High Wire Act

Wherein I ponder balancing a portfolio with ICOs

Perhaps you have seen circus acts where the death-defying performer walks a tightrope high above the crowd. He succeeds by maintaining his balance. Balance is important in more than just this context.

When I started learning how to manage my investments I learned about “diversifying” one’s assets and then I heard about “balancing” a diversified portfolio.

Diversification is the long word for “thou shalt not put all your eggs in one basket.” If you have any doubts about the prudence of diversifying one’s retirement nest egg, ask any Enron investor. When you buy one company’s stock, that one company can go out of business. Then you’re sunk. Conversely, if you buy ten companies’ stocks, then some can go up, some can go down, and some can go sideways. No problem, the winners winnings cancel out the losses of the losers. You don’t make as much as you might, but you’ve mitigated your through diversification.

This is part of why people buy mutual funds, the mutual fund manager picks some stocks using his great wisdom–which he charges you for. My response to this is to buy an index fund that spreads the risk over more than four thousand stocks. Know any company doing well? I own it. Any company losing big? I own it, too.

This spreads risk across all the different stocks offered by American companies, but ultimately this rests upon “equities.” However, the market has a tendency to go insane periodically and this will hurt all stock prices no matter how broadly I’ve diversified.

To further mitigate risk, it makes sense to hold not just one asset-class (e.g. equities), but to also hold other asset-classes, too. As I’ve mentioned before, I am looking for different asset classes that are anti-correlated with equities.

I prefer to hold productive assets, that is, assets that generate value over time. Since gold, silver, or foreign currencies produce nothing (even when their prices soar), these aren’t productive assets. Real estate is a productive asset when you rent it out. Stocks and bonds can pay dividends. Money-market accounts pay interest. Farmlands produce produce. Gold mines produce gold.

Retirement funds traditionally hold a mix of stocks and bonds. Conventional wisdom says, take your age, and own that percent of your portfolio in bonds, and hold the rest in stocks. If you’re 65 years old, hold 65% bonds, and 35% stocks. This has a problem when your age exceeds 100, and you’ll never believes what happens once your age exceeds 122.

Once you have an age-appropriate balance of asset-classes in your portfolio, you should periodically (once or twice a year) rebalance the portfolio to maintain the target percentage of stocks to bonds. Prices change over time. If stocks run up, then the ratio of stocks in your portfolio grows too big: sell some to buy some bonds. If stocks decline, then the ratio reverses. Then sell bonds to buy stocks. This makes you always buy low and sell high. But you must be disciplined to ignore market panics or manias to only do this according to your pre-determined schedule.

This is a great idea, but it requires you hold two or more different asset classes. I just described stocks vs bonds, but it could have been stocks vs real estate, or bonds vs cash.

I dislike bonds. The bond market has been distorted by massive government borrowing and interest rate manipulation by the Federal Reserve. Thus bond returns have been insufficient to buy catfood. This makes me look beyond the traditional rule of thumb. At this moment, I hedge an equities-heavy portfolio with real estate and cash. I have been looking for a different asset class than bonds to balance equities against to mitigate risk.

Then I heard about Bitcoin, Ethereum, and ICOs. The first two have been around for a while but the third was a mystery to me.

What’s an ICO? It sounds like IPO–an Initial Public Offering. You know what IPOs are, don’t you? They are the deals when Microsoft or Apple go public. Everybody knows they will make a lot of money. And nobody can buy shares in them at first except for a few well connected investment banks. After they make a ton of money, then you and I get a chance to invest in them.

Conversely, an ICO is an Initial Coin Offering–not the same as an IPO. Because when you buy into Microsoft’s IPO, you become a co-owner of Bill Gates’ company. (You hold an “equity” stake. That’s why stocks are called equities.) However, when you buy a ICO token listed here you get a promise for future goods and services. This promise is backed by a cryptographically secured “smart contract”. This is a form of debt, because it’s a contract between you and the startup company. There’s another name for contracts that a company offers for future goods and services: bonds.

Someone with a dream for an enterprise can raise capital bypassing brokerage houses, investment bankers, loan sharks, and vulture capitalists. S/He simply creates some ICO tokens and offers them for sale. The returns promised by some of these ICOs are amazing. This is the future of capitalism. It makes a greedy person like me start rubbing his hands together.

To whatever extent bonds prices are uncorrelated with stock prices, then it would seem that ICOs should be even less corrolated. They seem to me to be high-risk/high-reward investment opportunities.

Let’s delve into the risks. There are real problems inherent in the technology. Testing software is difficult enough, and testing a “smart contract” is particularly critical because it has so much riding on it. This is technical risk.

Then there’s regulatory risk. Did you notice the step in the ICO process where the startup asks the gubmint, “Mother, may I?” Nope. It’s not there. The Securities and Exchange Commission that likes to hear “Mother, may I” so that it can start devising hoops for the startup to jump through. Thus the SEC helps the public lose our money safely.

Governments, banks, and brokerage houses do not like being disintermediated. The US has the best laws that money can buy. You can bet your bottom dollar someone you’ve never heard of in the SEC is devising ways to throw a monkey wrench into ICOs. And corporate entities are working hard speading FUD (fear, uncertainty, and doubt) as fast as they can.

The government will do something, but the government has only limited power over a technology that is as decentralized as cryptocurrencies. If the US proves too difficult to work with, a company like TenX sets up shop in Singapore, where its government embraces blockchain technology.

Nevertheless, this is a source of regulatory risk, particularly when the US Government has power over your money. Like in an Individual Retirement ARRANGEMENT. It’s called an arrangement because the IRS has strings attached to every dime of your IRA.

So, ICOs are like high-yield bonds but they are risky. There’s a term for high-yield bonds with high-risk: junk bonds.

Oh, fine. Will I balance my retirement portfolio with the equivalent of junk bonds?

Not hardly. I think I’ll consider a REIT index fund until I understand the risks better. Meanwhile if I’ve got some gambling money to play with I’ll put it into ICOs.

Steve Poling

Masters degrees in math and computer science. Poet in several computer languages. I write stories about Sherlock Holmes' brother Mycroft, steampunk, and SF.

Grand Rapids, Michigan http://www.catfoodretirement.com