How Does One Navigate Crypto Mania?

Hey everyone, time to check in on the hottest topic in financial markets over the past few months. We made a post about speculative investments that mentioned crypto (Check it out here), but I figured I would go a little further and do an entire blog dedicated to it.

As folks who manage not only our own portfolio, but those of our clients as well, we like to follow some golden rules when it comes to investing. A couple of these rules are highly relevant to the risk of investing in crypto. The first one is: never concentrate too much risk in one asset or asset class. The other is: never invest in something you don’t understand.

As I said in the speculative investing blog, sometimes you break these rules and you get away with it. Crypto is a great example of that—people have made a ton of money by investing into it. But nameless others end up getting the short end of the stick.

I was around during the first major crypto pop in 2017, and I had people calling in asking to cash out their retirement accounts and other investments to put it all into crypto. Did it work out for everybody? Most certainly not. The bubble popped that time, and while those who held through this past year were able to recoup their investment and/or see nice returns, there are countless folks we’ll never hear about who lost a lot of money.

When we see these “bubble” scenarios they follow a similar pattern: they begin to gain traction in the mainstream, become the topic that everyone is discussing, and ultimately a huge amount of people throw a ton of money into it. Then the big dogs light the fuse on the operation, dump the bags on many unsuspecting folks, and move on far richer while the remaining investors duke it out with each other. Some of the early adopters and speculators get out in time, but ultimately the sheep who blindly follow into these things tend to get slaughtered.

What are some of the negative characteristics of unsuspecting folks investing in bubbles? Firstly, they tend to have very little, or no, understanding of what they are “investing” in. Secondly, they tend to put money into this investment that they can’t afford to lose. Lastly, they tend to have no exit point in mind because they are essentially gambling with their money. This is a recipe for disaster.

You’re probably yawning at yet another take by a “finance guy” trashing crypto. Don’t get me wrong—I am not anti-crypto or blockchain in any way. I actually believe that the technology and ideas behind crypto are extremely useful and will become a part of the future of our global financial/software networks. My concern is more so placed in the bubble conditions we are seeing resurface here in 2021.

A great example of a bubble that was built around a useful creation is the one that occurred at the turn of the millennia: the dot com bubble. Think about what we’ve seen with crypto: a promising, useful technology suddenly has all these knockoffs springing up that are running up in value like crazy. Companies are adding “Blockchain” to their business title and endeavors to get a boost in share price just like companies added “.com” back in 1999. Here’s a great detailed writeup on how this dynamic played out in the dot com bubble: https://ideas.ted.com/an-eye-opening-look-at-the-dot-com-bubble-of-2000-and-how-it-shapes-our-lives-today/. Was the internet a scam? Obviously not, but there were plenty of opportunists who happily duped folks into investing into worthless offshoots of a useful technology.

Here's a telling excerpt from the above source that I really wanted to share:

“Of course, the era didn’t end disastrously for everyone. Between September 1999 and July 2000, insiders at dot-com companies cashed out to the tune of $43 billion, twice the rate they’d sold at during 1997 and 1998. In the month before the Nasdaq peaked, insiders were selling 23 times as many shares as they bought.

So, who ended up holding the bag? Average investors. Over the course of the year 2000, as the stock market began its meltdown, individual investors continued to pour $260 billion into US equity funds. This was up from the $150 billion invested in the market in 1998 and $176 billion invested in 1999. Everyday people were the most aggressive investors in the dot-com bubble at the very moment the bubble was at its height — and at the moment the smart money was getting out. By 2002, 100 million individual investors had lost $5 trillion in the stock market. A Vanguard study showed that by the end of 2002, 70 percent of 401(k)s had lost at least one-fifth of their value; 45 percent had lost more than one-fifth.”

That party ended in tears for many folks, and the gravity of it is no joke. When we talk about bubbles popping, we are speaking of many inexperienced investors who lost their life savings. People who had to work many years after they planned on retiring. People who lost their homes, cars, etc. Marriages destroyed. Kids’ college savings out of the door.

The appeal of bubbles is there: you could become much wealthier than you imagined if you hit on this! We all have financial goals and struggles that getting rich quick would probably solve. This appeal is exactly what causes people to break the aforementioned golden rules.

