Category: Uncategorized

Categories
Uncategorized

Deciphering Blockchain Technology

Most people know that cryptocurrency is a decentralized, digital form of money that can be used for transactions, but what about the technology behind it? Blockchain technology was adopted in 2009 by Satoshi Nakamoto, the anonymous creator of Bitcoin, in order to support its function. However, not many people are aware of what exactly blockchain technology is, or about its many uses for cryptocurrency and beyond. With thousands of cryptocurrencies in existence, and with Bitcoin reaching an all-time high price of above $68,000 this November, they continue to rise in popularity and their influence is becoming more dominant. These digital currencies are likely here to stay and can no longer be overlooked, so now, it is more important than ever to be informed on cryptocurrency and its technology.

Popularized with the original Bitcoin whitepaper, blockchain is now the primary technology behind thousands of other cryptocurrencies. Blockchain is a type of distributed ledger technology; essentially, it is a database that acts as a public ledger to record digital transactions across a peer-to-peer network in a way that cannot be altered. Before diving deeper into how blockchain works, it is important to note some key characteristics of this technology. First, blockchain is a decentralized, peer-to-peer network where no single person or entity controls any of the data. This means that transactions occur directly from one party to the other without any third-party intermediary such as a bank, and there is no government involvement. Every transaction on the blockchain is verified through the peer-to-peer network, a process known as mining, which we will get more into later. Mining is completed through the proof-of-work framework, and this helps alleviate concerns of tampering, hacking, and fraud. Additionally, blockchain technology is distributed, meaning that everyone participating on the network has access to the entire database for full transparency. Anyone is allowed to join the network, and once they do, all transactions will be visible to that participant. The participants on the network are anonymous, and all transactions are secured and linked together through cryptography. As a result, no transaction can be altered once it is in the database, and every transaction is time-stamped to ensure there is no way to “double-spend.” The blockchain algorithms confirm that every transaction is permanent and in chronological order. Blockchain is also time efficient, as it is open 24 hours, 7 days a week. There were many attempts to create digital money before Bitcoin, but blockchain technology solved the issues that prior attempts ran into, making it an extreme success.

Blockchain can be thought of as an operating system that has different applications running on it, which are the cryptocurrencies like Bitcoin. These cryptocurrencies are built with blockchain technology, and each cryptocurrency has their own, separate blockchain. To better understand how blockchain technology works, it is important to know its three primary components: blocks, miners, and nodes. Generally speaking, the blocks are what collect all of  the information on the blockchain. There are four main elements within these blocks which are the data, the nonce, the hash, and the previous hash. The data being held in the blocks depends on the type of blockchain. For example, the Bitcoin blockchain stores all of the data regarding transactions, such as the amount, sender, and receiver. Essentially, these blocks act like boxes of receipts, and once the storage capacity of one block is filled, it is closed and will be linked to the previous block. The nonce, also referred to as a “number used only once”, is a 32-bit number that is randomly generated. This value is essential for the proof-of-work algorithm and is the number that crypto miners are searching for in order to be rewarded with cryptocurrency. The hash is a 256-bit number unique to each block, like a fingerprint. The block also includes the hash of the previous block which creates this immutable, unbreakable chain of blocks. This also helps with security, because in the event of someone tampering with a block, all following blocks will be changed and invalid. The only block that does not have the hash of the previous block is the initial block on the chain, known as the Genesis block. The second component of blockchain is the miners. Through mining, their goal is to find the “golden nonce” value, and when found, a new block is created on the chain. They will receive a reward of cryptocurrency for their work, and for some cryptocurrencies such as Bitcoin, this is the only way new “tokens” are entered into circulation. The third component of blockchain is the nodes, which are a critical part of blockchain’s infrastructure. Nodes are any electronic device, such as a computer, that allow for  a blockchain’s data to be accessible. In-essence, a blockchain exists on nodes. Additionally, nodes are needed in the mining process. When a miner attempts to add a block to the chain, all nodes will be notified, and they will either accept or reject the block based on the legitimacy of those transactions in that block.

Cryptocurrency is the primary reason for blockchain’s existence; however, more applications are beginning to be discovered beyond this. Businesses can use a private, or public, blockchain to track supply chains, store health care records, implement smart contracts, and more. Smart contracts are digital contracts on a blockchain that are automatically executed when certain conditions are met. Ethereum is the largest blockchain supporter of smart contracts, and it has extensive utility such as for automatic payments, crowdfunding, or registering a vehicle. Currently, companies including The Home Depot have implemented smart contracts to help resolve issues with vendors. Pharma Portal, a blockchain platform powered by IBM, tracks temperature-controlled pharmaceuticals through the supply chain to provide trusted data. These are only a few of the thousands of new blockchain uses being discovered and tested. In addition, more companies are beginning to accept cryptocurrency as a form of payment, showing its growing stance in society. Despite blockchain’s tremendous potential, the negative environmental impact that comes with blockchain technology and mining is raising concerns.

