Ouch! That hurt!

Most of us who have invested in securities (stocks, bonds) this year have seen deep red splashed all over our portfolios. It’s been one harrowing ride after another, all this year. This, after a fantastic 2017, where the markets went only in one direction, that is up. Investors grew very complacent after they were lulled into seeing day after day of low volatility, with markets globally trudging ever higher. Almost everything went up, not just stocks… bonds, bitcoin… you name it. Even stuff like “Tulip Coin” and “Dogecoin”, were able to skyrocket in value. The Tulip Coin was literally referring to the Dutch Tulip mania and the Dogecoin was a joke currency based on Shiba Inu from the “Doge” Internet meme. Talk about irrational exuberance!… The saying “a rising tide lifts all boats” couldn’t have been any truer.

2018 has been a whole new ball game. Volatility is back with a vengeance. The indices have been whipsawing violently with a +/- 2-3% gyration almost on a daily basis. Most of the major world indices are in bear market territory (-20% from the top). The crypto currency space has bitten dust as I predicted. Bonds are threatening to go into a protracted bear market after 3 decades of bull run. The adage “all good things come to an end” has proven itself to be true again in 2018. What should one do in such a scenario? Ordinarily, I would have said “nothing … just stick to your investment plan through thick and thin” and this is exactly what I am doing. But I think there is a more fundamental issue to be addressed before I just say “stick to the plan”. I think the key issue here is the “plan”, which in my case means the asset allocation plan. Let me explain…

Over the past year, I have been helping out a few individual investors to come up with an asset allocation plan. When I asked, before I started with the plan, almost everyone said they were very risk tolerant and wouldn’t lose sleep even if the losses were up to 50% of their portfolio value. I took their word for it and derived an aggressive stock heavy asset allocation plan. Now that they are seeing real losses, not 50% but just 5%, they are losing sleep and want to change the strategy to a more conservative one. I learnt a valuable lesson, never ask people how much risk they can take, as it would be very difficult for them to quantify, especially given that there hasn’t been a real bear market since 2012-13, in India, and most individual investors have pumped in huge amounts of money into the stock market only in the past couple of years. They simply don’t know what it feels like to see their portfolio suffer 20-25% loss in value.

Where there is a lack of experience, people tend to overestimate their ability to endure pain. This has a real base in psychology as well – the Dunning–Kruger effect is a cognitive bias in which people of low ability have illusory superiority and mistakenly assess their cognitive ability as greater than it actually is. I think this same effect is applicable to risk taking ability as well. People without actual experience tend to say that they have more risk taking ability than they actually do. Only when they are really hurt do they realize how much risk they can actually take.

Given this, when one starts investing, how does one arrive at one’s real risk appetite? Especially if one hasn’t suffered painful losses before? The only alternative I can think of is based on an honest appraisal of one’s risk appetite with the aid of risk attitude assessment models. The “Assess your attitude to investment risk” is an assessment model developed by Oxford Risk, an independent team of leading psychology academics originating from Oxford University. There are many such models available on the internet.

So, to every Investor, even before attempting to create an investment plan, please do asses your ability to take risk and use that as an input to derive your asset allocation plan. Things also change as time passes by, so, do assess your risk appetite once in 5 years and course correct your asset allocation plan accordingly.

I would like to end this topic by reciting an incident out of J.P. Morgan’s life, as it relates to seeing losses in one’s portfolio. When a friend complained, to Morgan, of restless nights, worried about his stock holdings, Morgan’s advice was to “sell down to the sleeping point.” This is very sage advice.

Lastly, I’d be remiss if I didn’t say “do nothing … just stick to your investment plan through thick and thin”… you’ll come out fine on the other side. Also remember, don’t bet on individual stocks, finding winners would be like looking for a needle in the haystack. It’s better to buy the whole haystack, i.e. the market, you are bound to have many needles in it. Also diversify geographically if possible.

With that said, I wish all my readers a very happy new year, may your investments touch new highs in 2019.

Icarus has fallen….

As you might have noticed, I have been on a longish hiatus from blogging. This is because I was preoccupied with other things. I will definitely try to stick to the fortnightly post cadence going forward.

I guess most people would have heard about the Greek mythology of Icarus. If not, it is a fascinating tale of how complacency and hubris cause the greatest of falls.