So, let’s look at the rule of knowing what you’re investing in. I won’t go on about crypto and blockchain technology, but if you’d like to educate yourself a bit more, I found the documentary “Cryptopia” on Prime Video very impartial and extremely useful.

Let’s examine some investing characteristics that have been mirrored across virtually all crypto-related investments so far:

· Extreme volatility. We saw an example of that this week—one Elon Musk tweet about Tesla no longer utilizing bitcoin and every crypto out there was down over 10 percent within minutes. (Update: More Elon Musk tweets have now sent BTC down below $43k per coin as of publication) (Source: https://www.cnn.com/2021/05/12/tech/elon-musk-tesla-bitcoin/index.html ) (Update source: https://www.cnn.com/2021/05/17/investing/bitcoin-price-elon-musk-tesla-intl-hnk/index.html )

· Whale ownership. A popular narrative about crypto is that it’s not under control of any government or huge entity. That’s a half-truth—many coins are primarily owned by a very small number of “whales”.

· Bitcoin is probably the most evenly distributed coin, and even with that being said, 50% of individual Bitcoin owners hold at least 500 coins (Current value of about $5 million). I used a pro-crypto source as many mainstream outlets have reported exaggerated whale ownership. Source if you’d like to read more: https://insights.glassnode.com/bitcoin-supplydistribution/#:~:text=On%20the%20large%20end%20of,31%25%20of%20the%20Bitcoin%20supply.&text=On%20the%20other%20hand%2C%20smaller,almost%2023%25%20of%20the%20supply.

· Needless to say, the risk is high when whales decide to dump, which is something we have seen already. To be fair, whales can pump the price up too, which is exactly what we’ve seen over the past year! But ultimately, they hold the fate of all the little guys in their hands and this is an ultra-high-risk asset.

· One more note: whale ownership is prevalent in the stock market as well. However, the broad market tends to carry less risk than crypto and is much less subject to shock crashes. Not that steep declines can’t happen in the stock market either. Past performance is not a guarantee of the future, but the volatility of the stock market has historically been dwarfed by that of crypto in its short lifespan. That’s a recipe for steep declines which have already manifested when Bitcoin fell over 50% in about six weeks in early 2018. It bottomed out a few months later almost 90% off the highs. The broad stock market hasn’t seen a decline like that since the great depression. (https://www.fool.com/investing/stock-market/basics/crashes/ )

· Questionable usefulness of the coin itself. Some coins seem to be simply constructed for the purpose of pumping and dumping. Not to continue to beat a dead horse but the little guys are all on their own as far as getting out before the dump occurs, and we usually get left holding the bag.

· How useful is a currency if it is as volatile as crypto coins are? I’m sure everyone has read at least one story about how someone bought a pizza with bitcoin back in 2012 and it could’ve bought them a Lamborghini today. Jokes aside, I think this presents a paradox. The investors in cryptocurrencies are either speculating for growth or they believe in the coin’s use as a currency. Those seem to be diverging goals as speculative investments need to be volatile, but currencies should be relatively stable.

· I am aware that the selling point has somewhat shifted to crypto being more a “store of value” like a precious metal, than a currency. This is the only thing I can say about that: if the entire narrative shifts to keep an asset price inflated I believe it should be cause for heavy skepticism.

· Anybody remember Long Island Blockchain Corp? Probably not, but I’ll tell a quick story. Back when crypto hit the mainstream the first time in 2017 an opportunistic publicly traded long island iced tea distributor decided to throw “blockchain” into its company name and proclaimed to be launching a crypto department of its business. It was a penny stock that shot up almost 1000% shortly after the name change! It bottomed back out in 2018 at about 10 cents per share, but it wasn’t done yet. Earlier this year it ran back up to $1.12 per share before it was delisted for failing to meet exchange requirements after not filing any financial reports for over two years (Source:https://www.bloomberg.com/news/articles/2021-02-22/long-blockchain-delisted-by-sec-after-riding-2017-s-crypto-craze ) You can still look at the aforementioned price movements by pulling up the chart using ticker symbol LBCC.

