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Risk and Volatility

Crypto Is Rat Poison

I haven’t written a lot about cryptocurrencies like Bitcoin because, until now, I’ve felt ill-equipped to really weigh in.  I was hesitant because of two of the four cornerstones of mindful investing: rationality and humility.  Rationally speaking, crypto seemed too complicated to navigate.  Humility-wise, it seemed like smarter people were describing things way beyond me.

The farthest I ever ventured was to say that crypto was too new to be safe and that the value proposition was based only on the idea that crypto will be incredibly useful in the future.  So, up to this time, I’ve been skeptical, but neither for nor against crypto.

Rat Poison

However, I started gravitating toward the “against” position when I read Charlie Munger’s op-ed about crypto.  I’ve often quoted Charlie and his partner Warren Buffett on Mindfully Investing because they’re both billionaire investors with a proven track record that embodies most of the principles of mindful investing.  Over the last few years, Charlie has called crypto “rat poison”, “venereal disease”, “stupid and evil”, and “almost insane to buy”.  Strong words!

Charlie recently wrote: “A cryptocurrency is not a currency, not a commodity, and not a security.  Instead, it’s a gambling contract with a nearly 100% edge for the house.”  The edge for founders and promoters of cryptos comes from buying in at the ground floor for virtually nothing, “After which the public buys in at much higher prices without fully understanding the pre-dilution in favor of the promoter.”  Munger recommends that the U.S. government should ban cryptocurrencies, just like China did in 2021.  If his sentiment becomes widespread on Capitol Hill, a total ban could result in all cryptos becoming worthless overnight, regardless of many other potential risks.

Signs of The Poisoning

Recent crypto news is finding traces of poison all over the place.  For example, 2022 was the biggest year for crypto theft, with at least $3.8 billion stolen.  For something that is touted as “immutable” and “unseizable”, that seems like a pretty leaky hole in the blockchain bucket.

Further, it concerns me that, like the days of profitless companies I observed during the Internet Bubble, the crypto investors losing the most money seem to be poor minorities.  It seems likely that this particular demographic may be the least informed on the intricacies of crypto.  Just like in 2000, the casino is again “winning” money from the gamblers who are least able to afford it.

And once again, most of the news focuses on price action or the tempting predictions of vast wealth from people who have a huge stake in the outcome.  For example, a former Goldman Sachs and Morgan Stanley analyst, who “correctly called the 2020 Bitcoin price boom” has predicted that Bitcoin is poised to go “parabolic”.  His reasoning?  The Federal Reserve may start to pull back on interest rate hikes.  What do interest rates have to do with the value of cryptos?  He doesn’t say.  Apparently, cryptos are just another “risk on” asset like stocks.  But cryptos bear no resemblance to stocks in either substance or function.

And let’s not forget the slew of crypto, crypto bank, and crypto exchange problems over the past few years.  From reading just a handful of articles I found reports of failures, legal troubles, or large losses involving: Grin Networks, Bitcoin Gold, Quadringa, Binance, Terraform, Kwon, Blockchain.com, Custodia Bank, Celsius, Genesis, Bitfinex, Kraken, Paxos, Three Arrows Capital, and Bitzlato.  Note that I don’t claim to know what any of these companies do exactly or what their specific troubles are.

Of course, the elephant I left out of this list is the FTX crypto exchange fiasco involving founder Sam Bankman-Fried among others.  (I like to call him “Sam Bank-Fraud”.)   FTX collapsed in November 2022 following reports of leverage and solvency concerns involving FTX-affiliated trading firm Alameda Research, which had received hundreds of millions from FTX.  FTX faced a liquidity crisis, failed to find sufficient bailout funds, and subsequently filed for bankruptcy.  Around the same time, FTX was hacked and hundreds of millions worth of tokens were stolen.  Sam Bank-Fraud has since been arrested and is facing criminal charges.  The new CEO identified the core issue as “plain old embezzlement” and said that FTX’s accounting practices were so bad that they now have to navigate a “paperless bankruptcy”!  Losses so far have totaled at least $8 Billion and counting.

So, everyone’s learned a valuable lesson with FTX and another outright crypto fraud couldn’t happen again, right?  Wait, this just in from Reuters: “Crypto giant Binance moved $400M” to a trading firm that happens to be also managed by the Binance CEO.  And did I mention that Binance is under investigation by The Department of Justice and the Securities and Exchange Commission for “potential breaches of financial rules…”?  This all sounds suspiciously similar to the FTX shenanigans.  And what was Binance’s main response?  They said, “Reuters’ information is outdated”.  Oh, that’s super helpful, thanks.

