Friday, February 22, 2013

Rebalancing Your Liquid Assets

It seems ironically amusing, and almost symbolic, that the Pope will be stepping down on the same day (Feb. 28, 2013) that the clock will run out on the sequester, after which many U.S. Federal government programs will be operating at substantially lower spending levels than previously, which many people (rightly) worry may nudge the U.S. (and the world?) into a newly-resurgent recession.  The more theologically (or conspiratorially) minded among us might even wonder whether the period of "many tribulations" prophesied for the next papacy might end up being brought into being by the resulting economic struggles.

One of many authors who have pointed out the
"perfect storm" of resource crises that mankind
will face in this century.
I personally am highly skeptical when it comes to such theories, but nevertheless, I do often worry about the long-term prospects for avoiding the collapse of (let alone growing) the world economy in the face of peak resource flows of various kinds (cheap oil, fresh waterphosphorus, arable land, etc., etc.).  Traditional economic arguments that "the market will always provide," due to higher prices stimulating investment into developing more efficient technologies that will extend the planet's productivity, in terms of the amount of human economic activity it can support, may no longer hold true in a world wherein many key resources are peaking all at once, while simultaneously we are getting pummeled by the impacts of rapid climate change along with various other manifestations of the degradation of Earth's ecosystems which we are causing through our civilization's over-development, and its resulting excessive resource draw-downs and polluting waste flows.  At some point, the spiraling complexities of multiple, cascading resource shortages and environmental crises may simply grow faster than our ability to cope, and the whole system could come crashing down like a house of cards.  Yet despite these enormous systemic risks, our politicians waste time arguing with each other uselessly about speculative trivia such as how to deal with naively-extrapolated Medicare costs 25 years from now, a time by which point, vast, rapid changes in our environment and our economy in the meantime most likely will have rendered the present debates on this topic almost entirely irrelevant.

In any event, during a period such as today when no sane person who is paying attention to the world can have much (if any) confidence in the ability of our so-called "leaders" to navigate a safe course through the dangerous shoals humanity is facing, it pays to hedge one's bets.  And, one way to hedge against the failure of the existing regimes of governmental and financial oversight (by nation-states, central banks, etc.)  is to invest in forms of wealth that are more or less immune to having their value destroyed by what we can anticipate will be future desperate maneuvers by political and financial leaders who will, sooner or later, find themselves rapidly losing control of an increasingly untenable global situation, as (for example) increases in agricultural and energy productivity eventually become unable to keep up with what is needed to sustain world population.  It world only take a year or two of, say, climate-change-induced crop failures in several major "breadbasket" regions around the world to exhaust all grain reserves and plunge billions of people in poor countries into severe famine conditions.  In such an environment, scenarios such as a devastating world war over resources between major powers become not at all unlikely.

For this reason, among others, I plan to maintain a significant chunk of my personal wealth (pitiful as it is at the moment) in the safest possible form, so that, if worse comes to worst, I will retain access to it even in a rapidly-deteriorating situation.

The world's safest, most convenient form of liquid wealth.
As I have argued in previous posts, one of the safest, and perhaps the safest, place to stash a "rainy-day fund" of liquid wealth is in the global electronic crypto-currency known as Bitcoin.  This is because of several desirable properties that Bitcoin holds, compared to other asset classes:
  • Unlike sovereign currencies such as the US dollar, it cannot be debased (its supply hyperinflated to worthlessness) by possible future irresponsible actions by governments, central banks, or anyone; 
  • Unlike precious metals, it cannot be debased through advances in mining technology, asteroid mining, and nuclear synthesis;
  • It can be transmitted electronically, in minutes, anywhere in the world, with very low fees, without needing to go through a bank or other third party;
  • It does not require trusting any other party to hold it for you (and give you access to it when you need it);
  • It can be held (and redeemed) anonymously;
  • It can be made as secure from loss or theft as you wish it to be; it can be backed up in multiple locations, and hidden away in the safest places you can imagine (you can even store it in your brain if you are so inclined).
The one risk in holding Bitcoins, which it shares with most other forms of money, is that its market value may someday fall to next to nothing if it becomes increasingly unpopular, which could happen if (for example) a clearly technologically superior alternative to it should arise.  However, even if this did happen, the new technology would probably be adopted only gradually, and this would give most people time to migrate their liquid wealth out of Bitcoins (and into the new currency) before Bitcoin's value falls too far.  In the meantime, a large and growing installed base of Bitcoin-based applications and services will ensure that the currency retains a relatively stable value for some time.  For the last year at least, the Bitcoin value has remained fairly stable, and has mostly risen (see below chart).

The price of 1 Bitcoin in US dollars has remained fairly stable, or risen steadily, for most of the past year.
It is interesting to note that the present value of 1 Bitcoin is US$30, close to its all-time high, and greater than the value of an ounce of silver.
You can buy one of these for less than 1 BTC already.

Further, we can argue that the value of Bitcoin has a lot more upside growth potential than the value of silver, or gold, or other precious metals.  This is because, relatively speaking, not very many people hold Bitcoin yet, since it is relatively new, and a lot of people haven't learned about it yet.

Furthermore, the total number of Bitcoins in existence is limited, by mathematical algorithms that cannot be changed except by a consensus of most users, to never be more than 21 million.

For comparison:  Just the amount of silver that has already been mined has been estimated at about 43 billion ounces.  This means that, if eventually Bitcoin becomes merely equally widely held to silver (despite its clear practical advantages over silver), that is, with an equal amount of wealth stored in it, 1 Bitcoin will at that point be worth more than 2,000 ounces of silver, or in other words, more than $60,000 in today's dollars.

