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On the Importance of Not Losing — A Guide to Compound Interest

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When I began to get interested in trading, about 20 years ago, I read many books on the topic. One day, I saw: “In order to make money in the markets, the importance is not to lose.” Duh! — did I tell myself while reading… only later to discover the real meaning behind that catchy phrase, which I have since applied when trading, and to a great benefit.

The eighth wonder of the world

In order to understand the true meaning of, “In order to make money in the markets, the importance is to not lose,” one has to remember what Albert Einstein famously said about compound interests being the most powerful force in the universe:

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t … pays it.”

Compound interests work both ways: when compounded positively, they can bring tremendous growth, but when compounded negatively, they can lead to disastrous losses. Therefore, in order to recover from a loss, the gain to breakeven grows exponentially with the magnitude of the loss.

For example, a loss of 10% requires a gain of just 11% to recover, a loss of 25% requires a strong gain of 33% to recover, while a loss of 30% (not much bigger than the previous 25% loss) requires a gain of 43% (much higher than the 33% needed to recover from a 25% loss), etc. A loss of 50% requires a gain of 100% to recover, and typically, a loss of 60% or more in the markets are almost unrecoverable.

Compound interest

Markets take the elevator down, but the stairs up

Markets tend to fall much faster than they rise. Compound that (no pun intended) with the compounding interests effect on the negative side, and one can easily see the problem, which is two-fold:

  • Small losses can become large very quickly due to compounding on the downside.
  • As markets take way more time to recover than they do to crater, recovering from a large loss may never happen in one’s lifetime.

Traditional financial markets: The 2000–2002 decline erased the entire total return of the S&P 500 — in excess of Treasury bills — all the way back to May 1996, while the 2007–2009 financial crisis wiped out the entire excess return of the S&P 500 all the way back to June 1995.

Crypto markets: From January 2016 to June 2020, Bitcoin (BTC) peaked at 83.7%, which requires a gain of 512% to fully recover. As at June 30, 2020, Bitcoin had only recovered 187%, still a long way to go to break even despite having almost tripled in value.

Focus on controlling losses, profits take care of themselves

It then appeared more clearly to me that “In order to make money in the markets, the importance is not to lose” meant: One has to keep losses small, as the bigger they are, the harder it is to recover.

Trading is, in fact, all about risk management.

When entering a position, people bet on a direction (either up or down) in which the market may turn, usually over a predetermined time frame with an expected probability above 50%. However, in reality, the probability of making the right call is often less, typically in the 30%–40% range for a successful trader.

This means that a trader will be wrong 60% to 70% of the time, whereas the initial expectation was less than 50% of the time, hence the need to focus on controlling losses that occur more often than one expects.

By the same token, winning positions will compound positively over time, leading to exponential growth — if one can keep the unavoidable losses contained. 

Capital preservation is key

Investors and traders, as human beings, have a tendency to chase performance, as it’s easy to extrapolate a previous trend. If a pattern has worked so far, why would it not continue as such for a while? Chasing performance tends to put more emphasis on capturing large moves at the expense of potentially being hit more severely, rather than trying to capture more modest moves with a focus on minimizing losses.

Over the mid- to long-term, traders are better off preventing/minimizing losses than chasing performance.

For illustrative purpose, let’s assume that we could systematically (i.e., with insight) capture a certain percentage of an upward move and a certain percentage of a downward move of Bitcoin (Bitcoin is here as a crypto asset example, but the same applies to traditional assets too):

  • Performance-chasing approach: “Capturing most of the upside is what matters.” Capture: 85% of an up-move, 80% of a down-move.
  • Capital preservation approach: “The most important is to minimize losses.” Capture: 60% of an up-move, 45% of a down-move.

The capital preservation approach delivers a total return almost four times that of the performance-chasing approach (17,195% vs. 4,359%) and reduces the drawdown by 42% (-28.7% vs. -68.5%).

Chasing perfomance vs. capital preservation

Importance of limiting losses

Theoretical example

This is a theoretical example, deliberately oversimplified for illustration purposes only.

During the corrective phase, the passively held asset loses $20, whereas exposure to the same asset through an actively risk-managed strategy loses only $10.

During the recovery phase, the passively held asset gains $30, whereas the same asset traded by the active strategy gains only $25.