The Nail In The Coffin

One could argue that these are all the normal growing pains associated with any new asset in an under-regulated market.  But for me, the final nail in the coffin was when I watched an hour-and-half video called, “Blockchain, Innovation or Illusion?”  Normally, I don’t watch videos or listen to podcasts because I find reading more efficient.  But this video captivated me in the first two minutes.  It contains reasonable information about the many oddities of crypto that I’ve never seen before.  The video is straightforward, uses common sense, explains jargon, and cites multiple sources for almost all of its claims.  That’s a lot more than I can say for most of the stuff I’ve seen describing the benefits of crypto.

So, the remainder of this post contains a longish bullet-point summary of the video.  You can probably read all the points below in 10 or 15 minutes, as opposed to watching the video for 1.5 hours.  If you’re not convinced that crypto is rat poison after reading the rest of this post, and still aren’t convinced after viewing the details in the video, then I have no reply to you.

By the way, my notes gloss over some points from the video and occasionally add a few of my thoughts.  But generally, these notes are pretty faithful to the main ideas and intent of the video.  If you have doubts or think I got something wrong, then watch the whole video yourself and comment there.

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Yet Another Article About The Next Recession

I’d wager that you could go on almost any news website today and find at least one article about the next recession.  And most financial news sites have multiple articles exploring different angles on the recession.  What is a recession?  Will there be a recession?   Which economic indicators indicate a coming recession or not?  How long and severe will it be?  How to prepare for a recession.  How to invest in a recession.  How will it affect Wall Street?  How will it affect Main Street?  I could go on.

So, with some trepidation, I’m adding to the blare of recession babble in today’s post.  That’s because I still have a couple of questions that haven’t received much attention, as far as I’ve seen.  Those questions are:

  1. What effect do recessions typically have on long-term investors?
  2. Why are so many expecting a recession, when considerable economic data still belie that expectation?

After some research, here are my answers.

Question 1: Recessions and Long-Term Investors

When it comes to the question of potential damage to your investment portfolio, most articles I’ve recently read focus on worst-case losses for stocks and bonds from past recessions.  For stocks, here’s a good example, which I adapted from some RBC Capital Markets research as summarized by Sam Ro at TKer.

Like all stock data presented in today’s post, the surrogate for U.S. stocks in this graph is the S&P 500.  The dates at the bottom of the graph are when each recession ended.  The average peak-to-trough stock loss across these recessions was -32%.  Ouch!  So, long-term stock investors should expect some pain with the next recession.

But let’s take a closer look at these scary data.  They represent the decline in stocks from the peak proceeding (or during) the recession to the subsequent trough around the same recession.  This measures the loss for an investor who bought in right at the absolute top of the peak and sold right at the absolute bottom of the trough.  While such people undoubtedly exist during each recession, the chances that any one investor would be so unlucky are extremely small.  And any deviation from this poorest-possible market timing necessarily results in a less severe outcome for the investor.

Since 1928, recessions have ranged in duration from two months (COVID recession of 2020) to five years (the Great Depression).  Because mindful investors are long-term investors, your investing timeframe is hopefully much longer than a few months.  So, what if we instead examine the impacts on returns for whole years throughout the recession for each such event since 1928?  Limiting the analysis to whole-year return data gives us a more realistic sense of what an investor with a 1- to 5-year timeframe might experience in the next recession.

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Investing Disasters and Deep Risk


Over the last month, I’ve been playing around with an intriguing returns dataset developed by researchers Jorda, Knoll, Kuvshinov, Schularick, and Taylor (“JST” Study for short).  It includes estimates of annual returns for stocks, government bonds, government bills (a proxy for cash), and real estate (including imputed rents) for 15 developed market countries going back to 1900.¹  The returns are calculated using local currencies and inflation rates, and the dataset is freely available to download here.

The JST dataset covers a remarkably tumultuous period in modern history including two world wars and the Great Depression.  And in this time, particular countries also experienced episodes of massive inflation, other stock market crashes, bond defaults, as well as less severe episodes of inflation, stagflation, and deflation.

Why Worry?

When I write about investing, I usually start from the pragmatic assumption that governments, economies, and markets will continue to function at some minimal level.  I’ve never concerned myself with investing disasters like world wars because I figure in those situations people will be more concerned with saving their lives than growing their money.

Perhaps having some gold socked away might help during the next zombie apocalypse.  But investing pragmatists argue that when civilization completely breaks down, the winner will be the person with the most guns and ammo not the person with the most gold, and certainly not the person with the most stock and bond certificates.

