Crypto-currencies Are Raw Human Emotion

If there's one noticeable trend that is going through a massive wave right now it is most certainly the crypto world. Due to its crazy dynamics and underlying setup, crypto-currencies might be the best example of human emotions mixed with investing since the tech bubble. It also might go down as one of the biggest booms and busts in the entirety of financial market history--on par with the Tulip Mania, Japan, and the South Sea Bubble.

The peak market cap of the major crypto-currencies reached over $800 Billion in January 2018. For some perspective, that's larger than the entire economy of countries like Turkey, the Netherlands, and Switzerland. It's bigger than the combined economies of Nigeria, South Africa, and Kenya. It's bigger than Google, Microsoft, Amazon, or Berkshire Hathaway. All in bits and bytes that don't provide any revenue or production whatsoever! If that's not raw human emotion and madness of the crowds, I don't know what is.

Two of my favourite books, and must-reads for any serious investor, are Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and Devil Take the Hindmost by Edward Chancellor. While Chancellor's book focuses almost exclusively on financial markets, Mackay's book also includes topics from fashion trends to fortune telling. They are great reads on crowd psychology--a very important factor in successful trading.

Crypto Factors

While I have done a decent amount of reading trying to understand Blockchain technology, I still don't entirely grasp the whole concept of the associated coins (or tokens) and why they carry some significant valuations. Sure, Blockchain has the potential to be game changing in terms of contract making, record keeping, legal tracking of property rights and ownership, and money movement.

I think the Ethereum platform in particular is doing some very cool things in these areas and more. Perhaps not ironically, Ethereum's co-founder and chief brainiac Vitalik Buterin (a fellow Canadian) is one of the biggest critics of high valuations for crypto-currencies.

So... while Ethereum is busy downplaying the valuation of its associated tokens and is doing cool things, the biggest crypto-currency--Bitcoin--has always seemed a whole lot more shaky to me. I've found Bitcoin to be strange in its allure and freakishly fraudulent in its promotion. It's actually the perfect fraud in many ways with all kinds of big red flags waving in your face: it's unregulated, the real coin holders are not traceable, invest is heavily promoted to the public by people with a vested interest, the platform has created an illusion of scarcity, and it's been adopted by a generally uneducated, inexperienced public market (in an investing sense, of course). Consistent with other famous bubbles, the higher it went the more outlandish the claims of valuation became. Predictions of Bitcoin $5,000 somehow became Bitcoin $1,000,000.

Another strange concept is the underlying valuation arguments for Bitcoin. The idea that a currency written by computer code and horded by its buyers can somehow be truly scarce is absurd. Yes, I understand the code only permits around 21 million Bitcoin to be released, but it's still just computer code and entirely non-tangible.

If some investors argue gold as a currency is useless, Bitcoin as a currency is really, really useless. At least gold looks pretty, has some industrial and jewelry usage, and is tangibly scarce making it a great representation of a store of wealth. Nevermind the fact that gold has been used as a currency and to measure of wealth for thousands of years. The suggestions that Bitcoin is a form of digital gold is totally insane.

What does Bitcoin really do and what value does it bring? Hell, the most valuable part of the whole thing, the Blockchain ledger concept, is open-source and free for anyone with moderate to great programming skills to copy and modify for their own use as they see fit. By nearly every metric, there are other Blockchain platforms which are now much better than the Bitcoin platform in every way.

The only other valuation argument, the cost of "mining", is also a type of Ponzi scheme in itself. The more popular Bitcoin becomes, the more miners jump on board to process transactions, the more expensive the mining process becomes. Nevermind the insane amounts of electricity and computing power being wasted.

I don't know and I won't pretend to know where Bitcoin will go from here. I think there are two very real possibilities over the next few years: 1) Bitcoin holds its own and makes new highs, or 2) Bitcoin grinds its way down to nothing.

One thing that Chancellor and Mackay's books so clearly established is that Financial Bubbles are entirely unpredictable. Human psychology and emotions, especially when it comes to money, can be irrational for a long time. Betting against human emotions is a very tricky and dangerous game. This leaves just one reasonable way to make money from crypto-currencies: trading.

