly. The bond issuers weren’t going bust and all coupons have been paid. The more predictable returns offered by the high yield bond funds will continue to underpin our medium-term return targets while their capital preservation qualities help ensure that if we do miss our target returns it won’t be by that much. We didn’t get lower volatility but we have reduced investment risk by our definition.
Higher returns will probably come from equity markets and the longer investment horizon we have the more probable that assertion gets (although Japanese domestic investors who invested at the peak of the Nikkei’s bull market in 1989 are still nursing 28% capital losses 32 years later).
Investment risk and risk management is a big topic and one we will no doubt return to in these updates. As professional investors acting on your behalf it is a huge part of the value we can add and something very hard to do well when you are investing on your own with your own money. It is also something that often goes unseen with the media focus on winners not losers. How many articles have we seen on the stellar rise in US tech share prices versus the 32 year losses endured by those invested in the Nikkei?
Going back to Netflix, it turns out the Medici’s also had liquidity problems in the 15th Century in their pioneering bond markets. They generally fixed their problems with murder, intimidation, bribery, outright war, and the odd dodgy marriage, which makes for great entertainment!