Morningstar - Q3 2021 - 9

Fourth, hidden transmission mechanisms
between the epicenter of the frenzy and the
broader financial system might expose previously
unknown vulnerabilities in the latter. A good
example of this is the impact on savers,
especially the retired, after the bursting of the
U.S. property boom of the past decade.
Finally, beware of escalating commitment. This
phenomenon was identified by Barry Staw
of the University of California, Berkeley, and it
describes a situation where enthusiasts become
increasingly committed to a belief after setbacks,
resulting in increasing investment (of either
monetary or emotional capital) and subsequently
greater loss as the outcome becomes inescapable.
This escalation is characteristic of a deterministic
view of the future. In reality, the future is
uncertain and, therefore, as investors, we should
be careful about adhering to a single opinion
too strongly.
We Remain Cautious
Perhaps the most notable observation is
the changing motive of cryptocurrency traders.
What started as a pool of early adopters
has morphed into a growing group of quick profit
traders. This motive is innately understandable
yet fraught with danger.
Knowing who is on the other side of a trade
is a key consideration we would emphasize.
For every buyer, there is a seller (unless you're
in the business of mining coins), so you
really need to think about what your edge might
be over that person or entity. Acclaimed
investor and fund manager Bill Miller famously
set a framework for thinking about your
investment edge, which he gracefully captured
in three buckets.
gInformational edge Do you truly have greater
access to insights or data than the pool
of investors?
gAnalytical edge Can you do more with that
information than the pool of investors?
07/18/2010
07/18/2012
07/18/2014
Source: Morningstar Direct. Data as of 06/30/2021.
07/18/2016
07/18/2018 06/30/2021
Wild Ride After dropping about 74% in 2018, bitcoin nearly doubled in price in 2019
and then nearly quadrupled during 2020.
CMBI Bitcoin TR USD
$80K
60
37.36
40
20
06/30/2021
gBehavioral edge Do you have a better
temperament or ability to understand others'
behavior than the pool of investors?
We as investors should be careful about
adhering to a single opinion too strongly, including
our own. Always think back to your edge as an
investor. If you don't have one, you should
tread very carefully. That's not to say an edge
isn't attainable in the exhilarating world
of cryptocurrencies-and some investors will
be able to capitalize on their edge.
The one thing we do know about market
irrationalities is that we must be incredibly focused
on the robustness of the portfolios we
manage. This is holistic by necessity, looking for
potential knock-on effects to other assets or
inherent vulnerabilities in the financial system.
In a study earlier this year, Morningstar researcher
Amy Arnott found that bitcoin can play a role
in portfolios, but its impact varies depending on
the time period.1
For the three years ending
December 2020, Arnott found that bitcoin was
4 times more volatile than equity indexes,
1 Arnott, A.C. 2021. " Does Your Portfolio Need Bitcoin? " Morningstar.com, Feb. 1.
morningstar.com/lp/magazine
9
07/18/2021
but when added to an all-equity portfolio, bitcoin
didn't add much volatility, because of its low
correlation with equities. Over the trailing
10 years, however, the picture wasn't as pretty.
Arnott found that bitcoin was 15 times more
volatile than equities. As a result, both risk and
returns increased with larger bitcoin weightings.
According to Arnott, even a 1% bitcoin
weighting would have led to a sharp increase
in standard deviation compared with an
all-equity portfolio, as well as significantly
worse drawdowns.
07/18/2020
06/18/2021
Ultimately, cryptocurrencies are complex and
extremely difficult to value, but such deep work is
exactly what is required to make a sound
investment. We would argue that now is a great
time to focus on portfolio robustness as part
of this analysis, which is really two sides of the
same (bit)coin. K
Dan Kemp is global chief investment officer at Morningstar
Investment Management. He is a member of the editorial
board of Morningstar magazine.
https://www.morningstar.com/authors/2076/dan-kemp http://www.Morningstar.com http://www.morningstar.com/lp/magazine
Morningstar - Q3 2021

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