"The market can remain irrational longer than you can remain solvent." - John M Keynes

Trading Bitcoin

I admit that I missed a huge trading opportunity with Bitcoin (and other cryptos). While its easy to have regrets about the things you don't do, I will stick by my strategy and conviction only to invest in liquid instruments in which I have some understanding.

I still don't really understand Bitcoin as a currency, which is one big issue that kept me away from it. Another big problem is liquidity. Until recently, there was no way to trade Bitcoin in a liquid environment for a reasonable cost. The popular wallets seem prone to hacking problems and their transaction fees were way too high.

I wouldn't trade stocks or ETFs if my brokerage was hacked every few weeks and liquidity dried up every time my system called for a sell signal. By that logic I also shouldn't trade cryptos.

However, there were some amazing profit opportunities in Bitcoin over the past few years and I thought it would be fun to take a look at the charts and see where the trading opportunities would lie. Due to the volatility in Bitcoin, I used a 20-week (similar to 100-day) EMA to keep the stops tighter to the price.

Full Bitcoin Chart with No Signals (July 2010 to March 2018)

Source: Yahoo Finance

I find this chart to be very interesting it itself. Bitcoin started at around US$0.05 per BTC. Looking at this chart from a logarithmic perspective (arguably the only way you should look at returns over time), you can see that Bitcoin did much better in the first half than the latter half. From 2010 to 2013, the price expanded from $0.05 to $1,241--an increase factor of 24,820!

From that peak until the next major peak in 2017, the price only increased from $1,241 to $19,870--an increase factor of 16. Still incredible of course, but you can see here that the real money in buy-and-hold was made at the start. The individuals who got into Bitcoin before the end of 2012 would have been able to accumulate massive amounts of Bitcoin for low overall cost. I would consider those buyers to make up the majority of the inside crowd because they control large chunks of the total Bitcoin supply.

Beginning in 2013, Bitcoin made its first big run. This is also around the time that I first heard about Bitcoin.

2-Year Bitcoin Chart with 20 Week EMA Signal (2013 to 2015)

Source: Yahoo Finance

The 20-week Exponential Moving Average is the highlighted blue line. This time period captured the first major move in Bitcoin. In 2013, the price started at $14 per BTC and ran up to $1,241 by November. However, by the end of 2014 the value had fallen back down to $264--a near 80% decline!

2-Year Bitcoin Chart with 20 Week EMA Signal (2015 to 2017)

Source: Yahoo Finance

In this next two year period, Bitcoin was in a drawdown for the entire time! Bitcoin finished 2016 at around $900 per coin. Still lower than the peak in 2013. Anyone who was HODLing Bitcoin would have chewed their nails down to nubs by the time the price hit a low of $157 in the beginning of 2015--a huge 87% peak drawdown. But things slowly improved from there. As we'll look at later, a trader could have made some nice profits in this time period.

2-Year Bitcoin Chart with 20 Week EMA Signal (2017 to Current)

Source: Yahoo Finance

This last period includes the latest run-up in Bitcoin. Once Bitcoin crossed $1,000 again in the beginning of 2017, things started to get really heated. Trading volume exploded from a few hundred million trades per week to tens of billions of trades. Considering there's a total of 21 million coins, about 17 million of which are in circulation and most of them hoarded by insiders, the trading volume is absolutely insane. This is raw human emotion at work here and it makes for a great case for trading using careful rules.

Trading Bitcoin with a Simple System (2013-Current)

Lets look at how a trader could trade Bitcoin in their portfolio using some very simple, rudimentary trading rules.We'll use the same 20-week EMA for signals. We'll assume the remaining part of the portfolio is in cash to keep the calculations straightforward.