So, for those who are already convinced that Bitcoin is the cat's meow, how should one proceed?

One could put one's entire personal wealth into Bitcoins, but that would probably be unwise, just in case someday there it suffers a systemic failure (e.g., if the cryptographic algorithms underlying it were found to have weaknesses - although most experts strongly believe this is not the case).

A more conservative approach, like in traditional portfolio management, is to simply maintain some fraction of one's wealth in Bitcoins (or any given form, for that matter).  This allows you to see some upside if the value of that asset appreciates, while limiting your losses to the fraction of your savings that is stored in that form.

Rebalancing your portfolio periodically can help you
hedge against risks from over- and under-investment.
Furthermore, if you periodically rebalance your portfolio to maintain the desired distribution of assets, then this has an effect similar to dollar-cost averaging, in that it causes you to purchase more of the asset when its price is low, and less when the price is high, so that the net effect is the "buy low, sell high" behavior that is the essence of good investing.

As an example, suppose initially you had $400, and decided to invest 1/4th of it in Bitcoin, and at that time the cost of 1 bitcoin was $10.  Then you have 10 BTC ($100 worth) and $300 in dollars.  Now, suppose that subsequently, the price of Bitcoin repeatedly fluctuates up to $100/BTC and back down to $10/BTC, and suppose you rebalance your portfolio each time the price hits these targets.

The result of this strategy would be, your wealth would increase by 3.25x (225% gain) each time the Bitcoin price goes up by 10x, then you rebalance, and then your wealth decreases by 1.29x (22.5% loss) each time the price goes down by 10x.  But the net result of each cycle is an increase in your total wealth by 2.52x (152% rise).  After just 3 of these up-down cycles, you would be about 16x wealthier overall than when you started.  See this spreadsheet for the calculations.

It is not really necessary to rebalance at particular price targets - you still can gain (although not as much) if you simply rebalance your savings periodically - e.g., after each paycheck.  As long the price is repeatedly fluctuating, up and down, you will still gain overall from applying this approach.  So, you can relax, and not worry about having to constantly watch the price and react instantly to price changes.

There is a simple formula you can use to determine how many Bitcoins to buy or sell each time you want to rebalance your portfolio.  Let us make the following definitions:
  • p = The percentage of your wealth that you want to keep in Bitcoin, expressed as a fraction (e.g., p=0.25 for 25%).
  • B = The number of Bitcoins that you have currently.
  • D = The number of dollars (or whatever your "home currency" is) that you have currently.
  • e = The current market exchange rate for Bitcoins in terms of your home currency (e.g., dollars per Bitcoin).
  • b = The number of Bitcoins you should buy (or if negative, sell) to rebalance your portfolio.   
With these definitions, the number of Bitcoins b that you should buy, right now, to balance your portfolio to attain the desired percentage p in Bitcoin is:

Number of Bitcoins b to buy to balance your portfolio.
(When b comes out negative, that just means to sell |b| Bitcoins, rather than buy.) This strategy thus becomes very easy to implement if you just track your assets and the Bitcoin price in a spreadsheet; each time you want to rebalance, just buy or sell according to the formula.

It takes discipline to maintain a portfolio-balancing strategy, though.  There is a temptation, when an asset price has been rising, to put more of your money into that asset, rather than less, and there is a temptation, when the price has been falling, to take your money out of that asset.  But, for an asset with a cyclical price pattern, that would be exactly the wrong thing to do.  (Since it would lead to "buy high/sell low" behavior, which is never a winning strategy.)

The price of Bitcoin might not turn out to be cyclical, it is true - but even if the price is steadily rising, rebalancing is safe to do - since that just means, if the price rises faster than your USD savings, so that "b" comes out negative, that you are taking out a dividend for yourself from your BTC investment - you still gain somewhat from the rise (although admittedly, perhaps not as much as if you did not rebalance).

The only scenario in which rebalancing is not safe is if the value of the asset is falling, indefinitely, towards zero - in which case you could end up losing all your wealth by this strategy.  So, it is probably a good idea to have a cutoff - a price where, if the asset value falls below that price, you will not throw any more "good money after bad" by investing it in that asset.  Personally, I would probably give up rebalancing my savings into Bitcoin if its price fell below, say, parity with the dollar, for any significant length of time.  But I do not expect that to happen, at least, not any time soon.  More likely, I think, is that its price will continue to rise significantly each year, for quite some time.


UPDATE 4/9/2013:


Since writing this post, I have been periodically rebalancing my BTC/USD portfolio.  Initially I rebalanced using the above formula whenever my %BTC rose one or two percentage points above or below my target percentage (which was 25%).  However, I soon realized this was inefficient (since this happened too often) and that my average gains would most likely be greater if I only rebalanced on larger swings, such as +/- 5%.  I designed a spreadsheet that would calculate automatic buy/sell thresholds that I could enter on Mt. Gox to automatically rebalance my portfolio whenever the %BTC strayed outside that range (20-30%).  I later increased my nominal %BTC to 30%, with the same tolerance of +/- 5% so that my range was 25-35%.  This strategy has been successful, although in the last couple of weeks, the Bitcoin price has risen so quickly that I have still had to rebalance about 5 times!  I have posted an example of a spreadsheet that can do all these rebalancing calculations for you at THIS LINK, feel free to download a copy and use it yourself!

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