Should I invest in bitcoin? (And other questions)
In a time of great uncertainty it’s important to remember that you probably have no investment skill, but that doesn’t mean you have to be incompetent.
At the time of writing (early 2022), there’s a lot going on. The US stock market is nearly as overvalued as just before the dotcom crash. Inflation is accelerating. Interest rates are on the rise and central banks look set to reverse quantitative easing. Russia has just invaded Ukraine. Tensions between the US and China are on the increase. US democracy itself seems to be fraying at the seams.
Clickbait abounds. Should I buy gold, commodities and oil stocks to protect against inflation? How will climate change affect my investments? Will emerging markets beat the US market? Is a crash coming? Should I get out of equities altogether? Are bonds safe anymore? Should I be in value or growth stocks? Are we returning to the stagflation of the 1970s? Is bitcoin about to soar to $100,000 or crash to $1000? Is it even time to run to the hills with guns and gold?
Facing FOMO if we don’t act and FOMU¹ if we do, we can yo-yo between decisions in a destructive way. I’ve faced this myself just recently as I’ve played out alternative scenarios in my head. This post is as much to calm me down as it is for you, dear reader.
Here are some reflections on all this turmoil.
We don’t know what will happen, so we need to be ready for anything
As humans we love telling stories. We tell them to explain the past and to predict the future. All sorts of biases cause us to lock onto our preferred interpretation and once we’ve done that it can seem obvious what’s going to happen. But the reality is that we live in radical uncertainty. Who would’ve thought, in February 2020, that the stock market was about to fall by a third within a matter of weeks and that we would spend two years intermittently locked-up at home, wearing masks, and becoming experts in R numbers? Who would’ve thought, on 20 March 2020, that over the next 21 months the S&P500 would double to end 2021 over 40% higher than it was before the pandemic started?
At the moment it’s obvious that we’re headed for a 1970s period of stagflation. The hangover from excessive monetary easing will combine with supply chain constraints, deglobalisation, armed conflict in Europe, tepid productivity and high starting valuations to deliver a decade horribilis for bonds and stocks. Gold and commodities will come into their own. According to Jeremy Grantham, the US is in the fourth super bubble of the last 100 years. In a notably bearish forecast, the firm he founded, GMO, is predicting cumulative negative returns of 36% for US stocks and 24% for US bonds over the next seven years. The story is so compelling that it’s persuasive to come out of the market and to invest in a mix of cash, commodities and serially underperforming (and hence ‘undervalued’) markets like the UK and Japan.
However, the obvious doesn’t always happen. Bubbles can inflate a lot before they pop. Grantham was warning of the dangers three years ago since when the S&P 500 is up over 50%. Central banks could overreact to what turned out to be a transient inflationary threat. A rapid increase in interest rates and reduction in central bank balance sheets could trigger a balance sheet crisis in our over-indebted public and private sectors. Recession and a subsequent fall in longer-term bond yields could follow leading to a recovery in bonds.
Alternatively, the diffusion of digital technology and AI through the economy could trigger one of the world’s periodic surges in productivity. Breakthroughs in renewable energy and nuclear fusion could solve energy crises once and for all creating a spurt of economic growth. Both of these could support continued strong equity growth.
The truth is, we don’t have a clue what the future holds or which one of many possible states of the world will come to pass. So rather than investing on the basis of a single story of the world, we’d better be ready for anything. Given that the fact we don’t know anything is consistent over time, our investment strategy should similarly be fairly stable regardless of today’s news flow.
You (probably) don’t have investment skill, but you can develop competence
There’s a raging academic debate about whether investment skill, which leads to investment outperformance, even exists, as opposed to just some lucky investment managers. (It probably does, although whether the benefits accrue to the investor or their clients is a different matter.) What’s almost certainly true is that you don’t have this skill. You also probably don’t have the skill to pick someone with the skill. Or, if you’re using a financial adviser, you probably don’t have the skill to pick someone with the skill to pick someone with the skill.
But overconfidence bias, recency, confirmation bias and our love of stories can convince us that we do have an edge or that we’re able to identify an adviser or fund manager that does. This can be fatal. We need to remain humble.
