When it comes to the internet lingo on investing, hodling refers to one’s ability to weather the market turmoil, particularly related to digital assets. While memes do not exactly spread due to the might of the scientific evidence backing them, when it comes to digital assets, hodling has been mostly the right strategy, and yet oh so hard to do. Why you might ask?

It is because digital assets are unlike any other asset.

Institutional investors make asset allocations decisions in a portfolio context. Retail investors allocate mostly based on what they think is going to pump with little regard to a portfolio context. Both have found hodling difficult for distinct reasons.

Literature around digital assets has mostly revolved around bitcoin and its role in a portfolio context, normally the 60/40 portfolio. Bridgewater Associates has studied the impact of bitcoin’s inclusion in a 60/40 portfolio versus gold and how it can soften the blow in drawdowns. Bitwise Investments shows that even small allocations to bitcoin would have dramatically improved both absolute and risk-adjusted returns of traditional portfolios. While hindsight is 20/20, applying old TradFi portfolio construction tools to digital assets is bound to produce nonsensical answers, especially when lumped with Gold as a portfolio diversifying hedge, i.e. store of wealth.

Hedges by definition have negative expected returns. That’s what makes them a hedge. In order to reduce a certain characteristic of a portfolio, such as its volatility, a portfolio manager might opt to trade something that reduces return but improves overall risk-adjusted metrics.

From that viewpoint, bitcoin is truly the unicorn of all assets in existence, ever.

Digital assets proxied by bitcoin have historically had legendary cumulative and risk-adjusted returns, with negligible correlation to all major macro risk assets as shown in the tables below.

Return Profile of Select Risk Assets. Source: Interactive Brokers, FRED, Yahoo Finance.
Notes: WTI excludes April 2021 market anomaly where prices went negative. We do not consider fiat currencies risk assets and believe the long-term real return to fiat currencies is zero. They are included in this document for illustrative purposes only.

Correlations of Major Assets. Source Interactive Brokers, FRED, Yahoo Finance.
Note: Weekly Returns 2015-08-06 to 2021-12-20

Since bitcoin first received mainstream press coverage circa 2013, it has beaten any major risk asset, including an amazing performance by US equities in that period, by at least double in risk-adjusted returns. This is despite bitcoin’s high annual volatility, nearing 80%.

If you throw bitcoin into a classic portfolio optimization framework that maximizes returns and minimizes risk by relying on historical performances, you effectively come out with a portfolio that almost entirely consists of bitcoin. Then, why over a decade later, is the allocation to digital assets including bitcoin is so low across the board?

Institutional participants frequently have a career risk that sums up in a strong preference to fail conventionally than succeed unconventionally. Legendary investor Peter Lynch in his seminal book “One Up on Wall Street” talks at length why small caps were so rarely present in institutional portfolios:

“In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: ‘You’ll never lose your job losing your client’s money in IBM.”

Now, take this career risk avoidance tendency and apply it to something as polarizing as blockchain-based digital assets, with a lot of headline risk and a tendency to lump all into the “scam” bucket, and you have a potent recipe for a lose-lose scenario for any portfolio manager brave enough to stick their neck out.

Thrashing non-aligned incentives aside, both institutional and retail investors are plagued by the extreme volatility of the digital assets. It’s not just that they have high standard deviation, but the added complication is that, unlike equities, they have positive skewness, coupled with rapid run-ups that would significantly dent your total returns if you missed out. In equities, generally speaking, the trend is slow and steady up with some spectacular crashes every once in a while. In the post-GFC world where perpetual QE and stimulus is just the norm, equity markets worldwide have been steadily going up with many indices steadily setting new highs.

Digital assets have a tendency to crash hard and stay below highs for extended periods of time. Bitcoin has had three extended periods in +80% drawdowns before it was able to recapture its previous highs. This is not something the average investor is used to. Most retail investors cannot stomach such volatility coupled with being underwater for years. Most institutional investors cannot have more than a year or two of poor returns before they get tapped on the shoulder. The table below shows major assets and how often they are below their most recent peak. When it comes to equities, it is rare to be down half your money. In digital assets, 2/3 of the time you would have been down half your money well below the previous peak.

Put differently, compare the drawdown plots for the SPX Index versus bitcoin. Bitcoin is only just over a decade old, so the time periods are not equal and there is a long way to go before any of this is statistically significant, but still it is striking to see how often the average Bitcoin trend chaser spends underwater versus the average Robinhood trader who has yeet into US equities with leverage.

That is a hard mental anchor to overcome. The average investor is a trend chaser. This means that most market participants rush the gates when the price is peaking and end up spending extended periods of time in drawdown, or worse, sell when the price has already crashed.

This is why at Firinne Capital we use a variety of metrics to gauge where we are in the cycle. One such indicator we have found helpful, is the hodl waves that we use to form our view of how fearful or greedy the market participants are. This is where the paper-hands feverishly trade into the market peak en masse and anxiously chase afterwards to get back even. Given how fast the run ups are and how long the winters last, this has been a recipe for disaster. No equity market behaves this way.

Market timing is hard, but we do believe that there are times where the risk/return trade-off is worth putting a tactical tilt on.

As for the average investor, it is best to just be #hodling.

Why #hodling is So Hard

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