As briefly mentioned earlier, cryptocurrency mining is the process where miners compete against each other to be the first one to solve a complicated computational math problem. They are attempting to find the correct nonce value that will generate a hash. The solution is completely found by guesswork and chance, like a gamble, where the miner’s system will spit out random numbers until the nonce value is found. Once it is solved, that miner has validated transactions through proof-of-work and has added a new block to the blockchain. Mining is essentially a way that network participants complete the proof-of-work algorithm on blockchain, or verify the legitimacy of transactions, and it allows for more “tokens” to enter circulation. Currently, the reward for being the first miner to complete this process for Bitcoin is 6.25 Bitcoins, and the reward rate is cut in half about every four years. In order to mine for cryptocurrency, you need access to a substantial amount of energy, mining hardware that is either an “application-specific integrated circuit” or a “graphics processing unit,” and mining software to join a network. Although the price of hardware can be costly, the amount of money spent on energy will greatly exceed that. Despite crypto mining being a very expensive venture with a high probability for failure, people still find this process appealing. However, mining is causing severe damage to the environment. As explained, mining requires an immense amount of energy, and major sources of electricity are coal and fossil fuels. Burning coal contributes to the negative effects on the climate, and according to CNBC, Bitcoin mining accounts for about 35.95 million tons of carbon dioxide emissions which is the same as New Zealand. China, where mining rigs utilized energy from burning coal, recently banned all crypto activity due to environmental concerns. Many participants in Texas, a popular place for crypto mining, are using wind power. Others across the U.S. are converting abandoned factories into mining facilities using renewable energy. However, these places draw up millions of gallons of water a day through pipes to cool the plant which harms the wildlife. Even with the use of clean energy, electronic waste remains a problem. Since all of the participating miners compete against one another, they all want the most efficient hardware. This means that their old systems are constantly being discarded and ending up in dangerous landfills. These devices contain hazardous chemicals that harm the environment and the health of others. Although this is a negative side of the new world of blockchain, it still holds immense promise for the future.

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

 

Categories
Uncategorized

Anxiety Over Inflation

One of the main concerns investors have as the world begins to emerge from the Covid-19 era is inflation. Inflation is daunting to investors because it results in a loss of their purchasing power, and it is more difficult for their investments to produce real returns above inflation. Prices have increased 6.2% since October 2020, as measured by the Consumer Price Index (CPI), marking a 30-year high. This has worried economists that we will enter a period of stagflation, which is weak economic growth combined with high inflation. Although the Federal Reserve believes inflation will settle down next year, investors should still be aware of the current and historical events surrounding inflation spikes, along with investments that have historically worked as a hedge for inflation.

A primary event that has contributed to this inflation spike is the reopening of the economy from the Covid-19 pandemic. Pandemics have historically caused a disruption between the balance of supply and demand. Typically, a pandemic would cause demand to fall due to more people being infected by a disease, which results in them consuming less. However, with the Covid-19 pandemic, policymakers distributed a substantial amount of stimulus. With the reopening of the economy, the stimulus has resulted in an increase of demand. The combination of the current supply shortage and high demand leads to higher prices, hence the sharp increase in the inflation rate. No one can be certain about how long these implications from Covid-19 will linger around the economic and political sphere. Additionally, generational attitudes are formed through shared events such as wars, recessions, and pandemics. All of the effects from a major event can often take years to appear, which means we have not yet seen all of the social changes that will occur due to Covid-19. As the newer generations begin to grow older and gain more positions of influence, we could begin to see a difference in societal and economic behavior.

Another current event affecting the high inflation rate is the supply-chain shortage accompanied with the labor shortage. The supply-chain shortage is pervasive in multiple sectors of the economy and according to Moody’s Analytics, it “will get worse before it gets better.” The computer chip shortage has resulted in a lack of new cars, which in turn, has substantially raised the price of new cars. In fact, this shortage has effected the auto industry so drastically that AlixPartners forecasts the opportunity cost of lost sales to reach $210 billion for the year. This led General Motors to shut down their production for a short time period in September. Car dealerships have very limited inventory on their lots, which makes right now a very expensive time to purchase a vehicle. Other supply shortages are occurring in the housing market and in retail stores such as grocery markets. Many shelves have appeared empty and there is likely no way to improve these conditions before the holiday season, resulting in many shoppers to rush to the stores to begin their holiday shopping early this year. Major contributing factors to the shortages include the effects of Covid-19, a dearth of workers, and port congestion. Examples can be found in a variety of industries. Covid-19 cases have recently experienced a considerable jump in countries such as Vietnam. Vietnam produces half of the apparel for brands including Nike and Adidas, resulting in supply shortages for the United States. The lack of labor is significantly prevalent in the trucking industry which has caused shipping prices to skyrocket and shipping ports to become badly congested. Many ports have shut down, in some cases due to workers becoming infected with Covid-19. When ports shut down, this causes the open terminals to become flooded. These are only some of the current events that are causing inflation to rise and instilling fear in consumers.

