What caught my eye this week.

People have a hard time with diversification these days, and it’s easy to see why.

• Developed world government bond yields are still pretty tiny compared to most of the past few decades.
• UK inflation-linked bonds are so dear they even scare my purist co-blogger The Accumulator.
• Cash pays you less than nothing, in real terms.
• Gold, if you like that sort of thing, has been stuck in a bear market for half a decade.

Meanwhile, global shares rally on. Why diversify and give up the gains? Yes, equities look expensive but so does everything else.

TINA, some pundits have dubbed such thinking. There Is No Alternative.

If you can stomach the volatility that will come with the inevitable big stock market crashes, then maybe TINA isn’t the worst date in town. I have been 95-100% in shares at some points over the past decade, so I’m not going to judge you. Shares should outperform other assets over the very long-term, despite the plunges.

There’s no rule that says you have to diversify, just because in theory it will mean a better risk-reward profile for your portfolio. You don’t get style points in investing.

If what you care most about is long-term returns – perhaps because you’re young, or because you’re investing spare money that isn’t underwriting next month’s rent – then going all-in on shares might be reasonable in these tricky times. (Especially if you’ve got a bit of home bias going on. UK shares look cheaper than most, in my view.)

However I would guard against pretending you have diversification that won’t hold up in reality.

Dreamy diversification

I often hear people say that instead of bonds they hold dividend shares, or value shares, or infrastructure funds, or some obscure investment trusts.

The theory, I guess, is these all pay a bit of income so therefore they are a bit like a bond.

Well, perhaps a very little bit.

In reality if markets do plummet 25% in a crash, you’ll probably get your 3% income from a dividend share, say. True. But they’ll still almost certainly take a 20%+ capital loss on the chin, too. Perhaps they’ll even do worse than the wider market, given how popular dividend shares have been since 2009.

Similarly, investment trust discounts can often widen sharply in an equity scare, even if the potentially alternative assets they own do stand up better than the market.

Correlations and consequences

The following graph from Tensile Trading shows three-year correlations for US assets. UK assets will behave much the same.

Note: The stuff that might really hold up in an equity crash is towards the bottom.

Source: StockCharts.com

Yes, it hurts to see the case for lousy old bonds. Honestly, I’m just as miffed as you are.

At this point in a typical cycle we might normally expect to move some of our share winnings into cash and government bonds paying 4-8% or so. To be fearful when others are greedy, as the Sage of Omaha says.

But we can’t get those rates, for all the post-crisis reasons we’ve all read about for the past 10 years.

I understand it’s hard to buy government bonds set to pay you less than 2% a year for the next five years. But if stock markets fall 20%, then that would be a relative return of 18% to the good, even before any potential capital rise.

Am I predicting an imminent crash? No, I don’t think anybody can do that. I do think a correction of some sort is probably drawing near, for what it’s worth. (Very little). But who knows about the timing.

I’m simply saying that if you want to diversify your portfolio, then own assets that actually diversify your portfolio.

Yes, they may be a drag. But if nothing does badly in your portfolio, it’s usually a sure sign that you weren’t really diversified, after all.

• For more on asset allocation in the current environment, watch this recent conversation with David Swensen, famed manager of the Yale endowment fund.

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What caught my eye this week.

People are increasingly reluctant to call bitcoin’s parabolic rise a bubble. With the price hitting $11,000 this week, those who dismissed it as a fad or a fraud at $100 look like idiots.

Those who own bitcoin get it. Those who don’t are antediluvian relics.

There’s nothing like a profit to turn people into prophets.

For what it’s worth (not much) I think bitcoin is in a bubble. Probably.

I’ve spent some time this year trying to understand bitcoin, cryptocurrencies, and blockchain – the distributed ledger technology that drives them – better.

I think I’ve succeeded. This summer I had a eureka moment when I finally got that bitcoin was a financial architecture as much as it was a currency or a store of value, and that owning some meant investing in that platform.

I even thought about buying a little. Alas, bitcoin had just hit $2,500 and I’m cheap.

So I didn’t.

Oops!

Having nerdy friends from my university days means bitcoin bubbled into my consciousness years ago. I even have the archetypal friend who mined them when you could do so without a liquid nitrogen cooled garage full of Chinese programmers.

My friend used his self-mined bitcoins to buy an Apple iPad.

Oops!

Eleven reasons why the price of bitcoin may be a bubble

I’ll spare you a primer on the technology (plenty exist – see the links below). Instead here are some random thoughts as to why I think it’s probably a bubble.

1. This graph

Source: WSJ

There might be another widely traded security that has gone up like that and not come down. But I can’t think of it.