However, the guns-and-ammo argument assumes one type of disaster: a complete breakdown of civilization everywhere.  In contrast, the JST dataset documents a variety of historical investing disasters, some more severe than others.  As an example, consider a Jewish person living in pre-WW II Germany.  In that time and place, even a closet full of guns and ammo would be pretty useless against organized platoons of Nazis with tanks and bombs at the ready.  But using saved gold (or other tangible assets like diamonds, jewelry, art, etc.) was key to some people escaping from Germany before the worst atrocities occurred.

Given the variety of possible investing disasters, it makes sense to at least consider which assets might help withstand such events, even if they are very unlikely to occur.

Deep Risk

Bill Bernstein wrote a fascinating booklet about just these sorts of investing disasters, which he calls “Deep Risk”.  Using historical data similar to the JST Study, he found four flavors of deep risk:

  • Severe or prolonged inflation – when the purchasing power of your money decreases over time.
  • Prolonged deflation – when purchasing power increases (negative inflation).
  • Confiscation – most often seen when new or higher taxes are enacted, but it can include governments freezing assets or even converting to communism.
  • Devastation – the destruction caused by wars, revolutions, and other widespread violence.

Deflation sounds innocuous, but it usually occurs during economic recessions and has pernicious effects like increasing the value of debts (which is bad for the stocks of companies that carry debt), discouraging consumer spending, and increasing inflation-adjusted (real) interest rates.

Historical Examples

Bernstein’s booklet made me curious about how stocks and government bonds have historically reacted to the four types of deep risk, and the JST dataset provides some answers to that question.²  Let’s go back to the example of Germany again because it offers a particularly dire example of deep risk as shown in this graph from 1900 to 2015 of the inflation-adjusted growth of one unit of local currency (denoted throughout by a “$” sign).

Wow! Now that’s some deep deep risk!  One “$” (Goldmark in this case) invested in German government bonds in 1900 would have been worth about one trillionth of its original value by the end of WW II.  Those bonds were literally worth less than the paper they were printed on.  The same 1900 investment in stocks would have lost about 91% of its value by the end of WW II.  That’s awful, but the graph shows that those stocks eventually went on to grow to nearly 50 times their original value.³

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Are You Ready for the Next Stock Market Crash?


I’ve been shouting about the virtues of investing in stock index funds for years now.  In just the last year’s worth of posts, I’ve made many confident¹ assertions about the merits of stock funds including:

And over the years, I’ve just as confidently pointed out the relative inferiority of other established assets classes including:

Stocks seem like the best game in town.

A House of Cards

However, many observers have pointed out that the stock market is currently seething with a bullish sentiment.  Feelings are so (dare I say it) exuberant that a big crash seems almost certain to ambush euphoric stock investors soon.  There are more than a few warning signs:

And if stocks aren’t expensive enough for you, the accompanying cryptocurrency craze seems completely unhinged.  One Bitcoin now trades for more than $55,000 based mostly on the hope that it will someday become incredibly useful.  The value of Dogecoin, which was literally started as a joke, has increased by over 4000% year-to-date.  And one enterprising guy recently created a cryptocurrency called “Scamcoin”, which he transparently presented as nothing more than a prank.  He made about $2000 in an hour.

I lived through the Dotcom bubble, and this all feels like déjà vu, although the specifics are different.

Lambs to the Slaughter

For more than a decade, the stock market has climbed relentlessly with only a few relatively minor slumps along the way.  (Yes, I consider March 2020 a “minor slump” for reasons I’ll explain in a moment.)  That means that many of today’s stock investors have never experienced a really scary crash or prolonged bear market; they’ve just seen stocks go consistently up.

And here I sit blithely singing the praises of stocks.  I imagine that my blog posts only reinforce younger readers’ existing biases towards stocks, grown from shallow yet compelling personal experiences.  Observing the Dotcom bubble, Warren Buffett said, “Nothing sedates rationality like large doses of effortless money.”  Since 2008, the S&P 500 is up 525% or 14.8% annualized!  Effortless money indeed.

So, what happens when young investors read my posts, load up on even more stocks, and then the stock market crashes, as it eventually will?  I’ve written that “worrying” about the future is a very unmindful thought process.  But if I worry about anything, at the top of my list is luring naive investors into the turbulent waters of stock investing.

Understanding Versus Feeling

Sure, most young investors are aware that stocks have periodically endured crashes and long bear markets.  But that’s entirely different from the experience of investing during the Great Financial Crisis, Dotcom bubble, Stagflation, or the Great Depression.  Most younger investors have heard tales of these events, but they probably seem like the quaint reminiscences of now senile grandparents.