More threats posing a risk to the economy are rising bond yields, potential interest rate hikes, and soaring energy costs. Investors worry about a rise in bond yields because it can trigger a fall in stock prices. We recently experienced the 10-year Treasury yield rising above 1.5% and the 30-year yield rising above 2%. This resulted in growth stocks and Big Tech stocks suffering the most. When there are higher bond yields, it decreases the value of future cash flows which in turn decreases stock valuations, especially for companies with anticipated growth as a major component of their stock prices. We can also expect to see a rise in interest rates at some point between 2022 and 2023. The Fed does this to make money more expensive to borrow in hopes this will slow down the pace of price increases. Natural gas and crude oil prices have risen to a 7-year high, heating oil prices rose 68% this year, and coal prices have drastically increased. High energy prices can increase inflation and cause consumers to not spend money on other products or services. This slows down the U.S. recovery pace and weakens economic growth. The mix of high inflation and slowed economic growth is known as stagflation, a term used to describe the economic standpoint of America in the 1970’s. Although unlikely, many are wondering if we are entering a period similar to the 70’s. The Great Inflation, an event lasting from 1965 to 1982, was a period where the cost of living for Americans soared. Prices for everyday items such as food saw inflation of 15% and the unemployment rate almost reached 10%. Consumers congregated in the streets and protested against these rising prices and for an increase in their wages. Wages eventually went up, but then companies instantly increased their prices even more, almost like a never-ending game of tag. This crisis began to dissipate after then-Fed Chair Paul Volcker raised interest rates to an astronomical 20% and launched a bull market for both stocks and bonds. Although there are similarities to what is happening in the economy now, the Fed believes that this high inflation is temporary, and we do not need to worry about another Great Inflation event happening anytime soon.

In order to protect purchasing power, investors should ultimately be aware of assets that have historically performed well as a hedge against inflation. It is important to note that these assets may not offer the same protection in the future and they have other risk factors which may not make them appropriate for everyone. First and foremost, stocks can be an effective inflation hedge. Specifically, stocks in companies that are able to pass on costs to their customers and maintain, or even expand, their margins tend to be well-positioned for inflation. Additionally, stocks that are not overly-reliant on future growth may be best due to the valuation reasons explained earlier. Real estate has also been a good historical inflation hedge. Investors can invest in real estate directly or indirectly through an investment vehicle such as a publicly-traded Real Estate Investment Trust (REIT). An MIT study in 2017 proved that the income from retail property is a better hedge for inflation compared to residential, office, and industrial property. Fixed-income, cash, and cash equivalents often suffer the most with inflation. However, Treasury Inflation-Protected Securities (TIPS) are designed specifically to protect against inflation. The interest on TIPS will never change, but the par value will rise with CPI. At maturity, the investor will be paid the higher value between either the original or adjusted principal. Commodities, including gold, other precious metals, coffee, and oil have also historically worked as a hedge against inflation. An investor can involve themselves with commodities through ETFs, purchase them physically, buy futures, or invest in mining companies. Although inflation is often beneficial for commodities, these are extremely risky and are tied to government regulations and other events. Cryptocurrency is a more speculative investment which proponents argue can serve to protect against inflation in fiat currencies. Bitcoin, for example, has a built-in inflation hedging mechanism due to the finite number of coins that can be mined. However, there is not a long track record to prove it’s effectiveness. Ultimately, investors should diversify their holdings within their portfolio and know how much risk they are willing to take to protect themselves against rising inflation.

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

Cracking Down on Crypto

In recent years, there has been an influx of interest in cryptocurrencies. The investor base is diverse: tech-savvy traders, aggressive speculators, hedgers prophesizing the doom of fiat currencies, Elon Musk fans, and even large institutions seeking to supplement their investments in alternative assets. This list is not all-inclusive nor is it mutually exclusive.  The insatiable demand for cryptocurrencies has wrought massive price increases. The price of Bitcoin, for example, skyrocketed to well over $60,000 earlier this year before paring some of the gains. The volatility associated with cryptocurrency can cause the value to drop precipitously; yet many people like the idea that it is not controlled by a government or financial institution.

Despite the strong appreciation for decentralized currencies, Chinese regulators have continuously attempted to ban them. In 2013, the Chinese government defined Bitcoin as a virtual commodity rather than legal tender. Later that year, China banned banks from providing any bitcoin-related services. Four years later, in 2017, China banned initial coin offerings and cryptocurrency exchanges. However, investors found many ways to get around this through offshore exchanges and over-the-counter platforms. China’s numerous attempts to ban cryptocurrency have shown the immense technological challenges of regulation due to crypto’s decentralized design.  Still, on September 24th of 2021, China once again launched a crackdown on cryptocurrency, and this is their most powerful attempt yet.

