A while ago I penned a column on the risk profiles of the various types of investments, envisaging a spectrum ranging from low-risk bank deposits to high-risk unregulated investment schemes such as property syndication schemes, with most other investments you can think of lying somewhere between the two extremes.
But perhaps we need to have a closer look at what an investment is – or rather what it isn’t. This comes in the wake of a news item published fairly widely, including in Personal Finance last weekend, about people who had borrowed money to buy Bitcoin and were now facing a credit crunch.
Question: When is an investment not an investment?
Answer: When it’s a gamble.
Technically, when you invest, you buy an asset – usually something tangible that you own, such as property or a share of a business. The reason for investing is that you are confident that the asset will appreciate in value. In the case of a safer cash investment, you lend money to a bank, receive interest on the loan, and get your capital back after an agreed period.
When you gamble, you take a bet on a particular event occurring. A bet is essentially a contract with another party (a bookmaker, casino or drinking buddy during a rugby match) that you will receive a certain amount of money over and above what you place on the table if the event occurs (your nominated gee-gee wins its race, the roulette ball settles on a red, or the Springboks score a winning try in the last five minutes of the game), and you will lose your money if the event does not occur. All of it.
Gambling typically involves a high degree of luck. But before we explore “luck”, let’s revisit the term “risk”.
Risk is the probability of your investment performing worse than expected – for example, you earn a return of 6% instead of the 10% you hoped for. The outcome could be worse: you could lose some or all of your investment capital. The worst-case scenario, which we will examine further in another column, is when you lose more than your investment capital.
A rule of thumb is that the more you stand to make, the higher the risk.
Committing your chips to black or red on the roulette table gives you 100% return in the time it takes to spin the wheel ... or 100% loss. The probability of loss is one in two, or 50% – the same probability as tossing a coin. That’s a much higher risk than, say, that of a high-risk equity unit trust investment, which may typically present a 20% probability over a given year of a 10% loss to your investment.
Let’s return to the risk spectrum, but include forms of gambling.
On the far left, we would still have bank deposits, the safest form of investment but unable to provide you with decent, after-inflation returns. Moving right, you would pass through bonds, listed property, listed shares, unlisted shares, debentures in property syndications … to horse racing, poker, blackjack and roulette.
Note that I have placed those forms of gambling that require a degree of skill or expertise to the left of those requiring plain luck (defined as success that cannot be attributed to anything other than mere chance). Many people do well out of betting on the horses, not because they’re consistently lucky, but because horse racing is their passion, and they’ve made a concerted study of it.
This applies even more to investments: the better you know the market and the more thoroughly you research a particular investment, the less luck is involved and the less risk you incur.
So where does a cryptocurrency fit into our risk/luck spectrum?
Although technically a cryptocurrency may be called an investment, risk-wise it lies somewhere between blackjack and roulette, on the far right (extremely high risk) of the spectrum – in other words, a gamble in all but name.
• The high volatility of cryptocurrencies;
• Their intangible nature; and
• The many unknowns surrounding them, meaning it’s unlikely that any homework on your part will improve your odds.
If you bought Bitcoin when it was $1 000 a few years ago and haven’t cashed out yet, you have benefited from the almost irrational surge of interest in the currency and have made a return of about 1 100%. I would suggest that you have been very lucky. The downside of relying on luck, however, is that you never know when it’s going to run out.
This is not a condemnation of cryptocurrencies. It’s just a reminder that the risks involved resemble those of gambling. And, as all responsible gamblers know, you only gamble with money you can afford to lose.