The investor invests looking for a profit. Which implies that you buy after a bullish forecast and sell after a bearish forecast. If you guess right, you win money. If you are wrong, you lose money. The most basic risk of the investor is that the price moves against him after taking a position. Of course, the one who does not risk, does not win. But the one who risks too much, can lose everything. If you are too conservative, you don’t grow. But if you are too aggressive, you flirt with ruin. The smart investor avoids these extremes and strikes a balance with a sound strategy.
Investing requires faith. That faith is the belief that we are buying cheap and the asset, sooner or later, will rise in price. The problem is that, in most cases, faith is blind. The believer feels that he is right. The believer wants to believe that he is right. But the believer is not guaranteed success. In fact, he is often wrong. And this is not necessarily due to incompetence. The investor is wrong, because his business is to place bets on random and irrational markets. Therefore, the investor must put all his effort to win, but, at the same time, he must be well prepared in the event of losing.
The highly emotional person often loses money because they often fall prey to wishful thinking and denial. In other words, you have a hard time admitting that you can be wrong. The crypto community is particularly vulnerable to this syndrome. Does Bitcoin have a future? Will Bitcoin go up in price in the coming years? If you answer those questions in the absolute affirmative, it is quite likely that your risk management is not very good. After all, if something is 100% guaranteed, there’s no point in managing a risk that doesn’t exist. If victory is certain, preparing for possible defeat is a waste of time. Is that assumption sensible? Is harassment realistic?
Now suppose we play an honest game of heads or tails with a coin. In theory, our chance of winning is 50/50. that would be ours win rate. But, to make things more interesting, we are going to put money on the matter. If we choose heads and win, we will receive 2 dollars. But if we lose, we lose 1 dollar. That is, we risk 1 dollar in order to win 2 dollars. So, in this hypothetical game, our risk/reward ratio is 1:2. Under such conditions, we might think that after tossing the coin 10 times we will get 5 heads and 5 tails. That is, 5 wins and 5 losses. (5×2)-(5×1)=5. In theory, we should have $5 in our pocket with that win rate and that risk/reward rate.
Of course, theory is not like practice. Most likely, reality differs from theory. We well know that if we toss a coin ten times, the result is not always 5 and 5. In fact, there is a chance that we will get a much more lopsided result. In effect, there is a chance of getting 10 losses in a row. Which is not a very serious problem, because what we would be putting at risk is only 10 dollars. In the case of putting all our assets at risk, another rooster would sing.
Now suppose we have an 80% chance of winning and not a 50% chance of winning with a risk/reward ratio of 1:3 and not 1:2. In this case, our advantage improves markedly (in theory). Nevertheless, In practice, we can lose everything in a losing streak, if we put everything in the same basket.
People who bought Bitcoin at $68K thought the odds were in their favor, however today they are roughly 70% under water. If bought on credit, a longer-than-expected bear cycle could spell bankruptcy. Suppose we buy with savings, but are still up to our necks in debt elsewhere. The core would be quite similar.
Why does it fall into this error? Well, the player thinks luck is on his side. If he gets a lot of losses in a row, he might think that victory is very close. For the matter of probabilities. If our win rate is 80%, you might think that after two losses in a row, you have to buy the drop, because a rebound is imminent. This error is called the gambler’s fallacy. And it is the road to ruin.
The gambler’s fallacy arises from a misunderstanding. At bottom, it is a misunderstanding of the law of large numbers in probability theory. In other words, small samples are not a reliable representation of the whole. We know that 13 years is not a long time, but we insist on using those years with irrefutable evidence that success is guaranteed. During a bull run, the rallies never seem to end, but that doesn’t mean the rallies will last forever. Those notions are quite related to the gambler’s fallacy. In many cases, investors underestimate their chances. And, in the process, they neglect to manage risk.
In another article, I delved into the concepts of win rate Y risk/reward rate in the context of risk management. Here I share the link of said article. The risk of ruin must be weighed, in a combined way, with these two concepts. Now, we know that Bitcoin can lose between 70-90% of its price. And a recovery can take two years or more. For risk management purposes, it is best to assume that the possibility of losing everything and forever is on the table. So it is reasonable to assume that we are talking about a risk of 1 in the span of a year.
How can we avoid the risk of ruin with that level of risk? We need a hedge. In other words, our other investments must have the capacity to produce an annual income equal to or greater than 1. That is, we put 1 at risk, but we have a hedge that produces 1 or more. Of course, if we put it all in Bitcoin, we lose that hedge. Which implies that the risk of ruin is quite high.
This protection is necessary for long-term investors who refuse to use a stop loss. without a stop loss, we have no choice but to resort to history to estimate the approximate risk we are assuming. In my opinion, 93% is pretty close to 1. And a year is a reasonable amount of time, because debts and obligations rarely wait more than a year.
In conclusion, the risk of ruin is largely avoided with a diversified and balanced portfolio. We must choose the size of the position according to its win rate and his risk/reward rate. Alsowe have to take into account the return on our safest investments. All numbers must add up. Our income must be able to cover the risks we take and the lifestyle we enjoy. Risk is not something we should leave to chance. You have to keep it under control.
Disclaimer: The information and/or opinions expressed in this article do not necessarily represent the views or editorial line of Cointelegraph. The information set forth herein should not be taken as financial advice or investment recommendation. All investment and commercial movement involve risks and it is the responsibility of each person to do their due research before making an investment decision.
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