The cryptocurrency industry has come under scrutiny for various reasons including money laundering, energy consumption, and the safety of peoples’ assets.  China’s new ban restricts cryptocurrency transactions and mining, making all crypto-related activities illegal in China. One reason for this ban is to allow China to reach their goal to become carbon neutral by 2060. The cryptocurrency mining process uses highly sophisticated hardware and a substantial amount of energy. Often, miners spend more money on electricity costs than what they mine is even worth. Since China is home to many crypto miners, China believes this has contributed to the power crisis that has interfered with their carbon goals. This electricity shortage has caused energy prices to increase along with blackouts across many of China’s provinces. However, some researchers suggest that most of the coins that are mined in China are generated by green energy. Proponents argue that Bitcoin mining incentivizes renewables due to the high energy costs. However, this is still somewhat controversial.

Some of the world’s largest cryptocurrency exchanges such as Huobi and Binance have already made drastic changes. Huobi is retiring all existing accounts of mainland Chinese users and will end account registrations for new users in mainland China by midnight of December 31st, 2021. Huobi announced that this is to protect the current users’ assets, and they will continue to announce more details of these changes in the future. This resulted in the token price of Huobi to slide down to an 8-month low. Binance has also complied with these new regulations and has blocked all account registrations with mainland Chinese phone numbers. A spokesperson from Binance explained that they take their compliance obligations seriously, and will follow regulatory requirements wherever they have operations.

While Chinese agencies are working together to make this ban successful, in the U.S., the Fed is considering its own digital currency. It is important to note that this is not the same as cryptocurrency. Cryptocurrencies are decentralized whereas a digital currency would fall under the control of the Fed. During the same week of China’s crackdown, the Fed made several comments about a potential digital currency. These comments are not new, however, since the Fed has been talking about creating a digital currency for quite some time. Chairman of the Federal Reserve, Jerome Powell, explained that the Fed is moving forward with their research into implementing their own digital currency and will soon release a whitepaper on the topic. There has been no final decision announced on this as the Fed officials want to ensure they make an informed decision and “do it right the first time.”

Some of the benefits, the Fed claims, of issuing its own digital currency would be to provide services to people who do not use banks and to quickly get payments to people, especially in times of crisis. For example, digital currency could allow for a faster and cheaper way to issue stimulus checks compared to the paper stimulus checks issued by the U.S. government during the COVID-19 pandemic. Opponents argue that the Fed creating a digital currency could have serious repercussions for the financial system. Banks may see a digital currency as a source of competition. Furthermore, since this is digital, there are chances of hackers and fraud. If the government does not protect the digital currency from major cyber attacks, people will begin to lose trust in the “lender of last resort.”

Although the Fed has been considering this for a while, many people believe they have fallen behind in a “global race for digital currency.” However, Powell does not agree as he states, “I think it’s more important to do this right than to do it fast.” It seems that the US was once a leader in technological innovation but now may be lagging. Places around the world are beginning to realize the importance of digital integration. The Bahamas have integrated a digital Sand Dollar, and other countries such as Australia and Malaysia are in the process of creating a cross-border central bank digital currency exchange program. El Salvador just recently became the first country to accept Bitcoin as legal tender, and even China has created a digital version of its paper currency called e-RMB. The world is experiencing technological improvements every day, and countries are starting to change aspects of their economies. The US establishing a digital currency could allow for easier banking while also keeping their technological edge and influence.

 

Disclaimer

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance, or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

Compounding the Issue

Compounding Coins

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

– Albert Einstein

The most important concept pertinent to investing is the arithmetic of compounding. The math is not immediately intuitive, but the effects, both positive and negative, have momentous impacts on portfolio returns. Investors who understand the drivers of compounding are best positioned for long-term success. Alternately, nearsighted investors who ignore the significance of compounding may struggle to reach their desired objectives.

Much has already been written about the importance of long-term investing, but the specific reason why it is essential to retain a long-term mindset often goes overlooked. It is easy to believe that stock market riches lie in huge overnight gains, especially after the GameStop incident earlier this year. The firestorm of media coverage surrounding these events can easily induce investors to subconsciously overestimate the frequency of such occurrences. However, in reality, patient investors have a much better chance of reaching “riches” in the stock market due to the exponential growth of compounding over time. Suppose an investment returns 10% per year. After ten years, each dollar invested would be worth $2.59. After twenty years, each dollar would be $6.72. After 30 years, each dollar would be $17.45. It is evident that the growth is not linear; it is exponential. Each incremental  increase in portfolio value leads to larger changes in the future.


Exhibit I: Exponential growth of portfolio for differing return assumptions.

Despite the benefits, compounding can also have tremendously adverse consequences for investors. The effects of positive and negative returns are asymmetrical, meaning negative returns actually have a larger impact on the portfolio in dollar terms than positive returns of the same percentage. To illustrate, consider an investment of $1 million. After undergoing a rough period in the market, the value of the investment is now $500,000, for a 50% loss. However, we cannot simply rely on a 50% gain to bring the investment back to $1 million. Now that the value is only $500,000, we must double our money for a 100% gain in order to get back to where we started.

