I have a friend who is a crypto fanatic. He is also very knowledgeable about the emerging asset class and has made a lot of money investing in it. In my opinion, the flawed point in his thinking is that he views percentage returns as the overwhelming case of the asset.
Because the speculative risk asset grows 500% in five years, that means it’s a good investment, among other factors. This approach is too heavily weighted in terms of return but does not take into account the mother of all investment decisions: what risk are you taking to get the return?
In finance, many professionals and insiders look at the unit of return per unit of risk. These people usually manage a lot of money, but this concept is just as important for small retail investors. Take Apple, for example, which has a compelling profit, cash flow, and brand history. We can prove these metrics scientifically. Hypothetically, let’s say Apple grows 6 times or 500% in five years. In comparison, crypto-asset A does the same over the same five years with agonizing volatility, sleepless nights, and multiple drops of 80%. In this hypothetical case, those assets give the investor the same percentage return, but Apple investors are much better off. They get the same return with less volatility and risk than highly volatile and speculative crypto assets.
Bitcoin could be one of the worst performing assets this year judging by its returns in terms of volatility. It rose to almost $ 64,000 in mid-April and is now about half that amount.
The Sharpe Ratio helps investors understand the return of an investment relative to its risk. The risk-free rate of return is the return on a risk-free investment, that is, the return that investors can expect without taking any risk. The yield on a US Treasury bond, for example, could be used as a risk-free rate. In general, the higher the value of the Sharpe ratio, the more attractive the risk-adjusted return.
Another way to look at this is to consider the risk of young black men being killed after seeking a financial return in the music business. Chicago rappers face affiliation risks with hardcore gangbangs and threats on YouTube and Instagram against other gang members. Let’s say the market opportunity to raise the stake and make more threats means a million dollar paycheck from record companies or direct selling.
The riskier you are and the more fans follow you, the more controversial and hardcore you look. Is the million dollar salary a good deal for the rapper, who does 20 diss tracks on YouTube to help him get his million bucks? The rapper is an investor. Everything looks good when you just look at the positive side – the check.
When we factor in the risks, the statistician and financier will say the rapper has a high risk of being killed or paralyzed in an attack by one of his victims based on historical patterns and data – the science . The scientist will say that the rapper is taking too many risks for that million dollars because there is an 80% chance that he will be murdered. The rapper might respond and say, “After I got my million dollars, I’m still alive. You are wrong! Because I haven’t been shot in the past three years, it means my investment was smart and savvy.
The three-year time horizon may not be enough to capture the real risks of what has been said and done. Someone could always come back after and murder the rapper. Most reasonable people who value life would agree that maybe $ 1 million return on investment is not worth the 80% chance of being murdered within five years. Sometimes we need time for the hot markets to return to the science of proven investing.
My main point is that it pays to be aware of how many units of risk we take for each unit of return. Just because a crypto has grown more than 500% in five years doesn’t mean you are compensated for the high risks you take. You may have to accept a lower return for a lower risk profile. Alternatively, you may be able to find another asset that can potentially achieve a similar return, but with significantly lower volatility and risk profile. Like Apple, outperforming while having a lower risk profile than the broader stock market and a significantly lower risk profile than the highly speculative crypto market.
Always be aware of the risks you take to get your return and whether you are sufficiently compensated for the risks. The Chicago rapper who took the million dollars could be murdered in the fourth year. He looked smart in third grade but was murdered in fourth grade. The bubble head only looks at the P in an income statement, only looks at the positives, and leaves out the potential negatives. The bubblehead does not consider returns on investment based on return on investment per unit of risk. What looks like a good deal based on past parabolic returns in a massive speculative bubble, probably isn’t.
I explained some of the risk factors for the potential crypto collapse and a larger speculative bubble on my April 11, 2021 podcast.
Listen to GHOGH with Jamarlin martin | Episode 74: Jamarlin Martin Jamarlin returns for a new season of the GHOGH podcast to discuss Bitcoin, bubbles and Biden. He talks about the risk factors for Bitcoin as an investment asset, including origin risk, speculative market structure, regulation, and environment. Are the financial markets at large in a massive speculative bubble?
What I’m saying isn’t sexy with the popular crowd because while everyone’s partying I’m bringing risk factors to the picture by watching past parabolic bubble returns. Brokers, exchanges, bubble pumps and marketing charlatans will keep things one-sided, focusing only on the opportunity to return in favor of the bubble. Thinking about risk first, before profit, will keep you in the game longer, in life and in the markets.