The cryptocurrency market has crashed. It peaked sometime in May 2021 but has gone down since. Major cryptos like bitcoin and ether have gone down about 50% while dogecoin has gone down about 70%.
What I find amazing is how negative people get when prices come down. Based on historical price movements in the stock, property and crypto makets, the downturns are usually great times to buy.
Reaffirming the cake and icing analogy
Of course, as I mention in my previous post about cake an icing, crypto is highly volatile, so it should be considered the “icing on the cake,” the extra returns above and beyond the core necessary “cake” portion of your net worth. Suppose you can live off $40k per year comfortably and you had $1 million invested in a balanced ETF that generates about $40k per year. Then any investments beyond that can be as risky as you wish and it will not affect your lifestyle. Because you have created a solid safety net, you are able to tolerate higher risk, and taking on higher risk allows you to potentially have higher returns.
Of course, you need to be sure that you are comfortable living off $40k per year. If you lifestyle inflates, you will need a bigger “cake” which means you won’t be able to take on as much risk, which means your opportunities for larger gains become more limited.
One of the most common biases I’ve noticed coming out of the recent crypto crash is the anchoring bias, which Wikipedia defines as “a cognitive bias whereby an individual’s decisions are influenced by a particular reference point or ‘anchor’.”
A great example of this is seen in Pro The Doge, a 33-year-old man who put in US$180k into dogecoin, which was everything he owned. At the time, the price of dogecoin was 4 cents. Dogecoin went up to around 75 cents, which resulted in his net worth ballooning to about US$2.8 million. However, he did not sell, and dogecoin went back down to 19 cents, and his net worth now is approximately US$800k, which means he is no longer a US dollar millionaire.
Of course, what should Pro The Doge have done? Clearly he should have sold all his dogecoin when it peaked at about $2.8 million, and many people have criticised him for holding onto his crypto as it went down.
However, market timing is very difficult. There is a lot of evidence that most of us are terrible at timing the market. Pro The Doge could have sold everything at $2.8 million, but it is easy to criticise him in hindsight, and if any of us had the ability to pick the tops and the bottoms perfectly, we would become the first trillionaire on earth.
So I don’t blame Pro The Doge for not selling. My point is that those who criticise him are suffering from anchoring bias. There is no reason why the all time high of $2.8 million is the “anchor” and that his current net worth of $800k must be compared to the all time high, which results in a loss of about $2 million. If you change the anchor to his initial $180k, then suddenly he has increased his net worth from $180k to $800k, which is more than a 400% return.
This practice of comparing the current price to when you got in or what your average entry price is (if you dollar cost average into the asset) leads to strategies such as “playing with house money.” The idea behind the “playing with house money” strategy is that Pro The Doge should take out his initial $180k and convert it into cash. This way it is impossible for him to make a loss.
However, this too is anchoring bias. In the same way that the all time high is an arbitrary anchor, so too the price you got in at is also an arbitrary anchor. It is useful for taxation when calculating capital gains tax, but it is not useful for your personal finances.
To understand why this it the case, consider that Pro The Doge is still dollar cost averaging (or buying the dip) into dogecoin. If he were to sell $180k worth of doge and covert it into cash, he would crystallise capital gains tax, and then when he continues to dollar cost average into doge, he would covert cash back into doge. Why covert doge into cash and then right after convert cash back into doge again? You are just adding more transactions and triggering capital gains tax when you don’t need to.
According to the “house money” strategy, this is what he should do, but as I have shown, this is self-defeating because he would be selling and then buying back into doge when he continues to dollar cost average into it.
I recall watching a video of Pro The Doge buying about US$30k worth of doge after it crashed because he wanted to “buy the dip.” If he were to sell $180k worth of doge and convert it into cash (as per the “house money” idea) and then go on to buy $30k of doge afterward, he would have been better off only selling $150k worth of doge and incurring less capital gains.
What this example shows is that when you get in is irrelevant. What matters is the volatility of your overall net worth and whether you can tolerate that volatility. For example, suppose your net worth is made up of 99% cash and 1% dogecoin. Suppose dogecoin went up 5x and suddenly you have 95% cash and 5% dogecoin. According to the “house money” idea, you should sell 20% of your dogecoin such that you are only playing with house money. This would bring your portfolio to 96% cash and 4% dogecoin. So you have gone from 5% dogecoin to 4% dogecoin and the rest is in cash. In other words, this will have almost no impact at all on the volatility of your net worth.