But even though you probably don’t have investment skill, you can develop investment competence. This is the knowledge of how best to invest, based on the fact that you have no idea what the future holds.
Bad stuff can happen so be ready for it
Investment markets have been extraordinarily accommodating since the financial crisis. Virtually every asset class has gone up in value: equities, bonds, property, gold and commodities. Since 2000, bonds have been particularly well behaved. In the subsequent two decades they not only delivered outsize real returns of close to 5% a year, but they were also negatively correlated with equity returns. When stock markets fell, bonds rose in value, enabling more stocks to be bought as portfolios were rebalanced, leading to enhanced returns as markets obligingly recovered in a matter of a few years (or less). This was a dream for the classic 60:40 equity:bond portfolio. Every dip in equities was matched by a rise in bonds generating high real returns with low volatility.
But life will not always be this smooth. Stock market crashes of 40 to 50% in real terms turn up every decade or two. So we’re probably about due one (I don’t count COVID, which was simply a short-term blip rather than a real crash like 2000 or 2008). And these falls aren’t always short-term. Although the recovery after 2008 and 2020 falls was quite rapid, the stock market has delivered negative real returns over periods of 15–20 years on a number of occasions, starting around 1910, 1928, the early 1961, 1999. So while stocks have always delivered good real returns over periods of 30 years or more, up to 20 years they are far from a sure thing.
Bonds have also had some terrible periods. Despite long-term average real returns of around 2% per annum since 1900, government bonds have had some horrendous decades, losing around one-third of their value in real terms in the 1940s and 1970s, and they look likely to do similar in the 2020s. Moreover, bonds haven’t always provided the quality of diversification they’ve become renowned for this century. During the decade from 1971 to 1981, while equities were losing over a quarter of their value in real terms, bonds also slumped by over a third. This was just a horrible period for investing. Indeed bonds and equities have been positively correlated more often than not going back to 1871. Stocks and bonds have again fallen together since the start of 2022.
We’ve all become used to things working out rather well in investment markets, which have been generally well-behaved and delivered strong returns for all manner of asset allocations. But it won’t always be like this and indeed may not be fairly soon. Any investment strategy needs to be stress-tested against a severe short-term stock market fall, but also the risk of negative real returns for periods of up to two decades. Don’t assume that bonds and stocks will bail each other out as they have in the past. Things may work out much better than this — I hope they do — but how would your investment strategy (and you) react if realistic worst case scenarios came about?
Diversification still works
The truly dismal prospective returns on bonds (which have prospective negative real yields of between 2% and 3% in the UK at the time of writing) encourages some people to invoke the TINA² argument in favour of stocks. Surely, they argue, stocks will not be priced to give a negative real return? But realised returns don’t always turn out as expected. As the 1910s, 1930s, 1940s, 1970s and 2000s show, equities can also deliver negative real returns for a decade, sometimes two. Bonds outperform equities in around a quarter of 10-year periods, and in one third of those it is when bonds have themselves delivered a negative real return.
One justification for equity market valuations is that interest rates are so low. But this cuts both ways. If this is true, then interest rates being low also implies that expected returns on equities are depressed and the risk of absolute and real declines in value is therefore increased. The risk management benefit of bonds depends on the relative not absolute pricing of bonds and equities. Even at low interest rates bonds can play a role.
At the other extreme, Jeremy Grantham fans may be wanting to pull everything out of the stock market and sit out the ‘inevitable’ crash. But what if this doesn’t happen and markets increase a further 50% before they pop? Or what if the ‘bubble’ unwinds by below average, but still positive, real returns over time rather than a market crash. Can you afford that missed opportunity?
What about gold and commodities? These assets deliver a limited long-term real return and can be highly cyclical, but in the short term can be very volatile and have on occasion shot up in value as equities have fallen sharply. For example, gold and commodities futures rose 80% and 122% in dollar terms from August 1972 to November 1974 while developed country equities were falling 40%. These assets therefore showed a counterbalancing positive return of two to three times the fall in the stock market. As a result a relatively small allocation to these assets could significantly limit the losses on the equity portion of a portfolio. Assets like gold are what hedge fund manager Mark Spitznagel of Universa Investments calls ‘safe haven’ investments (although it should be noted he’s not entirely convinced of how effective gold is in this role). Safe haven investments create a small drag on returns most of the time, but pay for that by shooting up in value exactly when you need it: when markets crash. This insurance against large losses can significantly enhance compounded returns over time. This is also the logic behind inclusion of gold and commodities in Harry Browne’s Permanent Portfolio and Ray Dallio’s All-Weather Portfolio.
