10 Nov 2017 A Word About Cryptocurrency and Risk Management

Here are two articles that came across my desk on Wednesday of this week: one in the morning entitled “Nearly a Third of Millennials Say They’d Rather Own Bitcoin Than Stocks,” and then one that evening entitled “‘$300m in cryptocurrency’ accidentally lost forever due to bug.”

[As an aside, you’ve probably heard the terms “bitcoin” and “blockchain” thrown around with increasing frequency recently. An impossibly quick primer on the subject is as follows: “Blockchain” is the term used to describe a database technology that acts as a distributed, decentralized ledger, tracking transactions over the internet. The distributed ledger is “open,” meaning there is no central intermediary like a bank keeping up with transactional data. Instead the blockchain relies on lots of individual players to act in their own self-interests in order for the blockchain to function correctly, and to incentivize that behavior, “cryptocurrencies” were invented. So, if I do what I need to do for the blockchain to work (the primary required behavior is a sort of data mining called “hashing”) then I’m compensated in whatever cryptocurrency is associated with the particular blockchain I’m working on. If I want to, I can hold on to that cryptocurrency forever, or I can find someone to pay me actual fiat currency for it, or I may even trade it for a different cryptocurrency. Bitcoin was really the first of these cryptocurrencies, and now there are more than a thousand.] 

I know that was weird, and trust me, I don’t understand 5% (probably 1%) of what’s going on with all of this even though I have taken an active interest in it. But I think it’s important to understand how hard blockchain and cryptocurrency are to understand, because “Nearly a Third of Millenials Say They’d Rather Own Bitcoin Than Stocks” but also, “$300m in cryptocurrency accidentally lost forever due to bug.”

The juxtaposition of those two articles reminds me that many people 1) Are unfamiliar with the assets that they’re investing in (and quite honestly it’s hard to even call cryptocurrencies an “asset”!), and 2) Don’t truly understand risk, because risk is tricky.

So I have a proposal for a new way for you to think about risk. The downside to my proposal is that it doesn’t quantify risk and is somewhat over-simplified. The upside is that it helps conceptualize risk and anyone can use it:

When you want to gauge and manage the risk in your investment portfolio, or your insurance coverage, or just about any financial area of your life, start with the following question: What’s The Worst That Could Happen? 

In the case of the millennials and others who invest in Bitcoin or Ethereum or any of the other cryptocurrencies, the worst that could happen is that your cryptocurrency could literally disappear into nothing in an instant, and you have basically no recourse to get it back. Lots of risk!

But you probably don’t have any exposure to Bitcoin. What about your 401k? What about the rest of your investment portfolio? How do you assess risk there?

Often—and I’m as guilty of this as anyone—volatility and risk are thrown around as synonymous when they are not. In other words, we say that risk in our investment portfolio is the degree to which it fluctuates in value, when in fact that’s simply describing volatility. In reality, risk—if we’re using the What’s The Worst That Could Happen framework—is something like this:

• You have too much exposure in your portfolio to equities or other volatile assets and you’re just about to start or are already drawing down those assets for retirement. The worst that could happen is the next bear market rolls through, you’re selling stocks at a discount because you have to, and your retirement lifestyle is significantly impacted.
• You are a good ways away from retirement, but your exposure to volatile assets is high enough that it causes you to swerve from your plan and make bad decisions. The worst that could happen is a bear market that you can’t stomach so you sell your stocks at a discount, and then miss the come up, and suddenly some of your once-achievable goals are not so achievable.
• You have a great job at a public company and receive generous compensation in the form of your company’s stock, and you feel pressure or some unspoken responsibility to hold on to that stock. The worst that could happen is you’ve effectively raised your career risk exponentially, because not only could you lose your job, you could also lose a significant portion of your savings due to a concentrated stock position. All from one bad event.

You see, risk is not just volatility, but volatility working in concert with bad timing and behavior, either forced (like having to sell discounted stocks during retirement since you are no longer working) or unforced (like having more volatility than you can stomach and compounding that by making an emotional decision).

You can’t control the bad timing; none of us can. But you can control to a large extent the amount of volatility you subject your portfolio to, and you can definitely control your behavior—even if it takes a trusted advisor to help you.

So as we head into year-end, maybe it’s a good time for you to take a look at your portfolio (hopefully in the context of a financial plan!) and ask What’s The Worst That Could Happen? It’s not meant to be a scare tactic, but simply a way to conceptualize a difficult yet really important reality. If the answer you come up with doesn’t feel adequate, give us a call. We’re here to help.