For example, when I wrote about the dangers of using leveraged funds in a risk parity strategy, the most common criticism (mostly from people who seemed younger than me) was that the Fed would never allow runaway inflation like the 1970s to occur again.  While that particular fact may be true, it completely fails to consider future events that may have a similar effect but due to different causes.

On top of that, cognitive research shows that our assessments of our own emotions are often capricious.  In one experiment, test subjects were asked to fill out a “life-happiness questionnaire”.  But before filling out the questionnaire, half the test subjects “luckily” found a dime, which had been planted by the researchers.  And of course, the folks who found the dime reported significantly happier lives than those who found no dime.  You can read about many other ways that we misjudge our feelings in Daniel Kahneman’s book, Thinking Fast and Slow.

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A Better Measure of Risk

The most widely accepted measure of investment risk is volatility, which is usually calculated as the annual standard deviation of asset returns.  However, I and others have pointed out that routine volatility (the daily, weekly, or monthly ups and downs) of an asset is a poor measure of the kind of risk that matters most to investors, which is the risk of a permanent loss.  A permanent loss is when your invested money is not available at the time you planned to spend it, such as when retirement begins.

An Investor Story

Why is routine volatility a poor measure of the risk of permanent loss?  To illustrate, let’s consider a story where I buy $1000 in an asset and sign a contract that says:

  • Upon penalty of death, I will not sell the asset for 10 years, and at the end of that period, I must sell my entire stake in the asset.

Let’s also say that the day after signing the contract and buying the asset, its market value plunges by 50% as shown in this graph.

That’s not a great start, but given the alternative under the contract is death, I won’t sell my asset prematurely.  Over the next 10 years, the asset takes the wild ride shown in the graph generating annual volatility of 30%, which is typically considered quite “risky”.  But at the end of the 10 years, the asset has produced a modest positive annualized return of 3.5%.

In this story, the perceived risk implied by high annual volatility causes no actual risk to me (the investor) over the period of the contract.  I suffered no permanent loss from the initial 50% plunge, as frightening as that may have been.  And I suffered no permanent loss when I sold the volatile asset 10 years later.

I’ve used stories like this before to illustrate that the longer you invest, the less relevant routine volatility is to your investing risk.  What matters most for long-term investors is the risk of a permanent loss at the end of the expected timeframe of the investment.

Simple to Say, Hard to Do

Unfortunately, the investing and financial services industry has never really offered a decent way to measure the risk of permanent loss.  Cullen Roche goes so far as to say that each investor’s true risk, can’t be boiled down to one number.  But because I’m the kind of person who likes quantitative measures, I always found this shrug to the risk question unsatisfying.

What’s so hard about quantifying the risk of permanent loss?  Among several difficulties often mentioned by informed observers, the most important seems to be that the investing timeframe used to define a permanent loss can easily turn out to be wrong.  For example, we can buy an asset with the full intention of holding it for 10 years, but unlike my death-contract story, in reality, we can sell liquid assets for reasons ranging from a dire necessity to a mere whim.

Further, I’ve presented estimates showing that life can dole out unexpected dire necessities much more frequently than you might assume.  I gathered statistics on life events like under-insured home disasters, long-term disability, continuing education costs, long-term unemployment, legal problems, divorce, business bankruptcy, and others.  Using average wage and actuarial data, I roughly estimated that there’s an 83% chance of having at least one of these dire necessities happen to you between the ages of 23 and 65, with an average cumulative cost of about $260,000¹.  So, you might buy a $100K in stocks expecting to hold them until retirement, only to find out a few years later that you need to sell some or all of those stocks to deal with a major under-insured health problem, long-term unemployment, or something like that.

Making An Estimate

Because of life’s uncertainties, I agree that estimating a permanent loss risk that applies to every investor and situation is impossible.  But by the same token, I don’t see how the widespread use of annual volatility accurately measures the risk for every investor and situation either.  Rather than giving up on permanent loss risk estimates, I prefer to attempt an estimate and consider whether the associated uncertainties are any worse than the uncertainties surrounding the existing risk paradigm of annual volatility.

In my last few posts, I’ve been using historical returns data to calculate how often various types of stocks have produced inflation-adjusted losses over various investing timeframes ranging from relatively short-term (1 year) to long-term (20  years).  After working on these types of statistics for weeks, it dawned on me that this was essentially a measure of permanent loss risk.

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