Jacob Peter Gowy’s The Flight of Icarus.

The story of Icarus

A long time ago, Crete was ruled by King Minos and there, in his palace of Knossos, was a master craftsman named Daedalus, famous for his sharp intellect and clever mind. Daedalus was the Minos’ chief architect. Years passed and Daedalus fell in love with Naucrate, a mistress-slave of the king, and married her. They were blessed with a child whom they named Icarus.

Life went on without incident until one fine day Minos called upon Daedalus. He wanted the architect to design and build an enclosure for the Minotaur, a creature with the body of a man and the head and tail of a bull. This monster in truth was the son of Pasiphae, Minos’ wife, but not by the King himself. Years ago, following his ascension to the throne of Crete, there had been much squabbling amongst King Minos and his brothers. Minos had fervently prayed for a sign from Poseidon to assert his claim to the throne. The sea god, impressed with Minos’ devotion, had sent him a snow-white bull as an omen that he should be ruler supreme. Overjoyed, Minos had vowed that he would sacrifice the bull to the sea god, but consumed by avarice, he kept the bull for himself. Angered at Minos’ disrespect and betrayal of trust, Poseidon avenged himself by cursing Pasiphae to fall in love with the bull.

Filled with desire for the bull, Pasiphae asked Daedalus to construct for her a hollow wooden cow. Getting into the strange contraption, she made amorous advances towards the bull. Their bizarre union resulted in the birth of the Minotaur which was half-man, half-bull. Ashamed at his wife’s deed, Minos wanted to hide the monster which was growing violent and gigantic day after day. For this reason, he asked Daedalus to build a labyrinth for the beast, a structure with many twists and turns where a person could get lost interminably. Such was the intricacy of the edifice that even Daedalus had a tough time finding his way out.

The Minotaur was kept at the center of the labyrinth, hidden away from prying eyes. It had to be fed with young people and was the horror of Minos’ enemies and subjects. But unfortunately for Daedalus, the King imprisoned him and his young son, Icarus in a high tower, so that they couldn’t reveal the secret of the labyrinth to anyone.

Daedalus and Icarus were languishing in their prison atop the tower. Every day the master craftsman would ponder over their escape and how they could work such a miracle. He suddenly realized that their only escape route was by air since King Minos had control over every vessel that left the island. Moreover, Minos had issued strict orders to search thoroughly every ship leaving Crete.

Instead of growing impassivity over their fate, Daedalus came up with a marvelous plan. He had observed the birds that were flying around the tower. He studied in great detail their mannerisms and hit upon an idea of how to escape. For a large period of time, he was gathering all the feathers he could find lying around and joining them together with wax. He fashioned two pairs of wings, one for himself and the other for his son. The day arrived when they were to execute their escape plan but Daedalus had a grave warning for his son. He forbade Icarus to fly too close to the sun for that would melt the wax, or to fly to close to the sea for that would dampen the feathers. Father and son both then perched on the edge of the tower parapet and leapt off. Flapping their wings furiously, they were able to emulate the birds and in no time, were flying over the sea, putting great distance between themselves and Crete.

It was a whole new experience for Icarus. He, a man, could now fly like the birds. After a while, unfortunately, Icarus, filled with complacency and hubris, soon forgot his father’s warning. He was so filled with the exhilaration of flying that he flew too high and too close to the sun. The intense heat melted the wax on the wings, the feathers came loose. A few minutes later, poor Icarus plummeted down into the sea and was drowned. Daedalus was struck with horror but there was nothing he could do to save his son.

Source: www.greeka.com

Most investors are no different from Icarus. They get so drunk on their abilities when things go right that they lose the ability to pose, what I call,  the “what if” questions. They fail to understand that what goes up very quickly must come down equally rapidly. Reversion to the mean is as true in investing as 2+2 is 4 in arithmetic.

It is always complacency and hubris before the fall. A classic example of this is the Midcap and Smallcap rout that the Indian markets are going through now. All the market pundits who professed, on business news channels, that Midcap and Smallcap stocks will continue the momentum they had in 2017 are nowhere to be seen now. Everyone’s a pundit/genius stock picker when things are doing well. Warren, in his inimitable style, says it best

“Only when the tide goes out do you discover who’s been swimming naked.”

