The NY Times recently published an article by Nathaniel Popper and Su-Hyun Lee that highlighted some of the realities cryptocurrency investors are now facing. In the article titled, “After the Bitcoin Boom: Hard Lessons for Cryptocurrency Investors” various individuals around the globe discuss why they invested in cryptocurrencies and how their investment decision has impacted their lives financially.
For those of you who have read my articles (Investing in Bitcoin and Other Cryptocurrencies, and Still Thinking About ‘Investing’ in Cryptocurrency?) posted on retirementknowledge.education, you pretty much know how I feel about cryptocurrency investing. Nonetheless, I thought I would share this article since it brings to light a financial behavior that ruins so many investment portfolios.
The article starts off with a gentleman describing his mistake as getting “…caught up in the fear of missing out and trying to make a quick buck.” That sentiment is arguably the same for the other individuals interviewed and probably tens of thousands more around the world who purchased cryptocurrency over the past year. But what has really hurt the investors in the article, compared to many others that invested in cryptocurrencies, is that they suffered from optimism bias.
In financial terms, optimism bias is a belief that bad investment results can happen to others, but not to you. This belief often leads investors to have an excessive allocation to an investment. Their overly optimistic view led the investors to purchase more and more cryptocurrencies without much (if any) consideration for the total at risk. Even to the extent of taking out a loan to purchase more cryptocurrency.
It is easy to play armchair quarterback and assert that the investors were simply too greedy, or they should have known better than to invest when cryptocurrencies were skyrocketing, as some have suggested. But, do you really think that they would have invested heavily in something that they thought there was even a 1 in 3 chance of losing 60%, or more? They were so optimistic about cryptocurrencies that I’d bet some of them thought there wasn’t any potential for loses…Zero. The others probably thought there was very little chance that cryptocurrencies would lose value.
While it’s probably not the case for the 20 somethings in the article, many people have been financially ruined due to optimism bias. An employee having a large portion of company stock in their company retirement plan is an example of optimism bias. According to a recent article by FORTUNE, many of the GE employees purchased a large amount of the company’s stock in their 401(k) retirement plan. Since the beginning of 2016, the share price of GE has fallen almost 60%. The article goes on to list other major employers whose employees are purchasing a large amount of company stock in their retirement plans. Some of the top companies listed include Sherwin Williams, Colgate Palmolive, Exxon, Lowe’s Home Improvement, Dillard’s and McDonalds. And who could forget the employees of Enron who lost their job and retirement savings in a New York minute back in 2001.
Fortunately, optimism bias is easily avoidable. One way is to make it a rule of thumb that no single company stock or asset (ie: Apple, Exxon, Bitcoin, Gold, etc..) will make up more than 10% of your total investments. For instance, let’s say you have $400,000 in diversified investments and $100,000 in savings and you would like to take a gamble on Bitcoin. If you limit your Bitcoin investment to $50,000 or less, you won’t be financially ruined if you lose it. Mad…yes. Ruined…no.
Also, if you are able to purchase employer stock in your 401(k) retirement plan, (ie: you work for GE and are able to purchase GE stock in your company retirement plan) then you should consider limiting your purchase of your employer’s stock even further. Something around 5% to 7%. Holding a large amount of employer stock significantly increases your risk. A negative event for the company could result in the loss your job and your retirement savings at the same time.
Optimism bias can lead to financial ruin, but it easily avoidable. With our investment markets close to all-time highs, now is a great time to take a look at your total portfolio and make sure that you are not subject to a major setback due to an over-sized investment.
Kevin Warman, CIMA®
Last Updated (9.11.2018)