Exhibit II: If an investment returns an initial amount shown on the x-axis, what subsequent return needs to be achieved in order to match the starting dollar amount?

The question then becomes how investors can use compounding to their advantage rather than fall prey to unfavorable outcomes. Risk management and investor temperament are crucial. Risk is unavoidable. However, the amount of risk that is being taken must be carefully measured and monitored to ensure that it is not out of line with what the investor can tolerate. Investment professionals typically measure risk by volatility, or standard deviation. High volatility implies a magnitude of returns higher than historical tendencies would estimate. Note that magnitude says nothing about direction. It is not necessary that volatility will ultimately result in harm to an investors’ portfolio since volatility does not imply permanent loss; it only implies wide swings in value. However, when investor behavior is involved, volatility can easily result in permanent loss. This is especially true if it turns out that the portfolio risk was not properly managed or was more than the investor’s risk tolerance could allow for. The investor may panic and sell, foregoing potential high volatility gains in the recovery. Over the long-term the impact of these mistakes can be devastating even though the true impact might not be clear on the surface. The reason: compounding. The investor is missing out on the largest gains of the recovery, and when they do eventually get back in, their portfolio is starting from a lower value. Investors would be wise to follow Charlie Munger’s first rule of compounding: “Never interrupt it unnecessarily.”

Of course, the caveat to Munger’s quote is the word, “unnecessarily.” Just as investors can fall into the trap of panic selling, they may be influenced by the disposition effect. The disposition effect is a behavioral anomaly referring to investors’ natural tendencies to sell assets that have risen in price (thus locking in gains) and hold onto assets that have fallen (thus avoiding the aforementioned permanent loss). Each situation is different, and there is no clear answer on how to act. To maximize the probability of success over the long-term, it is vital for investors to have an investment process that they follow with discipline. This can help minimize the influence of emotions and allow their investments to compound over time.

Compounding, as it relates to investing, occurs at multiple levels. At the highest level is the compounding of the portfolio value. This is not only related to the individual performance of the underlying securities but also how the portfolio is constructed and how drawdowns are managed (drawdowns are the losses of the portfolio from peak to valley). Diversification is imperative for reducing portfolio risk. The bellwether for diversification is the balanced portfolio consisting of stocks and bonds. Historically, the correlation between stocks and bonds has been low. This has allowed the two asset classes to perform particularly well together and lessen the volatility as compared to an all-stock portfolio. There are also more complex strategies that can be used. Hedge funds are well known for their focus on risk mitigation. Many hedge funds employ long-short strategies where they bet on certain stocks and against others. The offsetting positions, they hope, will minimize the systematic (market) risk and allow the fund to grow steadily despite market conditions (depending on the specific strategy; there are many variations of the long-short portfolio). These are only a few examples, but there are numerous types of strategies with the same aim: achieving steady returns and avoiding significant drawdowns to maximize portfolio growth over time.

The second level of compounding occurs at the individual stock price level. Famed mutual fund manager Peter Lynch popularized the term “tenbagger” to describe stocks that increase ten-fold over the initial buy price. Many investors focus specifically on seeking out these kinds of stocks. Needless to say, tenbaggers are rarities, but not every stock needs to be a tenbagger for an investment to be considered a success. Some investors may even find success through trading stocks over short time horizons (e.g., weeks, days, seconds, etc.). Renaissance Technologies’ Medallion Fund is the quintessential example. The quantitative hedge fund (which is now closed to the public) is believed to have achieved an astonishing average annual return of 66% gross of fees from 1988 to 2018 according to author Gregory Zuckerman. This was done by consistently generating small gains and using a fair amount of leverage in a large portfolio of securities. Due to the mathematics of compounding, these small gains do not simply add up over time; they multiply, which can result in staggering numbers.

Exhibit III: Compounding should  not be treated as some abstract mathematical mirage. Investors should understand how compounding occurs at multiple levels and directly affects value over time.

 

 

Disclaimer

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance, or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

Fallacies and Financial Markets

Hand Flips Coin Image

When predicting uncertain, random events, we often take mental shortcuts or go with our gut feelings, which can lead to statistical illusions and suboptimal actions. Our cognitive biases are not consistent with the law of probability because most of us find it frustratingly unintuitive and challenging.

The gambler’s fallacy, also known as the Monte Carlo fallacy (first coined by famous researchers Amos Tversky and Daniel Kahneman in 1971), is a cognitive error that describes our tendency to believe a previous event or series of events can influence the outcome of a future, random event. This can be simply illustrated with a coin toss. If a person flips a fair coin five times and each time it lands on heads, the observer may erroneously conclude the next flip is more likely to be tails. This line of thinking involves an inaccurate understanding of probability. Each coin flip is randomly generated and statistically independent, which means previous flips have no bearing on future flips. If we keep flipping the coin indefinitely, the fraction of heads in the total number of outcomes converges to 50 percent, the long-run average. Ultimately, the gambler’s fallacy is the mistaken belief that random sequences should exhibit systematic reversals.