2. It’s too volatile to be a currency

A useful currency can’t go up and down 20% against the dollar in 24 hours. If it’s not (at least partly) a currency, then what (partly) is it? If it is a currency then it will have to stabilize. Have we happened upon the right price, right now? Seems unlikely. Are prices going up because they can? Seems likelier.

3. Its ascent is being talked about everywhere

Everywhere! Great sign of a bubble.

4. Seriously, even my girlfriend told me about her bitcoin

I’ve yet to see a woman quoted in an article about bitcoin, which does weaken the bubble case (it might suggest there are still huge demographics to be pulled in). Perhaps it’s begun, though. Plenty of women are into investing. Many are even readers of this blog. My girlfriend is neither. Yet this week she – well – boasted about the value of a fractional bit of bitcoin she picked up along the way. She’s never talked about shares, ISAs, bonds, interest rates, pensions – not even property prices.

5. The overnight wealth creation seems to defy common sense

At $11,000, bitcoin has a market cap of $185bn. Is it reasonable that $185bn has been magicked out of nowhere just because sufficient people believe their bitcoins are worth $11,000 a pop? Perhaps it’s not so ridiculous. Fractional reserve banking means High Street banks add to the money supply all the time. Or is it so different from a stock market being worth 1% more today than yesterday? While $185bn is a big number, it’s a tiny fraction of the world’s wealth. On the other hand, surely that valuation should be tethered to, well, something? States and fiat currencies at least have armies and taxes. And gold has rappers’ teeth. If bitcoin really is on its way to becoming a hybrid of gold and the US dollar, then I can just about accept its rapidly created market cap, except…

6. Governments will want a piece of the action

The bitcoin market is unregulated, and the bitcoin network is creating a store of wealth without governments getting any. Until governments are fully involved, I think the price can’t be trusted. What’s to stop them banning it? Fine, they’d fail, but is the average citizen going to risk breaking the law for an illicit floating world currency – let alone the average billionaire?

7. The price is self-limiting

The higher the price of bitcoin climbs, the less likely people will want to spend their bitcoins. Can it function as a currency then? Hmm, I say. It could still be a store of value though.

8. There are questions about the technology

Initially touted as incorrigible, the cryptocurrency has been splitting. Just keeping the show on the road already consumes as much energy as Ireland. Then there are the hacks that shake faith in a digital currency much more than a bank heist. (Although really stealing bitcoins from a digital wallet or store is just the same. The integrity of the blockchain is the important thing.) Questions about technology don’t mean it’s necessarily a bubble – and they don’t mean it (or blockchain) won’t succeed. Rather, this could be the equivalent of a video-on-demand Internet service in 1999 – right idea, wrong time. But for me these issues do make it harder to trust the price action.

9. Initial coin offerings

Do you know about ICOs? They are unregulated funding rounds for would-be the next bitcoins that have raised more than $3bn globally. Pretty much on the back of napkins. There’s now an estimated 1,200 new digital crypto-currencies out there. On the one hand they might seem to validate the concept – even the failure of all but a couple to gain traction might support the rising price of bitcoin, because it has gained traction. But on the other hand… really? Doesn’t this seem a little, well, nutty? Just a bit?

10. Company name changes

Companies are changing their names to mention bitcoin and seeing their valuations soar. (Here’s a British example, and a US one). Again, not slam dunk proof, but we’ve seen this movie before. Famously, adding ‘dotcom’ to a company name in the late 1990s spiked the price. More recently, I recall a tiny UK music technology firm that changed its name to something to do with rare earth mining at the top of the commodity cycle. At least, it suggests a speculative aspect at play.

11. I’m writing about it

I’ve mostly tried to keep cryptocurrency off this site because it just seemed too iffy. But here I am, adding my two pence worth. When the last blogger turns, you know a bubble is upon us.

True, some telltale signs are missing. For example I haven’t yet heard of babies named Bitcoin or Ethereum. [Update: Reader E. wrote to let us know that baby Bitcoin was recently born and named in the Crimea.]

Football managers are also getting in on the action.

A bubble does not mean a permanent bust

To end on a hypocritical ass-covering note, I’m not really sure bitcoin is a bubble.

It looks like one, smells the same, and has a letter from its mum. But occasionally the world does change. Perhaps this is one of those times.

I’m also not calling a top. Bubbles can keep climbing for years, and it’s easy to see more catalysts for bitcoin.

Think back to how the first exchange traded gold funds seemed to stoke that boom. Bitcoin futures will arrive in a couple of weeks, and I suspect ETFs will follow.

