# How Not To Invest

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Includes: GBTC
by: Jonathan Prather
Summary

Markets may be rational, but people are not.

Don't buy high and sell low.

A personal case study on what not to do.

## Early September 2015

I found myself in a cramped study room, over-illuminated by headache-inducing fluorescent lights. Across from me sat two impeccably dressed investment banking associates. This was my first real interview, and I was determined to win a job on Wall Street. Associate 1, a man in his early 30s, never blinked and spoke with an impassioned cadence that reminded me of Patrick Bateman's monologue on ending apartheid. Associate 2, a woman in her late 20s, was a "speed-talker" and possessed a permanent courtesy smile that you might find on a timeshare brochure or Chick-Fil-A employee.

Juxtaposed with these Wall Street sharks, I wore a "buy-one-get-the-store for-free" Jos A Bank suit that graciously covered my sweat-drenched shirt. After we briefly exchanging pleasantries, the two associates set about grilling me with complicated behavioral and technical questions. For about twenty minutes, I managed to bob and weave through the onslaught of verbal jabs. My newly gained confidence quickly subsided, however, when I answered (incorrectly) an unexpected "brain-teaser".

Here's the question:

There are two boxes. One has \$100 inside and the other has \$0 (implying a 50% probability). It costs \$20 to open it and find out. I only have \$10, so I need someone to invest another \$10 with me.

If there is nothing inside the box, we both get \$0. However, in the event there is \$100 inside the box, how much of the \$100 would you require as your return for you to want to invest with me?

In isolation, the first part of the question is a basic measure of expected value:

Part 1

 Payout \$100 Probability of Payout 50% Expected Value \$50 Less Investment (\$20) Expected Return \$30

With an expected value of +\$30, a rational investor ought to invest. To my credit, I was able to make it this far during my interview; however, I slipped up on part 2 by failing to recognize the importance of the second variable at play - required return. More specifically, the impact of risk appetite on required return.

Part 2

When accounting for an individual's risk profile, you create a range of potential values:

 Investor Type Risk-Averse Risk-Neutral Risk-Taker Investment \$10 \$10 \$10 Required Return \$40 \$25 \$10 ( / ) Probability of Payout 50% 50% 50% Required Payout \$79.99 \$50.00 \$20.01

Therefore, the answer is this: a rational investor with a high tolerance for risk should demand at least \$20.01 of the \$100. If offered only \$20, they will be indifferent, and if offered anything below \$20, the investor ought to reject the proposal because it has a negative expected value.

Conversely, a risk-averse investor will require the maximum payout that still offers me a payout with a positive expected value.

## Markets May Be Rational, But People Are Not

Here's my issue with the scenario above. People (myself included) aren't that rational. Ask yourself, do you calculate the expected value of every decision you make? Of course not. Casinos would quickly go out of business if everyone did. Instead, we rely heavily on heuristics, or intuitive judgment calls, to make most of our decisions.

I believe this is highly pertinent to investing. We are all human, and we are all perfectly capable of making irrational investments. I am intimately aware of this fact because I've watched myself make a number of terribly avoidable missteps.

In this article, I'm going to discuss a specific series of missteps that I wish I could take back, and I'm going to highlight how those slip-ups were driven by faulty intuition. My hope is that you will learn from my experiences so that you might recognize your own biases and avoid making the same mistakes.

## Cognitive Bias and Investing

For those interested in learning about cognitive bias, I recommend reading the works of Amos Tversky and Daniel Kahneman. This abstract, in particular, discusses a heuristic I'm personally guilty of: the desire to recoup losses by doubling down.

For those who don't necessarily like reading academic articles, I highly recommend reading Michael Lewis' book The Undoing Project. A portion of the book is devoted solely to addressing major contradictions in our understanding of expected value. In particular, I would like to highlight two questions from that book.

Question 1

Which of the following do you prefer?

Gift A: A lottery ticket that offers a 50% chance of winning \$1,000

In most cases, people took the certain \$500. In fact, research found that in order to convince a majority of people to take the gamble over the certain gain, you have to lower the certain gain to around \$370. This suggests that people are predominately risk-averse when evaluating gains. Not a particularly shocking discovery, However, things get interesting when you re-frame the exact same question in terms of losses.

Question 2

Which of the following do you prefer?

Gift A: A lottery ticket that offers a 50% chance of losing \$1,000

Gift B: A certain loss of \$500

When reversing the question, Tversky and Kahneman discovered that people were now eager to take the gamble. This finding was contradictory in and of itself, but they decided to take it one step further. They lowered the certain loss to \$370, and they found that a majority of participants still preferred to take the gamble. Effectively, this study showed that most people will go beyond rational thinking in an effort to avoid a loss.