What this example shows is that the “house money” idea is just another form of anchoring bias. What you should do instead, in my opinion, is look at the overall volatility of your net worth and see if you are able to tolerate that volatility. To know if you are able to stomach the level of volatility of your portfolio, you need to look at your necessary spending vs non-necessary spending and then work out what portion of your net worth is the “cake” and what portion is the “icing.” The “cake” portion should be made up of low or medium volaility assets so that you can reliably and comfortably draw down on it or generate passive income from it to cover your necessary expenses.
For Pro The Doge, it is hard to know how big his cake fund is. It is a personal matter that depends on not just your current obligations but also what your future needs are. For example, Pro The Doge currently lives in a studio apartment. However, if he feels that in the future he must live in a large house (e.g. if he plans on raising a family), he will need more money in his “cake” fund. However, if he is happy living in a studio apartment because it is lower maintenance and if he doesn’t want kids in the future, then he will be able to take on more risk.
Pro The Doge going all in on doge seems very risky to me, but it may be justified if he is comfortable living on little and keeping his obligations low.
How we understand risk tolerance
I remember when I booked in an appointment with a financial advisor to discuss my superannuation. It was a free meeting set up by my super fund, so I figured I’d book in time. At the session, I was given a questionnaire that set out to determine my risk tolerance. It asked me questions such as “are you willing to take on more risk if it leads to potentially higher returns?” Of course, I answered yes for that. Most people just want higher returns, so when they learn that you need to take on more risk in order to get higher returns, they will take on higher risk.
As a result of this meeting with the advisor, my super fund was set to a “high growth” strategy that was almost all in equities. Then the GFC happened and I have to admit that I was shaken watching money I saved disappear so rapidly. I experienced FONGO (“fear of not getting out”), and as a result I dialed down the risk in my super fund slightly to the “growth” strategy instead. However, once the markets went back up again, I suddenly felt FOMO (“fear of missing out”) and quickly scrambled to invest in equity ETFs and even to get a margin loan (which I still have today).
My point is that risk tolerance is something we need to experience to understand. It is normal, in my opinion, to think we can tolerate risk in order to gain higher returns, and this is why so many talk about tracking stock indices like S&P500 or the ASX200 but rarely talk about bond indices like the Vanguard Global Aggregate Bond Index.
In my opinion, we gain a better understanding of our true risk tolerance when we personally experience both FOMO and FONGO that comes from price volatilty. The problem with most people is recency bias. When prices shoot up, they feel FOMO and their risk tolerance is too high, but when prices collapse, they feel intense FONGO and their risk toleraence is too low. You need to remember how you felt when prices spiked and crashed and adjust your asset allocation accordingly such that you minimise both FOMO and FONGO.
I am also concerned about complacency due to constantly rising prices. Cryptocurrency has been rising for the past decade even when you consider the wild swings, but it is no guarantee that it will continue to go up. An asset class can keep going up even in the long run until it does not. However, this applies not just to cryptocurrency but also to e.g. the stock market. The stock markets of the US has gone up historically for the last century or so, which may lead many to think that it is inevitable that it will continue to go up. However, what if it doesn’t? This is why it is important to reduce risk and volatility up to the point where you are financially independent.
Conclusion about crypto
I do personally own cryptocurrency, but it makes up about 25% of my net worth, which is a level of risk and volatility with which I am comfortable. Most of my crypto is concentrated in bitcoin, ether and dogecoin.
If I had to advise on whether someone should invest in crypto or not, I am hesitant to advise them that they should because one of the biggest downsides of crypto is how difficult it is to secure. If you keep your money in a bank account, if you suddenly forget the password needed to log into your internet banking account, you can simply go through the password reset process or just walk into the bank and talk to somoene who can verify your identity and unlock your cash. There is a human element to the traditional banking system, but with crypto there is no human element, which is by design. If you lose your crypto mnemonic passphrase, your funds are gone forever. If you merely expose this passphrase to someone, they can sweep all your funds and it is impossible to reverse the transaction.
The future of crypto is uncertain, but I think over time crypto will become less volatile as the crypto world will integrate with the traditional financial system. We are seeing today bitcoin ETFs and large companies like Tesla investing in bitcoin, and conversely it is possible to buy tokenised stocks. All this shows that the two worlds are merging, and I speculate that this merging will continue into the long term. If these two worlds do merge, I speculate that the crypto world will be the main beneficiary as net value will flow from the much larger traditional system into the much smaller crypto system. As such, it is a good idea, in my opinion, to allocate a portion of your portfolio to crypto, but it should be considered the icing on the cake rather than the actual cake itself.