If bitcoin ETFs track the price by investing in bitcoins (rather than synthetically) then they’ll surely boost the price, at least initially. It’s still a hassle to buy bitcoin, compared to adding some alongside your trackers and bond ETFs on Hargreaves Lansdown.

Millions more punters could flood in and send the price skyrocketing! Or the ETF-afication of bitcoin could strip it of its mystique and the price could crash. Who knows?

A price collapse wouldn’t necessarily mean the end of bitcoin or blockchain, any more than the bursting of the dotcom boom halted the Internet.

Bitcoin could go on to be a household name for the rest of our lives, something we all might use. Perhaps it is the future of currencies? Maybe it is a new store of value?

It seems unlikely that blockchain technology will go away anytime soon – it’s too easy to think of applications. (As a would-be home buyer I’d love all the information pertaining to my potential purchase to have been recorded and distributed for everyone to see. It would save hundreds of emails, dozens of letters, and a wodge of money).

But bitcoin right now?

If it walks like a duck and talks like a duck, it’s a duck.

And Bitcoin is probably a duck.

I mean a bubble.

• Good Bitcoin primer (with more at the bottom) by Bloomberg Business
• This Motley Fool podcast is another excellent introduction [Podcast]
• Patrick O’Shaughnessy’s superb Hash Power series goes deep [Podcast]
• Smart take on the mania aspect – The Reformed Broker

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One of the most easily spotted and ever-repeated psychological errors we make is recency bias. This is the tendency to believe that what has happened lately will continue forever.

You see it all the time in comments on Monevator.

To give just three examples:

• In 2008 and 2009, loud commentators called me irresponsible. I said it was a good time to invest while the markets were cheap and fearful. They urged other readers to keep their money in gold and/or under the mattress.

• Remember when emerging markets were doing well a few years ago but developed world shares were in the doldrums? Putting any money to work in the US or (god forbid) Europe was considered the mad folly of an old has-been who’d never heard of Nintendo.

• American friends told me to steer clear of US house builders. They said the upcoming millennial generation all liked renting and living in their parents’ basements. I wanted to invest with a US friend directly into US property as that economy began to recover. But he was gun shy. Now the US housing market is booming, and millennials want their own homes. (A similar story can be written in the UK – see my post on UK home builders from late 2011).

Of course, I can be as prone to recency bias as much as anyone. But by definition it’s easier to see it in other people.

Onwards, downwards, and upwards

Recessions are a great time for students of recency bias to pull up a stool, crack out a soda, and start taking notes.

People are invariably gloomy during recessions, and they’ve often lost money. Many are scared. Jobs are lost among family and friends, if not your own.

Commentators lament we’ll never again see a glorious time of easy access 0% credit cards and people day trading shares from their bedrooms, nor young women carrying five or six brightly-coloured bags of cheap clothes down Oxford Street.

Yet things do bounce back. The economy does recover. Stock markets sniff it out sooner, and begin to climb 6-12 months in advance.

In the long-run (short of rare catastrophes) things aren’t so bad.

Here’s one we did earlier

These highs and lows are well-illustrated by this pair of graphs highlighted this week by The Value Perspective:

Source: The Value Perspective/Bloomberg.

Ready to have your mind blown? The two charts show the same thing:

One may look deeply volatile and scary and the other smooth and reassuring but they actually both represent the same information.

The chart at the top shows how US gross domestic product (GDP) numbers have bounced around since the end of the second world war while the chart on the bottom shows the cumulative effect of that – the actual nominal growth of the US economy in that time.

I keep trying to explain this to people about Brexit. I expect volatility short-term – we’re already seeing that – and with respect to the second chart I expect our slope to be less steep than it would have been.

But we’ll still grow, eventually, over the long-term. It’s just we’ll probably have slower growth, lower total output, and hence a lower standard of living. There will be less money to spend on the NHS and so forth than we would have. And all for very little gain.

To tie this back to investing, here’s one of my all-time favourite graphics from Portfolio Charts.

Look at the following graph. Which of the scenarios – the three colored lines – would you have rather invested through?

Source: Portfolio Charts / Peter Martin.

Ready to have your mind blown, again? They all show the same returns!

To quote Portfolio Charts:

If you’re like me, the yellow portfolio intuitively seems to have the lowest volatility and the magenta option seems downright terrifying.

Well guess what — they all have the identical average return and standard deviation!

The blue series is taken from a real fund. The magenta series takes the exact same returns numbers and simply reorders them from worst to best while the yellow series juggles them to stay as flat as possible.

While the order of returns has a massive effect on the personal experience of the investor, it has no impact at all on the standard deviation calculations.

Ponder the first two graphs of US GDP and this third graph showing how sorting returns changes our perception of risk.

This is brain food for investors.