Why Cryptocurrencies Become Less Risky as Prices Rise & Vice Versa!
A Discussion of Yield & Investing Fundamentals, Investor Psychology and the Concepts of Strength and Weight of Evidence
Today I want to explore a fascinating and counterintuitive concept: why cryptocurrencies—unlike stocks—become less attractive and more risky as their prices decrease, and conversely, why they may be (or appear to be) less risky during periods of significant gains.
This somewhat counterintuitive idea has been discussed by notable investors such as well-known X user @borrowed_ideas and Nassim Taleb, the author of The Black Swan.
We'll delve into the concepts of yield, investor psychology, and historical lessons to understand this phenomenon.
The Recent Performance of Bitcoin
Bitcoin has been on a remarkable journey over the past months, experiencing significant price appreciation and capturing the attention of investors worldwide.
Up a staggering 115% year-to-date and 36% over the last month, Bitcoin's rally has intensified, with the cryptocurrency approaching the significant $100,000 threshold.
This surge has been fueled by various factors, including increased institutional adoption, geopolitical events, and heightened interest from retail investors.
The rally has been particularly notable since the recent U.S. elections, with market participants speculating on how political changes might impact regulatory stances and economic policies affecting cryptocurrencies.
As Bitcoin's price climbs, it reignites debates about its intrinsic value, risk profile, and role in an investment portfolio.
The Paradox of Price Movements in Cryptocurrencies vs. Stocks
A while ago, Abdullah Al-Rezwan, better known under his X pseudonym @borrowed_ideas, tweeted:
"When a FCF generating company is down 50%, the probability of another 50% decline likely decreases. When a non-cash generating asset such as crypto is down 50%, the probability of another 50% decline likely increases."
Nassim Taleb shared a similar take a few years ago:
"Something like Bitcoin with purely circular attributes (which includes no yield) becomes LESS attractive at a lower price, in a path-dependent way (a fall from grace)."
At first glance, this might seem paradoxical. Isn't a lower price always more attractive to investors?
To unravel this, we need to understand the concept of yield and the difference between productive and non-productive assets.
Understanding Yield and Its Significance – The Anchor for Productive Assets
Yield is a measure of the earnings or cash flow generated and realized on an investment over a set period, expressed as an annual percentage based on the current market value of the asset.
Essentially, yield tells investors how much cash they will earn each year relative to the market value or initial cost of their investment assuming no growth.
The formula for yield is:
Yield = Annual income (e.g. dividends) / investment value (i.e. cost basis)
For example, if you purchase a share of Company XYZ for $100 and it pays an annual dividend of $2, the dividend yield is 2%.
When we think like actual owners of a business, yield becomes a critical metric. It reflects the free cash flow (FCF) yield, which is the annual free cash flow generated by the business divided by its market capitalization.
If a business with a $100,000 market cap generates $9,000 in annual FCF, its FCF yield is 9%.