· The Long Island Blockchain situation is kind of funny, but at the same time it is tragic because real people lost real money following a trend…twice! The point is that investors should be very careful in these environments. While many speculators were probably laughing at the people who were duped, plenty of speculators probably got burned too. Often the scams aren’t quite as obvious as the Long Island Blockchain situation.

· Another risk associated with crypto is political risk. It’s very unlikely that the governments of the world will sit idly by while crypto takes over the financial system and usurps the world’s currencies. It’s important to keep track of how this may affect crypto investments. Investopedia has a good writeup on how governments are getting into the fray: https://www.investopedia.com/news/bitcoin-has-regulation-problem/

Also worth noting: one of the major crypto exchanges, Binance, is under heavy scrutiny from U.S. regulators at the moment. Source: https://www.bloomberg.com/news/articles/2021-05-13/binance-probed-by-u-s-as-money-laundering-tax-sleuths-bore-in

Ultimately if a large percentage of speculative whales (and the retail bloc of speculators) decide to head for the exits and take their profits, the pain will be quick and excessive for the ordinary folks who have put their money into these investments and didn’t get out in time.

So how do you navigate this as an investor? The key in this, just like the dotcom bubble, is to go back to the golden rules.

· Know what you’re investing in! There will likely be survivors of this bubble, which will be companies who create and adopt the technology well.

· Don’t concentrate your risk! If you’re gambling, then only utilize gambling money. If you feel that crypto would add diversification to your portfolio then allocate it properly so you don’t lose too much should it go belly-up.

· Have a clear-cut objective. If you’re trying to ride the wave then you should know exactly when you want to exit on the upside and on the downside. If you’re investing for the long-term go back to the first bullet point and do your due diligence to find the companies/coins you believe in.

· Don’t invest money you can’t afford to lose. Regardless of how much you believe in something it’s rarely prudent to throw all your money at it. A lot of people have lost a lot of money being “right”.

As an advisor this is especially hard to navigate. It is generally against ours and our clients’ interests to invest in such risky assets. When these investments hit the mainstream we get a lot of questions about it. We also deal with funny folks who say we are bad advisors for not getting our clients rich with crypto!

Understanding complex financial situations is difficult, and analogies provide a concise way for us to illustrate concepts. My analogy for crypto is this: let’s say you have a vitally important meeting to get to in an hour and I, your advisor, am your chauffeur. It usually takes 45-50 minutes to drive there under normal conditions. However, if we put NOS in your engine and go 150 down the highway, we can get there 30 minutes early and you can grab coffee and a snack before the meeting! Sure, we just vastly increased our chances of getting into a horrific accident or running into other impediments that would cause us to miss the meeting, but we could get there early in a thrilling manner! I would probably be your favorite chauffeur ever if we pulled it off.

On the other hand, if I screwed it up for you I not only have possibly ruined your big opportunity, but I may have hurt both of us, and either way my career would certainly be over. Needless to say, the risk is probably not worth it for either of us!

The exception to this analogy is the financial advisors who are providing a more speculative service to their clients by helping them pick stocks and individual investments. They may have a business model that provides more direct guidance on these investments as their advisory structure may differ from big-picture long-term financial planning.

As financial advisors it’s our job to try to reduce uncertainty and to help put you in position to achieve your goals. Putting all of your money into ANY speculative investment is a high-risk, low-reward scenario. Why risk ruining your financial situation when we can provide prudent advice and solutions to help put you in great position to achieve your goals? It would be nice to have the crystal ball and be able to make all of our clients rich overnight, but the reality is that if it were that easy everyone would be doing it. We also have a fiduciary duty of care to attend to, which we take seriously. Our fiduciary duty, in short, is that we don’t expose you to overly risky investments which may adversely affect your ability to achieve your goals. Often these types of investments do not square with that duty.

For obvious reasons most advisors stay away from crypto investments due to the aforementioned risk. With that being said, your advisor should be able to at least discuss these matters with you. A good advisor covers every aspect of your financial plan and that means helping you determine your “casino” number and potentially talking you out of making overly risky decisions! That is what we strive to do for our clients here at The WealthTenders. Our inbox is open with any questions or feedback!

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