Another statistical illusion is related to the hot hand in basketball, in which people predict that random sequences will exhibit excessive persistence rather than reversals. Nearly every basketball player, coach, or fan believes that players can have “hot hands,” meaning that they are on a hot streak and are more likely than average to make their next shot. However, in the landmark 1985 paper, The hot hand in basketball: On the misperception of random sequences, psychologists Thomas Gilovich, Robert Vallone, and Amos Tversky (GVT) concluded that the hot hand is a cognitive illusion representing the tendency to detect patterns in randomness. The expectation that a trend will continue in the future is known as the hot hand fallacy.


Hot Hands and Gamblers Fallacy
The hot hand and gambler’s fallacies are two important cognitive biases that affect investment decisions in financial markets. The hot hand belief is at play when investors chase hot stocks or funds believing that the past strong performance will be indicative of future results. The gambler’s fallacy manifests as the disposition effect when investors sell winners too soon and hold losers too long. Unfortunately, such biased decisions often lead to unfavorable consequences for investors. As the famous British economist and mathematician, John Maynard Keynes once said, “The market can stay irrational longer than you can stay solvent.”

 

Disclaimer

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance, or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

Digital Gold Rush

The prices of cryptocurrencies such as bitcoin, ether, and dogecoin have surged to highs that few investors would have imagined a year ago. Dogecoin alone, which was created as a joke, was up more than 15,000% this year at its peak in early May. The recent surge in cryptocurrencies appears to have started in May of last year when the famous hedge fund investor Paul Tudor Jones became one of the first mainstream investors to embrace bitcoin as a hedge against inflation. The attention on bitcoin and dogecoin from Tesla Inc. Chief Executive Elon Musk added further fuel to the rally and helped usher small investors with their freshly minted stimulus checks to enter the fray.

It is hard to calculate the value of cryptocurrencies. Investors instead are speculating that prices can keep rising solely on social-media sentiment and momentum. However, over the past few weeks, bitcoin and other prominent cryptocurrencies have seen a steep decline in their value after Chinese government comments spurred fears of a regulatory clampdown. Bitcoin’s price alone fell from more than $57,800 at the end of April to less than $38,000 as of the end of May 21st.  Ether’s price also took a hit, losing 50% of its value from early May’s high. Such wild swings can leave investors vulnerable to further losses, especially when the hype fades.

What is happening today is very much reminiscent of what happened during the California gold mania. On the morning of January 24, 1848, James Wilson Marshall, an American carpenter and sawmill operator, reported some shiny flakes of gold on the American River at Coloma, about fifty miles northeast of Sutter’s Fort (later known as Sacramento). This led to the greatest gold rush in the history of the United States with settlers swarming west towards the promise of prosperity and riches.   However, merchants made far more money than miners during the Gold Rush. An early California pioneer and an entrepreneur by the name of Samuel Brannan is considered the first to publicize the California Gold Rush, which created one of the biggest migrations of people from around the world to California. Brannan capitalized by buying up all the picks, shovels, and pans he could find before running up and down the streets of San Francisco shouting “Gold! Gold on the American River!” He became rich but many others lost money in trying to.

From Dutch tulips in the 1600s to the dotcom internet bubble in the 1990s, investors with visions of sudden wealth have long clamored for new financial crazes.  However, these speculative manias often end badly, especially for the late comers.

It should be noted that when there is this much excitement around something, there is usually some grounding in truth. Although the dotcom bubble may conjure images of “pre-revenue” companies and rampant speculation, the overall belief was that the internet would change the average person’s way of life and usher commerce into a digital age. You would have a hard time arguing today that this has not transpired. The early days of the internet serve as an apt comparison to blockchain technology: both are transformative new innovations with great potential. Further complicating matters, while blockchain technology itself may prove valuable, it is unknown which cryptocurrencies (if any) will be a part of that. This is where diligent research and understanding of the differences between cryptocurrencies as well as awareness of potential risk factors come into play.

There is no get-rich-quick scheme that works; well, except for maybe the creator of that scheme. “I can’t tell you how to get rich quickly,” the prominent Hungarian stock market guru and trader André Kostolany liked to say. “I can only tell you how to get poor quickly: by trying to get rich quickly.”

In times of unusual stress or excitement, speculation can spread with great rapidity and rumors can be fabricated. And the period of the digital gold rush may be no exception. It may be time to pay heed to wisdom, especially when the Fed signals adjusting the ‘liquidity spigot.’

