“Prognoses only at the end of the game.” This pearl, one of many uttered by Portuguese footballer João Pinto, hides an undeniable truth: it is easier (and safer) to make predictions about the past than the future. In the world of investments, this fact is a corollary of the traditional disclaimer “past performance is no guarantee of future returns.” This does not mean, however, that valuable lessons for the future cannot be learned from an analysis of past events. This is what we will try to do here.
Imagine a visionary investor who bought bitcoins on the last day of 2013 and held the position for nine years. He obtained a return no less than spectacular, accumulating, at the end of the period, 23.5 times the amount invested (in dollars). This means an average annual return of more than 45%. Despite the excellent performance, the path was turbulent. In three out of nine years, bitcoin posted losses. On two occasions, bitcoin fell more than 80% off its high and didn’t recover to this level for about three years.
These numbers illustrate how, historically, bitcoin has richly rewarded long-term investors who weathered the long, dark winters. However, not all investors have this profile. As they are high volatility assets, crypto assets, and bitcoin in particular, attract a large number of investors looking for short-term profits by trying to hit the right moments to enter and exit the market. This strategy can be more risky than it seems at first glance.
Despite the fantastic performance of crypto assets in the aforementioned nine-year period, if our investor had missed the 28 days with the highest return, that is, less than one month out of a total of 108 months, his accumulated return would drop from around 2,250% to a slightly negative value—a loss. This means that being out of the market in a few decisive moments can have a huge impact on the bottom line of the investment. It is evident that the same reasoning could be made in the opposite direction, that escaping some of the worst days can greatly improve the final result of the investment. However, the point here is that, by only intermittently exposing himself to the market, the investor adds to the uncertainty inherent in bitcoin’s returns. This is an additional variability that arises from his decision to be allocated or not.
To illustrate this effect, we can simulate a large number of random investors. At the end of each day, each investor throws a coin in the air. If the result is heads, they get exposure to bitcoin the next day and if the outcome is tails they do not. We simulated ten thousand results of this “strategy” applied between 2014 and 2022. There is a great dispersion of results. In 4.1% of simulations, a better result is obtained with this coin flip than simply maintaining a long position all the time. This, you might say, is the glass half full viewpoint. At the opposite end of the distribution, we have 3.9% cases in which, at the end of the period, there was a negative return. That is, even if you are long about 50% of the time in an asset with high returns, there is a non-negligible chance of incurring a loss.
Many investors would argue that their ability to choose their entry and exit timing is better than the complete randomness represented by a coin toss. The simulation presented here, however, does not consider transaction costs, which tend to be substantial, especially for individuals. This makes it even more difficult to succeed with this type of approach. A study conducted by economists Bruno Giovannetti and Fernando Chague, from the Getulio Vargas Foundation (FGV EESP) showed that the vast majority of individual investors who carry out futures day trades on Brazilian stock exchange B3 lose money. One would not expect anything very different in the crypto market.
The obvious conclusion is that you shouldn't try to time your exposure to crypto and instead maintain an allocation over time, correct? Not quite. Assuming that the investor is not someone with an exceptional talent for deciding when to enter and exit the market, it is likely that they will look for some set of rules to determine these actions. The crypto market does indeed present good opportunities for applications of this type of heuristic. However, to be successful, it is fundamental that the investor combines three factors: rigor in the development and testing phase of the rules, discipline in their implementation, and low transaction costs. This combination is much more likely with professional managers than individual investors.
Back to the player João Pinto, legend has it that a reporter once asked him if he was superstitious. "No, that's bad luck," he replied. In the world of investments, decisions are always made in uncertain environments and, naturally, results observed a posteriori can be more or less favorable. This is what we often interpret as luck, good or bad. However, there are certain behaviors we know have a high probability of failure, no matter how “lucky” investors may be. Repeating these behaviors is giving too much chance to bad luck.