The tide has definitely gone out for the NIFTY Smallcap 100 index. It has almost given up 2/3rds of the gains it made in 2017. I wouldn’t be surprised if it gave up all the gains of 2017 and then some. Who knows, I don’t, and I also don’t pretend to know. Some constituents of the index have even lost up to 80% of their value from the peak. People were blindly piling on stock of companies which had gone up tremendously, without much regard for the fundamentals of the business. It was a pure momentum play. Mr. Market, as Ben Graham put it, can swing, on a dime, from being euphoric to manic depressive. Even before you could say “what’s happening”, you could have lost half your portfolio, especially if you bought things at the top. People’s hubris is what I blame. They still feel that they can somehow, with minimal effort, by following stock tips from business news channels or newsletters, can generate superior returns. Nothing could be further from the truth.

Nobody can absolutely time the market. The only safe way to generate long term returns, for most retail investors, is to systematically invest, diversify, periodically re-balance and, last but not the least, check hubris and emotions at the door.

Mythology has a lot to teach, especially Indian and Greek ones. If you don’t learn from others’ experience, you are bound to learn from your own. So, let’s not be victims of complacency and hubris. Let’s not suffer the same fate as Icarus, who didn’t heed to his father’s advice.

Bitcoin & The Duck Test!

The Duck Test is a popular form of Abductive reasoning. It is based on logical inference, which starts with an observation, and then seeks to find the simplest and the most likely explanation. It goes something like this…

If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.

The test implies that a person can identify an unknown subject by observing the subject’s habitual characteristics. A more generic, heuristic based problem solving approach is found in Occam’s razor, which is attributed to William of Ockham. In all its simplicity the Occam’s razor says…

The simplest explanation is usually the right one

Using these principles on Bitcoin price action: if it looks like a bubble, behaves like a bubble and feels like a bubble, it probably is a bubble.

I stuck my neck out and called the farce on cryptocurrency here. I am more convinced than ever that this is a bubble.

Each asset bubble goes through 4 Phases. Now look at the price action of Bitcoin.

This, to me, looks like a classic bubble which is in the Blow off Phase. In fact, it has followed all phases of the bubble life cycle to the T. Now, let’s look at some of the other classic bubbles in history.

Do they look familiar? Bitcoin enthusiasts say that this time it is different from the Dutch Tulip Mania or the British South Sea Company bubble. Isn’t it always?

The bubble is always fed by people who are out to make a quick buck and understand nothing about the underlying asset they are investing in.

See the WSJ video on bubbles and read the article below which was published on the 29th of November 2017.

https://video-api.wsj.com/api-video/player/v3/iframe.html?guid=518F37A8-B7B4-43AC-869E-6F0B3568EAB6&shareDomain=null

Source: WSJ

Bitcoin Mania: Even Grandma Wants In on the Action

The digital currency has gone from tech curiosity to mainstream topic, leading its value to jump more than 10-fold in 2017

By

Peter Rudegeair and Akane Otani

Nov. 29, 2017 6:04 p.m. ET

Rita Scott’s grandson convinced her in mid-November to get in on the latest investing sensation and buy bitcoin. “I thought it was a big coin,” the 70-year-old said. “I didn’t even know what it was, a piece of coin? Why would I invest in a piece of coin?”

With a few hundred dollars of her money invested in it, Ms. Scott quickly caught on and started checking the price several times a day, even while playing poker at a casino in her hometown of Las Vegas.

Late Monday, as the price approached $10,000 for the first time, her grandson, Anthony Santa, sold the bitcoin that he and his grandmother held, netting what he said was a gain of around 45% over just a few weeks.

That was prescient. While bitcoin later topped the $11,000 mark—reaching its highest level in its nine-year history—the virtual currency tumbled more than $2,000 later Wednesday as several exchanges struggled to handle surging volume. It rallied again later to trade at $10,214.

“Believe me, I didn’t have this much fun with T. Rowe Price,” said Ms. Scott, a retired secretary and taxi driver, referring to her mutual-fund investments.

Bitcoin, a stateless digital currency that shares some investment characteristics with gold, has captured the imagination of investors.

As its value has doubled since mid-October and risen more than ten-fold in 2017, the currency has transformed from a curiosity among techies to a hot topic for mainstream investors.

But the speed of its ascent has some warning that it will end in tears. And, as Wednesday’s quick reversal shows, bitcoin is extremely volatile—the currency has declined more than 50% on eight separate occasions since 2011.