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

Systematic Crises & Managing Risk

Effective risk management is essential to successful investing. There are numerous sources of risk that can affect stocks, bonds, and other financial assets. One of the most dangerous is systemic risk. This involves a domino effect in which one sector, or even company, becomes a hazard to the entire financial system and global economy. The best example is the 2008 financial crisis in which the housing bubble burst and large banks holding low-quality mortgage debt suffered huge losses. This was the catalyst for tightening credit spreads, plummeting stock markets, soaring unemployment rates, a global recession, and severely damaged confidence in the financial system. Still, there were a few astute investors who were able to predict the blowup in mortgage-backed securities by analyzing the housing industry and the quality of loans, or lack thereof, at the height of the bubble. However, it is much harder to predict systemic risk when it comes from one, single source.

Ten years before the financial crisis, the saga of Long-Term Capital Management (LTCM) would serve as a dire preview. The $126 billion dollar hedge fund nearly collapsed in 1998 as a result of risky investments funded by excessive borrowing, and due to LTCM’s “too big to fail” stature, the Federal Reserve had to intervene and broker an arrangement for a group of banks to bail out the fund. Luckily, the Fed’s intervention helped to limit the domino effect that would have ensued had LTCM been allowed to fail.

In March of this year, a single investment firm again sparked chaos with risky investments funded by excessive borrowing. Archegos Capital Management, a multibillion-dollar family office, had built considerable leveraged positions in large media companies, such as ViacomCBS, before unpopular news came out that caused these stock prices to decline precipitously. The large losses suffered by Archegos triggered a margin call, which forces a borrower to inject more capital or sell borrowed securities. Eventually, the firm’s lenders seized the securities and began selling them en masse throwing the underlying companies’ share prices into further collapse. Despite regulators’ best efforts, potential systemic risk is ever present and can come seemingly out of nowhere.

Systemic risk often stems from the failure of risk management at an institutional level, but that does not mean that risk management cannot be used to effectively protect your portfolio from times of crisis. Portfolio and risk managers often employ a variety of hedging techniques and risk control actions that include position sizing, stress testing, running Monte Carlo simulations, and monitoring risk metrics on an ongoing basis. Additionally, managers that follow a strict process and have rules in place to limit irrational decision-making in times of deep market stress may have a better probability of controlling downside risk.

 

Disclaimer

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Employees and clients of Passage Global Capital Management may own securities discussed in this article. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

 

Categories
Uncategorized

The Wisdom of Crowds

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham

One of the founders of modern quantitative investment management is Jack Lawrence Treynor, a doctor’s son born in Council Bluffs, Iowa on Feb. 21, 1930. His pioneering work on how discount rates should depend on risk contributed to the development of the Capital Asset Pricing Model, which quantifies the trade-off between risk and return. That relationship is what gave rise to the notion of a stock’s beta, or its sensitivity to market movements. Jack Treynor also wrote extensively on quantitative analysis, anticipating seismic shifts in the financial world by decades as the chief editor of the Financial Analysts Journal.

He is also known for his jelly bean Experiment in 1987, when as a finance professor, he brought a jar into his class that held 850 jelly beans and asked the students to guess the number of beans inside. The group estimate was 871, which was about 2.5% off; only one of the 56 people in the class made a better guess.

Michael Mauboussin, a global financial strategist and an adjunct professor of finance at the Columbia Business School also did a similar experiment in January 2007. He asked his 73 students to independently guess the number of jelly beans in a jar. There was a $20 reward offered for the best guess, and a $5 penalty for the guess farthest from the correct answer. The average guess of the class was 1,151 while the actual number of beans was 1,116. The consensus was off by 35 beans, or 3.1 percent.  Of the 73 estimates, only two were better than the average.

These are some classic examples of group intelligence commonly known as the Wisdom of Crowds, which is also the name of a thought-provoking book authored by the New Yorker business columnist James Surowiecki. He examined the proposition that, under the right circumstances where topics are complex, problems are large, and outcomes are uncertain, the crowd can make a smarter decision by leveraging the collective intelligence and insight of a group of people rather than an elite few, no matter how brilliant. However, for Wisdom of Crowds to work, it requires that the group needs diversity (cognitive and social) and independence (without too much influence from others).

When there is a lack of diversity and independence, the collective wisdom stops working efficiently. Jack Treynor tested this new idea with a second experiment.  He provided two bits of misinformation to the class after students recorded their first guess. He warned the students that there was air space at the top of the jar and the jar walls were thinner than normal.

Such misinformation prompted most students to change their original answers, causing the modified average results to be worse than the original by a factor of four. When making the first guess, students could see with their own eyes that there was air space at the top of the jar, and they could see exactly how thick the glass was. Yet, they were swayed by the influence of Treynor and the narrative he cleverly constructed. Just as there is wisdom in crowds, there is sometimes madness in crowds.

As the jelly bean experiments demonstrate, the wisdom of crowds concept tends to be more effective when there is a diverse group of opinions in the crowd and guesses are not influenced by others. The stock market is certainly one such place where group consensus and sentiment affect asset prices, especially in the short run (although it is highly efficient in the long-term). Discerning predictable information from random noise in the markets requires independent research, strict discipline, and a knack for analyzing the rationality of group behavior. Short-term madness may lead to longer-term opportunities as the wisdom of crowds ultimately prevails. This is key to the success of active investors.