Gold and commodities worked great in the 1970s. But in the dotcom crash they only increased by around 0.35 times the fall in equity markets and in 2008/9 commodities actually fell in line with the stock market while gold only increased by around 0.4 times the market fall. Given that gold and commodities together will typically only form at most 10–20% of a portfolio, outside of the 1970s they’ve not achieved much as a safe haven.
And should you invest in bitcoin? The problem is we don’t really know what bitcoin is yet. Is it a currency, a safe haven asset against the collapse of trust in central banks speculative asset or a speculative investment? It might be any of these or something else altogether. Given this uncertainty it is hard to see anything other than a very small portion of a portfolio being allocated to bitcoin other than on a very speculative basis.
Highly uncertain markets can trick us into focussing on what we think is the most likely source of uncertainty (e.g. runaway inflation). But this can cause us to focus excessively on a single risk and skew our portfolio to assets that deal with one scenario but aren’t affective across many scenarios or for the long term. And uncertainty has a habit of surprising us, with the danger that we find that focused on the wrong risk. Any investment strategy should be created and diversified so as to withstand a range of market conditions, because we don’t know what’s coming. If analysis shows that your strategy overlooks important credible scenarios then by all means adjust and get your diversification right. But diversify your investments in a way that as aligned with the flexibility and time horizon of your goals, and avoid tricking yourself into focussing just on your favoured (and therefore perceived most likely) short term scenario.
Returns will likely be lower in the near future than they have been in the recent past
Jeremy Siegel shows how US stocks have consistently delivered 6% pa real returns over periods of 30 years or more from a variety of starting points. But we can’t all wait 30 years. Given low interest rates and high market valuations it is expected, although not certain, that over the next one or two decades returns on all major asset classes will be lower than they have been in the recent past and likely also below their long-run averages. We need to calibrate our expected returns accordingly. This shouldn’t affect our investment strategy as much our savings rates (higher), the level of our financial goals (lower or more distant), or the probability we assign to achieving our goals (lower).
Hoping to maintain returns at historic levels by loading up on alternatives, private equity or higher equity allocations adds risk — and risks disappointment. A level of realism is required.
Remember, all you need is enough
Capital markets have done a great job of delivering good enough returns over long enough periods for those investors prepared to stay the course in a balanced manner. There will always be an investment strategy that would’ve delivered you higher returns. FOMO is a dangerous emotion that can create the flip-flopping that leads to buy high/sell low decision making. Make sure you understand how much is enough and what return is enough for you to meet that goal. Think about how you can maximise the probability of achieving that, rather than chasing after ever higher returns. Staying in the market, in a consistent way over time, is often a way to achieve that.
Keep calm and carry on
Unless you fancy yourself or your adviser as a market-timing guru (please don’t) your investment strategy should be set up to deal with a wide range of market circumstances and so be broadly consistent across time. However, careful review may expose weaknesses in your approach. Your portfolio mix may have drifted away from your desired risk profile due to varying returns on different asset classes. Given strong recent portfolio performance you may find you can take less risk in future to meet your goals. Or changing circumstances may increase your capacity to take risk. A simple equity-based strategy started out early in your career might need refining and diversifying as financial freedom comes into view and your investment time horizon shortens. You may find important asset classes missing from your risk-management toolkit.
By all means adjust, but these should in most cases by marginal improvements as opposed to a fundamental realignment. Short-term news should affect your investment strategy less than you think. You just don’t have the skill to interpret what it means. But you can still develop competence, to design and operate an investment strategy that endures over time.
A consistently executed plan has a better chance of succeeding over the long term than a random set of reactive decisions.
¹ Fear of messing up.
² There is no alternative.
Nothing in this article should be taken to represent financial advice. It is generic commentary based on typical circumstances and not tailored to your own situation. If you’re not sure what to do, you should take financial advice.