Another source of concern: The latest move higher in bitcoin’s price is drawing in more individual investors.

“They see the price break $10,000, obviously they see the news, they hop on their app and go ahead and buy bitcoin,” said Bobby Cho, head of over-the-counter trading at Cumberland, the cryptocurrency unit of a high-speed trading firm in Chicago.

Paul Joseph Spelce, a 22-year-old graduate student in New York, was one of the newcomers who bought in. Over Thanksgiving dinner with friends last week, the conversation was dominated by talk of bitcoin. “Even this woman who didn’t have a computer at home couldn’t stop talking about how bitcoin was going to reach $10,000 soon,” Mr. Spelce said.

After stewing about it over the weekend, he pulled an all-nighter poring over articles about bitcoin’s rise. He repeatedly searched the price of bitcoin on Google.

At about 6 a.m. Wednesday, he placed an order to buy $50 worth of bitcoin on Coinbase. Hours later his position was up about 11%. Then it was down 9%. “When I clicked, it was just one of those feelings. I’d finally read enough, finally felt confident enough to do it,” Mr. Spelce said. “My friends all think I’m crazy.”

Friends of Tony Horsely in Atlanta have been more understanding. The 78-year-old investor began investing in bitcoin over the summer just to add some spice to his portfolio. Soon, he moved about 5% of his portfolio into the coin and an exchange-traded fund based on the currency. He started writing a periodic, informal note to about 30 friends, in which he talks about bitcoin’s price dynamics and the logistics of buying it.

“I’m late to the game,” he said, “but I’m enjoying it.”

While some of his friends have expressed doubts, Mr. Horsely says about half a dozen joined him in buying. Meanwhile, he has accelerated his purchases, picking up more bitcoin on Nov. 24, and then Wednesday morning.

The fervor for bitcoin has been global. Tom Reaney, owner of the Burger Bear restaurant in London, started accepting bitcoin about five years ago after a customer asked to pay for some bacon jam with the virtual currency.

Recently, nearly as many people ask Mr. Reaney about investing in bitcoin as using it to pay for a meal. “It’s quite lucrative,” says Mr. Reaney, who owns seven bitcoin. Even though he views a drop in price as inevitable, he says “I don’t want to pull my money out because it keeps going up.”

But bitcoin’s volatility is making many conservative investors hesitant, some of whom work in finance.

At the Asia Securities Industry & Financial Markets Association’s annual conference in Hong Kong on Wednesday, only two of about 150 professional investors raised their hands when asked if they had invested during a session on cryptocurrencies.

“It’s incredible that we’re [seeing this] at a finance event, but it’s actually very common,” said the panelist Henri Arslanian, PwC’s China and Hong Kong leader for fintech.

Mr. Arslanian, who also teaches a fintech course at the University of Hong Kong, said when he asks his students that same question, usually about 30% of them say they own virtual currencies.

He said in the past few weeks he has received so many requests on how to trade cryptocurrencies that he has put together “a template response.”

While individual investors might be piling into bitcoin, some are cashing out quickly, potentially adding to the currency’s volatility.

Nathan Hoyle, a 27-year-old Londoner training to be a Navy pilot, bought £1,000 worth of bitcoin in September as a “curiosity,” he said.

When he saw the rally picking up steam, he decided he would take his profit and run if it got close to $10,000 from the $3,500 level where he bought it.

When the price rose above $9,800 Wednesday, that was close enough. He said he sold his position, booking a £1,780 profit. “Now, I’ll wait for another price crash and buy again,” Mr. Hoyle said.

—Paul Vigna, Christopher Whittall and Georgi Kantchev,Steven Russolillo and Alexander Osipovich contributed to this article.

When grandmothers who know nothing about what they are investing in, but are blindly investing because it is fun and because they are making a quick buck, that is the time one needs to be very afraid about the bubble bursting very soon. In retrospect, since November, 2017, when the article was published, Bitcoin went close to $20,000 and is now back at around the $10,000 mark. I wouldn’t be surprised one bit if Bitcoin goes higher from here before the bubble starts to deflate decisively and it reaches a value which is a mere fraction of where it is today. When that happens, don’t blame me for not warning you! Till next time safe investing.

Read the disclaimer here.