 

Disclaimer

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

Categories
Uncategorized

The Greater Fool Theory

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

– Charles MacKay

Extraordinary Popular Delusions and The Madness of Crowds (1841)

 

In the early morning hours of Friday, December 15, 1989, an Italian-American artist, Arturo Di Modica, with the help of a few friends dropped his latest work, the world-famous Charging Bull sculpture, outside of the New York Stock Exchange. The 7,100-pound, 11-foot-tall bronze sculpture was later re-erected on Broadway just north of Bowling Green in the Financial District of Manhattan, New York City.  Arturo Di Modica first conceived of the Charging Bull in the wake of the 1987 Black Monday stock market crash. His Charging Bull statue has become a physical manifestation of a ubiquitous Wall Street term, the bull market, and it has inspired veneration from tourists and investors hoping for a cut of the stock market riches it represents.

The current bull market, fueled by record low interest rates and friendly fiscal policies, continues to attract more, especially younger, investors. Homebound, internet savvy folks jump on the speculative bandwagon to try to make fast money without much regard to the business fundamentals of company shares and valuations. The proliferation of online trading platforms like Robinhood and commission free stocks and options trades offered by brokerage houses are also helping propel the huge momentum rally. Shares of dying retail chain GameStop rose a meteoric 1,625% in January, epitomizing a speculative mania not seen since the dot-com bubble in the late 1990s. There is a distinct difference between investing and speculation. However, day traders’ temptations to make quick profits and a sense of FOMO, or fear of missing out, are pushing them into new asset classes such as silver, which is another example of market madness and the herding behavior.

The problem with such speculative moves and chasing momentum stocks like GameStop and AMC Entertainment is that investors are betting that someone will buy the investment from them at a higher price. This is called the Greater Fool Theory. They are hoping that a greater fool will come along and take the shares off their hands. However, as experienced and professional investors know well, momentum fueled by the madness of crowds is a double-edged sword. It amplifies gains but can also magnify losses when the sentiment changes with almost no notice.

As Isaac Newton eloquently stated in the spring of 1720, “I can calculate the motions of the heavenly bodies, but not the madness of people.” When you are riding atop the charging bull and the bubble is burst, take care not to get bucked. If you are thrown from the reigns, beware the stampede.

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

 

Categories
Uncategorized

Why Magnitude of Payoff is So Important

Manager hits a ball creating rising business chart. Concept business vector illustration

“If I’d tried for them dinky singles, I could’ve batted around six hundred.” – Babe Ruth

Babe Ruth is considered one of the greatest baseball players of all time. He hit 714 home runs, a league record at the time. Over his career, he collected 2,873 base hits. He was a seven-time World Series champion, and he made baseball’s “All Century” team. However, for many years, Babe Ruth was also known as the “King of Strikeouts.” He led the American League in strikeouts five times and accumulated 1,330 of them in his career. However, despite his large number of strikeouts, he was one of baseball’s greatest hitters, establishing many MLB batting records, including career home runs. Babe Ruth accepted his failures because he knew his successes would more than make up for them. His approach and mindset illustrate one of the most important concepts in portfolio management and investing: expected value or mathematical expectancy. Celebrated hedge fund tycoon George Soros, the man who broke the Bank of England after making a profit of $1 billion by shorting the British pound, once summed up the same concept by stating: “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” This is also called the Babe Ruth effect. In other words, it is not the frequency of winning that matters but the frequency times the magnitude of the payoff.

However, many people are wired to avoid losses when making risky choices when the probability of different outcomes is unknown. In fact, investors are known to perceive losses on their investments as greater than they actually are. This is outlined in prospect theory, which was formulated in 1979 by Daniel Kahneman and Amos Tversky. Investors naturally prefer to be right more frequently than they are wrong. However, this mindset causes investors to overlook the key concept that the frequency of correctness does not matter as much as the magnitude of correctness.

The understanding of frequency versus magnitude, or in other words, the understanding of winning a few big payoffs while taking small, frequent losses, goes against investors’ intuitions. This investor bias of prioritizing correctness over payoff magnitude goes to show the importance of focusing on expected value when making investment decisions.

For example, take a look at this hypothetical portfolio below:

As you can see, even though the probability of the portfolio going up is less than the probability of the portfolio going down, the magnitude of portfolio return when the portfolio goes up offsets the higher probability of loss when the portfolio goes down. Therefore, the expected value, how much your portfolio is expected to gain or lose on average, is positive.

To sum it all up, investors do not necessarily need to be exactly like Babe Ruth or George Soros to have long-term success in these types of probabilistic exercises. However, it is essential that investors understand expected values, risk management, and perhaps, most importantly, themselves and their own emotional tendencies if they wish to achieve success with their investments. Keep in mind, just because something has a lower probability, it doesn’t mean that it’s not worth betting on.

 

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.