Scenario and Rules
Starting Portfolio Value: $100,000
Maximum Entry: 10% of portfolio value
Trading Frequency: Weekly

Trades and Portfolio Value
Trade 1 on Jan 1/13: Buy 714 BTC at $14, $90,004 cash, total portfolio $100,000
Trade 2 on Jun 30/13: Sell 714 BTC at $76.50, total portfolio $144,625
Trade 3 on Jul 7/13: Buy 153 BTC at $94.42, $130,178 cash, total portfolio $144,625
Trade 4 on Feb 2/14: Sell 153 BTC at $659.57, total portfolio $231,092
Trade 5 on Mar 2/14: Buy 36 BTC at $627.05, $208,518 cash, total portfolio $231,092
Trade 6 on Mar 16/14: Sell 36 BTC at $551.16, total portfolio $228,360
Trade 7 on May 18/14: Buy 40 BTC at $570.44, $205,542 cash, total portfolio $228,360
Trade 8 on Aug 10/14: Sell 40 BTC at $485.50, total portfolio $224,962
Trade 9 on Jun 28/15: Buy 83 BTC at $270.14, $202,540 cash, total portfolio $224,962
Trade 10 on Aug 2/15: Sell 83 BTC at $263.87, total portfolio $224,441
Trade 11 on Oct 11/15: Buy 85 BTC at $261.67, $202,199 cash, total portfolio $224,441
Trade 12 on Jan 28/18: Sell 85 BTC at $8,218.05, total portfolio $900,733
Trade 13 on Feb 11/18: Buy 8 BTC at $10,417.23, $817,395 cash, total portfolio $900,733
Trade 14 on Feb 18/18: Sell 8 BTC at $9,610.11, total portfolio $894,276
Trade 15 on Feb 25/18: Buy 7 BTC at $11,504.42, $813,745 cash, total portfolio $894,276
Trade 16 on Mar 4/18: Sell 7 BTC at $9,544.84, total portfolio $880,559

This is a great example of how you can profit enormously when trading, even with very simple risk parameters. It's probably fair to point out the level of risk in this system is still too high for me personally. I would limit my entry to something like 5% of the the total portfolio, but I also wouldn't have the rest of the portfolio in Cash.

In my example, assuming the rest of your portfolio made no returns, your portfolio would have jumped from $100,000 to $880,559 in just five years--a compound annual return of 52%.

Another interesting fact is only 50% the trades were profitable while the rest resulted in small losses. This rate of successful trades is common in trading systems. It demonstrates that you don't need to be right all the time, you just need a system and proper risk management.

An observant idiot would look at this example and say, "Yeah but if I would have considered Bitcoin as my 'play money' and HODLed the 714 BTC from January 2013, I would be worth $6.2 million right now!"

Sure, hindsight is always perfect in theory. But how would you have reacted through the 87% drawdown after the 2013 run? Or the 55% drawdown we're in right now? That's risking an enormous amount of your capital on one shaky asset. I'd take the 50% annual returns along with my sanity, thank you very much.

Trend following and risk controls are the path to sustainable wealth over long periods of time. HODLing anything, especially without very good diversification, is relying on wishes and prayers. We call that gambling, not investing or trading.

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Handling A Market Downturn

The masses are very skeptical about early retirement. They are insecure, their own choices reflect financial servitude, and they believe a life of forty-hour work weeks for forty years is predetermined for them.

When you run around with these mental blinders on it's easier to condemn financial freedom than make the changes in your life that open up early retirement for you.

Many people are critical of early retirement by pointing out failure with two main questions:

  • What would you do all day? and
  • How will you handle a scary market downturn?

The first question assumes that you will turn into a deviant or a useless blob if you don't have an outside commitment of forty hours a week to keep you in line. We talked about that here.

Dealing With the Markets

We all know that stock markets go up and down. Market movements often dominate media. Financial media is a narrative between market optimists and pessimists. The talking heads and the predictors who strive to provide entertainment value.

Depending on where you go and what you read, the talking heads predict roaring bull markets that will go straight up and make everyone rich. Or they make your fear investing because markets are on the edge of a collapse.

Truth is they don't know. I don't either. In the last 100 years, the U.S. stock market had four occasions where stocks crashed 50% or more (inflation adjusted). It will likely happen again at some point.

A net worth that moves like this freaks people out!

