Risk (Stocks vs. Bitcoin)
Which would you choose?
Yesterday, I wrote about the offensive side of investing, returns (aka making money). It makes sense then to cover the other side, which is defense (aka risk).
To start with a simple example, if two people came to you and said they doubled their money in a few hours, you’d be impressed. Then, after the overwhelming jealousy washed over you, you’d probably ask, “How’d you both do it!?”
The first person says, “Well, I spent years learning the science and art of blackjack and methodically applied a strategy honed over years of research and practice to carefully grow my winnings over the course of an afternoon.”
The next person says, “Well, I walked up to the roulette wheel, put all my money on red and, wouldn’t ya know it, red came up and I won!”
Gambling is never risk-free (otherwise it wouldn’t be gambling, duh) but one of these double-your-money approaches feels a lot riskier. On the one hand, you have a random but methodical blackjack profit climb with small wins and losses along the way. On the other hand, you have someone recklessly betting their entire stack in one all-or-nothing shot.
Risk can mean both positive outcomes (you bet red on roulette and red comes up) and negative outcomes (you bet red on roulette and black comes up) but really it’s about the variance and uncertainty of those outcomes. One of these casino strategies has huge swings and another has smaller swings.
Applying that idea to the stocks and bitcoin example from yesterday, we can make a histogram with the frequency that each range of gain or loss occurred during the two-month trading window:
Stocks have a decent amount of deviation over this time period but bitcoin saw huge daily swings up 10% or down 10%. The Dow has only seen about a dozen daily swings that extreme in a hundred years! 10% up or down for bitcoin is like a random Tuesday - no big deal! The deviation and, therefore, risk of bitcoin is just so much higher than stocks.
Return will always be tied to risk. The nature of almost all investments is to go up and down, some more than others. Doubling up on a bitcoin investment is impressive but it comes at a greater potential cost compared to stocks because bitcoin has so much more deviation and risk.
That’s not necessarily a bad thing! The roulette player doubled up much faster than the blackjack player. For some people, risk is attractive. It presents opportunity.
Risk is a powerful tool we can harness to set our potential returns. But, just like a bad defense, if we don’t have a sound understanding of the risk associated with potential returns, our offensive gains can be wiped out very quickly. After all, almost anyone who has spent some time at a casino has a story about someone who played recklessly and did not walk away with double their money.