## A Personal Case Study on How Not to Invest

With that idea in mind, let me tell you a story about how I single-handedly screwed up my all-time best investment.

August 4, 2017. My first year as an investment banking analyst had just begun. As a frugal individual with minimal debt and excess cash of \$10,000. I wanted to invest. After a few in-depth conversations with a fellow analyst regarding the virtues of crypto currency, and some personal research, I decided on Bitcoin. The price at the time was \$3,250, and I went all-in.

December 30, 2017. After briefly spiking to almost \$20,000 a couple weeks prior, Bitcoin prices declined precipitously to \$13,000. Fears of a bubble, market saturation, and lack of use cases began to weigh on me. I decided to sell half of my position to cover my initial investment and lock in a profit.

January 5, 2018. Prices rebounded sharply to \$17,000. Immediately, a sense of regret permeated my mind, as I missed out on 30% gains. I was certain Bitcoin could only go up at this point. After all, John McAfee said he would eat his own **** if prices didn't reach \$1,000,000 by 2020. I proceeded to reinvest \$20,000.

January 12, 2018. Prices stooped to \$14,000, but I remained undeterred. This was exactly what happened in December. I told myself I wouldn't make the same mistake twice and miss out on a prime buying opportunity, and I purchased another \$10,000 worth of Bitcoin.

February 2, 2018. Prices decline to \$9,000. What the heck is going on? Surely this is temporary. Wasn't I at a ~500% return only two months prior? This must be an abnormality. I'm gonna make this all back in a matter of weeks, I said as I hit the "Buy" order on another \$10,000 of Bitcoin.

June 8, 2018. Prices decline to \$7,500. Eject, Eject, Eject. This is nothing but bubble. I can't believe I was such an idiot for reinvesting. There is no real value here, only wishful thinking. Jordan Belfort was right, this is just a massive Ponzi scheme. It was here that I decided to sell my entire crypto position and return to the world of normal investing.

A Visual Representation

 Date Buy / Sell Qty # Bitcoin Price (\$) Gain / (Loss) 8/4/2017 Buy 3.077 \$3,250 - 12/30/2017 Sell (1.538) \$13,000 \$30,000 1/5/2018 Buy 1.176 \$17,000 \$36,154 1/12/2018 Buy 0.714 \$14,000 \$28,009 2/2/2018 Buy 1.111 \$9,000 \$10,863 6/8/2018 Sell (4.540) \$7,500 \$4,052
 Total Returns Risked (\$50,000) Paid Back \$54,052 Return \$4,052 Return % 8.1%

Alternative 1

Now, let's take a look at what would have happened had I done nothing after December 30, 2017.

 Date Buy / Sell Qty # Bitcoin Price (\$) Gain / (Loss) 8/4/2017 Buy 3.077 \$3,250 - 12/30/2017 Sell (1.538) \$13,000 \$30,000 5/1/2019 Sell (1.538) \$5,306 \$18,164
 Total Returns Risked (\$10,000) Paid Back \$28,164 Return \$18,164 Return % 181.6%

Alternative 2

Let's take it one step further and pretend I never sold.

 Date Buy / Sell Qty # Bitcoin Price (\$) Gain / (Loss) 8/4/2017 Buy 3.077 \$3,250 - 5/1/2019 Sell (3.077) \$5,306 \$6,327
 Total Returns Risked (\$10,000) Paid Back \$16,327 Return \$6,327 Return % 63.3%

Yikes! I would have put less capital at risk, made a higher return, and saved myself the anxiety of the watching my portfolio decline.

Note: I've altered actual dollar amounts to express nice round numbers. The percentages, however, are the same

## Where I failed

My first mistake came from a breakdown in how I framed the situation. I initially purchased an asset at \$3,250 and sold at \$13,000. In isolation, that is an astounding return which I should have felt good about. Instead, I witnessed prices rebound to \$17,000 and felt that I'd lost out on gains.

Second, I failed to remember that "past results do not necessarily reflect future performance". I fully believed the January decline from \$17,000 to \$14,000 mirrored the decline, and subsequent rebound, I witnessed in December.

Finally, I made the classic mistake of chasing a loss. I felt a powerful need to win back what I had lost, and ultimately made a costly gamble.

## Conclusion

We make choices everyday based on personal intuition. It is far too easy to invest based on a gut feeling. Personally, I wish someone would have told me how irrationally I was acting. Perhaps then I might have taken a step back, properly analyzed the situation, and made wiser choices. My hope is that you learn from my mistakes and remain cognizant of your own biases that may be driving your investment decisions.

As for Bitcoin, after much reflection I remain cautiously optimistic about its long-term outlook. I recently allocated about 5% of my portfolio into GBTC. But this time around I don't check the price every five seconds and I'm committed to a five-year holding period.

Disclosure: I am/we are long GBTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.