Singapore, SINGAPORE – The essayist and scientist Steven Jay Gould was once diagnosed when he was in his forties with a deadly form of cancer of the lining of the stomach. When the oncologist gave him the diagnosis, the report was almost like a death sentence — the odds of median survival for that particularly vexatious cancer was eight months, information which Gould naturally received akin to walking the green mile. Now people respond differently to news of this sort. Some may be drawn to deep dive into researching their ailment — nothing motivates the pursuit of information than then knowledge that what you don’t know could literally kill you — while others would make final preparations. The prolific writer that Gould is, he decided on the former as opposed to the latter and uncovered some rather different information form the doctor’s grim prognosis. What Gould soon found out was that the expected, or average survival of people with the same cancer as his considerably more than eight months. Apparently, the good doctor did not draw the distinction between expected and median. Contrary to this doctor’s belief, the two terms are mutuo se expellunt. But what does that have to do with crypto? We’ll get to that shortly.
Median means roughly that 50% of patients diagnosed with the same cancer as Gould died before eight months, but the 50% who survive longer than eight months generally go about life just like a regular person and fulfil the average life span of 73.4 years predicted by actuarial insurance mortality tables.
So what does all this have to do with crypto?
If your investment in ICOs (initial coin offerings) last year was akin to the proverbial monkey flinging darts at a board, your results towards the end of 2017 would have been as if that monkey had scored 10 out of 10 bullseyes and not only that, but those bullseyes were where the darts themselves each landed on the tail of the one before it. Not just a statistical improbability, but a physical impossibility. But that was exactly what was happening in 2017. As ICO fever took hold, all and every manner of ICO project was returning multiples on investment, yet somehow when the music was playing, nobody stopped to consider the reversion to the mean. As the ICO bubble started to burst, the mainstream media quickly seized on how the vast “majority” (a term loosely used) of ICO projects were scams and that many lost their own personal fortunes in what pundits have compared to the Dutch tulip bubble. But was that the case?
The issue with reporting (and I hold nothing against reporters or the media, sensationalization sells page views faster than sensibility) is that it’s easier to catch attention with sweeping statements and headlines than it is with a measured assessment of the actual results. So exactly how risky were ICO investments?
According to a PWC report in collaboration with Crypto Valley in June this year, a total of 3,470 ICOs were announced. Around a third of all announced ICO projects closed successfully. So assuming you had invested one dollar in every available ICO, 1,156 would have successfully closed their funding. That’s not to say that you would have lost the other half of your money, because the majority of ICOs which did not close their funding rounds successfully (not hitting soft and/or hard caps) would have had to return investments to their investors. But if we look at the median, the number of ICOs which did not pass any returns in their token values to investors the number becomes a staggering 80% of ICOs which either have no minimum viable product or whose ICOs are now well under water. The trick is in the law of large numbers. Had you bet on all the ICOs available to be bet on, you would have caught the top twenty most funded ICOs and the of those, the returns have been phenomenal. Today (despite the bear market) you would be a dollar-denominated millionaire. Many funds took that same approach (also known as spray and pray) a style of venture capital investing where just one or two hits are sufficient to cover 90% of the losses. In other words, investing in cryptos was not just profitable, but statistically, a once-in-a-lifetime opportunity on a statistical scale the likes of which we are not likely to witness again anytime soon.
In irrational markets, such as the kind which existed in ICOs towards the end of last year and the very earliest parts of this year mean that a focused, studied approach would have yielded significantly less alpha than a distributed approach to investing.
Several years ago, I went to Las Vegas. Having watched the movie “21”, I was convinced that I could teach myself to count cards at blackjack as well and to make a killing in Vegas. I checked-in at the Treasure Island Hotel on the Strip and put myself in front of the blackjack table. With only US$125, I turned that initial stake into US$2,500, a twenty-fold increase. But in reality, I made about US$25 an hour, or just slightly double of minimum wage. I share this nugget of information not to show off, but to admit that I was lucky. The mean is not something that is a given, nor is reversion to the mean. I was lucky because even though I admittedly did stick to all the rules of card counting (never bet more than 5% of your total pot on any hand) and stuck strictly to the rules of basic strategy, my odds against the casino were still a paltry 48.90%. The casino still had the numerical edge over the long run. And if I had continued playing long enough, not only would I have lost my paltry US$125, I would have probably lost my shirt as well, because of reversion to the mean. Which is why they say “the house always wins.” It’s not that there are no winners in casino, but when we start overlaying such experiences with the bias of assumed skill, is when we miss the point. Too often randomness is ignored in the outcome of fortunes. It would be a mistake to attribute my success at the blackjack tables in Vegas to skill. Yes, I was disciplined, but there are dozens of disciplined players as well who never make any money at blackjack. They key is that I literally played thousands of hands, scalping small enough profits from each one to make it count in the long run. Which is how high frequency traders make money, by making miniscule scalps in nanoseconds to return substantial alpha regardless of market conditions.
So how does one profit from the crypto revolution?
I recommend the two “Ds” of allocation. Due diligence and diversification. Just as Warren Buffett is loathe to invest in things he does not understand, we must be slow to allocate into projects for which we have no clue of the underlying technology and its viability. Yes, it’s not easy to understand software code, yes, blockchain technology is not a cakewalk, but yes it’s worth it. If you’re truly seeking alpha in this space and you care about longevity, then the best investment is an investment in yourself and your educating yourself on the technology that has the potential to revolutionize the world. But if the technology is sound and you’ve obtained your most basic of blockchain chops and you like the project, does that mean you go all-in? As much as it would be tempting to punt big on an ICO project which you’ve spent the better part of a year studying up on, the key is to adopt either thematic themes of ICO investment or a broader trading strategy which is agnostic to existing market conditions. The idea is to trade as many items as much as possible and as often as possible for as long as possible. Because ICOs are not cards in a casino where the deck is stacked against you, strategies such as statistical arbitrage can pay out well over a longer time horizon. Over time you will certainly make less than a lucky punter who went all-in on a hot ICO, but the key word here is “time” and more importantly, the elimination of the need for luck.
The writer is Patrick Tan, Partner and General Counsel for cryptocurrency quant trading firm Compton Hughes.