S&P500 1995-2011. Source: Yahoo! Finance

The fear of losing half your money is enough to make most people just avoid the markets all together. They huddle together and put their money in "safe" GICs, bonds, and real estate. They try pay off their mortgage.

Many don't save at all and wait for the government to spoon feed them a promised stipend sometime in the future.

Rational thinkers who pursue independent thought and understand risk know there are strategies to help deal with these massive, and generally temporary, downturns. A little bit of risk acceptance can go a long way towards better, more profitable investing.

Saving Enough

You can't retire early if you don't have enough money. Not having enough money and hoping for outsized returns or perfect market conditions is a recipe for disaster. Accumulation of investable net worth matters.

If you have 30x your annual spending needs invested in productive assets, you will virtually never fail financially in retirement. You can increase your spending with inflation every year, you can maintain various asset allocations, you can "set and forget". The margin of safety at this level is immense.

Even if you have 25x your annual spending invested in productive assets, you are very likely to avoid a financial catastrophe. But you must be broadly invested, follow a sound strategy, and watch your spending. You would theoretically be far more likely to die before running out of money.

Diversify

The next easiest guard is diversification. Successful investors reduce exposure to any single market.

Way too many people have too much of their portfolio permanently in one broad asset class. It might be U.S. stocks and bonds, it could be Canadian dividend stocks, it could be rental houses. Concentration is dangerous.

Simply put, you don't want to be an infallible Japanese early retiree in 1989 fully invested in the roaring, never-goes-down Japanese stock market.

In the next two decades, you would see your portfolio fall off a cliff and plunge into the depths of the Pacific. This epic market crash might never come back; nearly three decades later, Japanese stocks are still at around half their peak level.

Nikkei225 1989-2009. Source: Yahoo! Finance

If the same Japanese retiree would have invested in a global stock portfolio, their investment account would have chugged along averaging 7% per year since 1989 (in Japanese yen terms).

While others sweat a salary job and jump off buildings because they're bankrupt, the diversified retiree would be tending to their bonsai and calligraphy with nary an ulcer.

You can diversify across countries, currencies, asset classes, and strategies to guard yourself from financial failure.

Strategies

Proper use of investment strategies is very helpful in preventing a market downturn catastrophe. Some strategies are complementary while others are correlated.

Buy-and-hold 100% in a stock index is probably among the most dangerous in early retirement because you can't dollar cost average into a falling price scenario. You're basically rolling the dice that you don't retire just before a market crash or high inflation period.

If you are withdrawing money from a falling asset, the effects of the fall are exacerbated. This is known as sequence of returns risk. To limit sequence of returns risk, you can hold a cash cushion, invest in complementary assets, or you can follow a disciplined timing strategy.

Cash cushions are effective in their purpose of limiting withdrawals in a drawdown environment, but they also reduce overall returns. Depending on your investment strategy, large bond allocations can actually reduce your financial success rate.

Complementary assets allocations, such as mixing a hedged strategy (like long/short or managed futures) with a stock strategy, can reduce the full effect of a stock market crash. Hedged strategies tend to do well in market downturns while holding their own in bull markets. However, the best of these are often only accessible to larger investors.

I invest in a disciplined timing strategy. I'm always trying to simply, simplify, simplify while maintaining an edge. So far it has worked out well. In the future I believe the lessons learned will mean better discipline, fewer mistakes, and better results.

Confidence in Strategy

The biggest advantage going into early retirement is having complete confidence in your chosen strategy. I don't mean blind confidence because you read a few good books and read an amateur blog or two.

Rather, I mean having experience and controlling your emotions. Ignoring market swings and sticking to a sound process is how you win the long game.

This is why I'm a huge fan of managing your own money instead of hiring a financial advisor—especially if you are young. Nothing is better than making your own mistakes when you are young, learning from each experience, and forging your own confidence going forward.

An honest, fee-only financial advisor can do a great job of steering your investments and helping you avoid big mistakes. But they can't outperform broad markets over the long term and they can't prevent you from overriding their advice. They're basically just there to help you make good money decisions, promote tax efficiency, and manage your investments using basic models.

It's easier to have true confidence in yourself than to rely on confidence in others.

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