HODLing during the Dotcom boom, a cautionary tale (and how indexing might help)

TL/DR:

HODLing alone is not an effective strategy for investing. We look at a study that applied a HODL approach to investing in Dotcom era startups and tie that back to the Cryptocurrency markets of today. The best advice for most investors is to apply an indexing approach such as those used in the stock markets by investment giants like Vanguard and Morningstar with a simple tool like this .

HODL Definition: (pronounced /ˈhɒdəl/ HOD-əl or as individual letters) refers to holding the cryptocurrencyrather than selling it.

HODL on to your pants

Television host and comic John Oliver astutely stated the goals of most cryptocurrency investors on his popular show Last Week Tonight as, “HODL.. which states don’t sell when prices drop, instead HODL in the face of FUD (Fear Uncertainty and Doubt), otherwise you might miss out when the coin MOONs or rockets up in value, meaning you will get REKT or lose money and never be able to afford the trader’s ultimate goal, a LAMBO which is short for a Lamborghini because of course it f***ing is. "

HODLing is more than a rallying cry for the masses. It is our gut instinct for dealing with the highs and lows of the market. This mantra means that we buy and hold for the long run. But how effective is this strategy? Which stocks should we invest in?

While there are literally thousands of crypto currencies to pick from, the top 20 currencies by market capitalization occupy over 87% of the market and the top 5 currencies occupy 75% of the market. Many investors are lured into investing in new coins in the hopes of betting on a currency that has the potential for reaching stratospheric growth, a so-called ‘moonshot’. However picking an individual currency is a risky proposition. The market for crypto currencies is unregulated and ripe for exploitation. In addition to crypto currency scams, pump and dump schemes and ponzi schemes like BitConnect make investing an increasingly risky proposition.

Looking at the Dotcom Boom

The chaos and uncertainty that currently clouds the market for crypto currency investors is not a new thing at all. In fact, this situation is very much similar to the early days of the dot com boom and bust. During a period from 1995 to 2000, the NASDAQ index rose five-fold to a peak at over 5000 points, buoyed by an investor frenzy. By 2001, the bubble had burst and the majority of dot com startups had gone bankrupt, erasing trillions of dollars of value and eroding over 75% from the NASDAQ composite index.

So, what about the moonshots of the dotcom era? In fact, there are successes from the dot com era that are still in business today and have consistently delivered superior returns to investors. Amazon is one great example. When Amazon first went public in 1997, its stock was priced at just $18 per share. A thousand dollar investment in Amazon, or roughly 55 shares would be worth a staggering $496,000 today (1). However, picking an Amazon out of the pile of companies has proven to be a very difficult task.

A June 2017 article from Shroders online tracked the performance of 207 companies from March 2000 (at the peak of the dot com boom) that were of a similar size and scale to Amazon. Their analysis showed that an investment of £1000 in each one of the 207 companies back in March 2000 would have delivered on average a return of £4.10 in today’s dollars (2). This lackluster performance is simply due to the fact that many of the 207 companies went bust and only a handful succeeded. It turns out that picking a successful stock out of hundreds or even thousands of options is very risky, and spreading your investment across a large number of stocks doesn’t mean that you get a greater reward either.

Enter indexing strategies

For the uninitiated, an Index is essentially a list of companies in the stock market based on certain criteria, such as the size or Market Cap of a stock. Many of us are familiar with the S&P 500 or the Dow Jones Industrial Indexes. An index fund takes an investor’s capital and spreads it out across the various stocks that comprise an index. The most common way to do this is to invest a proportionate amount in a stock based on how much the stock comprises of the index. For example, if the market cap of a stock occupies 10% of the total market cap of an index, then you would invest 10% of your capital in this stock. This is known as the weight of a stock in the index.

While index funds have been around since the 1960s, it was John Bogle, while studying at Princeton, who came up with the first commercially viable model of an index fund. Bigler went on to in 1975 through the company he founded, The Vanguard Group. Bogle posited that by investing on an index that covered a large enough portion of the market (such as the S&P 500), an investor was essentially placing a bet on the entire market. In fact, if you added up the Market Capitalization of the companies in the S&P 500 today, that would result in about 80% of the entire market by market cap. (3)

Rebalancing the index

By investing in all of the currencies in an index, you’re protecting yourself against the potential volatility of any one individual currency. However, there is an issue of volatility of the index itself. In other words, as the market cap of underperforming currencies decrease they will drop off the index, and stronger performing currencies will enter into the index to replace them. As a result, there’s a constant stream of currencies entering and leaving an index at any one point in time. This means that an investor needs to make trades periodically to buy or sell currencies such that their portfolio accurately reflects the composition of the index. One strategy is to allow a threshold of drift of the currencies in your portfolio of +/- x%. As long as the percentage of your total holdings occupied by a particular currency doesn’t exceed this limit, you’re pretty safe from having to rebalance.

Low costs

Index funds are also attractive because they carry very low costs or management fees, since the fund manager is essentially making buy or sell decisions based on the underlying index. For example, the Vanguard 500 Index fund charges an 0.2% annual management fee compared to the industry average fee of 2.0% charged by mutual fund managers. There are a number of crypto currency index funds, however the management fees are somewhat higher than in conventional stock markets. I’ve created a tool that you can use to construct your own fund and save a few bucks in the process. Read on for more information.

Fixed capped indexes

A key principle of index investing is to insulate the investor from the volatility of a single currency. It’s therefore important to prevent an index from being dominated any one currency or group of currencies. A fixed capped rule sets a maximum limit that no single currency on the index can exceed. For example, BTC occupies a weight of 40% of the total market cap of the index. By setting a fixed cap rule of 15%, the maximum holding of BTC in the fund is capped at 15%. The remaining 25% (40% minus 15%) is redistributed proportionally across the remaining currencies in the fund.

I’ve created this spreadsheet tool that uses a fixed capped weighting on a portfolio and automatically redistributes the weighting among other currencies.

Capped weighting can also be applied to different categories of currencies, such as Privacy, Platform and Utility. A maximum cap can be set to prevent the index from being dominated by any one individual category.

In conclusion

Reference:

1. https://www.investopedia.com/articles/investing/082715/if-you-had-invested-right-after-amazons-ipo.asp
2. http://www.schroders.com/en/uk/the-value-perspective/blog/all-blogs/how-many-of-amazons-dotcom-peers-from-march-2000-exist-today/
3. https://us.spindices.com/indices/equity/sp-500

Disclaimer: The information provided on this page is not investment advice, and while I aim to conduct objective research and verify my resources, you should always perform your own research before investing in a crypto currency, or any other investment vehicle.