At the end of the correction/recovery cycle, the passively held asset’s price gained 10% while suffering a drawdown of 20%, whereas exposure to the same asset but backed by an actively risk-managed strategy gained 15% with only a 10% drawdown.

Efficiently risk-managed vs. passive holding

Even if the active strategies don’t capture all of the upside moves of a passive holding, over time, they outperform greatly by minimizing the losses along the way, while the compounded interests take care of the profits.

Conclusion

A systematic and robust risk-managed approach is the only way to make money when trading over the long term — not because you’re going to catch all of the right moves, but because you’ll cut the losses early when you are wrong, with no overthinking. Admitting error is harder than one might think for a carbon entity such as a human, but a no-brainer for silicon entities.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, you should conduct your own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

David Lifchitz is chief investment officer and managing partner at ExoAlpha, an expert in quantitative trading, portfolio construction and risk management. With over 20 years of experience in these fields and 8+ years in information technology with financial firms, he has notably been the former head of risk management at the U.S. subsidiary of Ashmore Group ($74 billion in assets under management in 2018), dedicated to alternative investments. ExoAlpha has developed proprietary institutional-grade trading strategies and infrastructure, monitored 24×7, to operate seamlessly in the digital asset markets applying strong risk management principles.

Source: https://cointelegraph.com/news/on-the-importance-of-not-losing-a-guide-to-compound-interest

Blockchain

Eyeing EU Banks, Hex Trust Teams With SIA on Crypto Custody

A multinational payments firm is partnering with cryptocurrency custodian Hex Trust to help its European banking clients hold digital assets.

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Multinational payments firm Sia is partnering with cryptocurrency custodian Hex Trust to help its European banking clients hold digital assets.

“When you have one bitcoin, it’s not a big problem, but when you start adding 10, 20 or 100, you have a treasury and you have to decide where to store this,” said Daniele Savarè, SIA’s innovation and business solutions director. “We are discussing digital custody needs with banks in Europe.” 

The firm is also helping banks manage and safekeep security tokens and central bank digital currencies, he added.

Through SIA, Hex Trust plans to offer European banks the software to custody digital assets on behalf of their customers. Hex Trust will also act as a sub-custodian for banks that don’t want to directly offer the service, said Hex Trust CEO Alessio Quaglini. 

Currently, Hex Trust works with three banks – Mason Privatbank Liechtenstein AG and two unnamed Asian banks. Quaglini said Hex Trust has 10 other banks that are exploring the custodian’s products.

Going forward, SIA will be the primary distribution partner for Hex Trust to offer digital-asset services to banks in Europe, Quaglini said. 

Source: https://www.coindesk.com/hex-trust-sia-crypto-custody-eu-banks

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Blockchain

Collider Labs Raises $1M to Invest in Blockchain Startups

The venture builder is seeking to invest in early-stage startups with a focus on transparency, privacy and “fairness.”

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Collider Labs has raised $1 million to be invested in early-stage blockchain and cryptocurrency startups.

In an announcement Thursday, the venture builder said the raise had brought on board several notable limited partners including Efficient Frontier CTO Alon Elmaliah and Follow [the] Seed Founding Partner Andrey Shirben.

Collider provides funding and liquidity and actively participates in building up startups alongside their communities and founders, according to the firm’s founding partner, Avishay Ovadia.

The company is actively seeking to invest in early-stage blockchain and crypto startups globally, with a focus transparency, privacy and “fairness.”

Collider “is a venture builder that somewhat resembles an accelerator” Ovadia said. With some “key characteristics” that differentiate it from a typical accelerator.

Venture builders, also known as startup studios, pair with early-stage startups and utilize their own ideas and resources to, if all goes according to plan, construct viable enterprises.

According to Ovadia, Collider forms partnerships with founders, invests in teams and works alongside them as what he calls “Investors in Residence.”

Source: https://www.coindesk.com/collider-labs-raises-1m-to-invest-in-blockchain-startups

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Voyager Agrees to Buy LGO Markets and Merge 2 Firms’ Tokens

Two cryptocurrency trading firms are merging, and in a rare twist, so are their tokens.

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Two cryptocurrency trading firms are merging, and in a rare twist, so are their tokens.

Voyager Digital, a publicly traded digital asset brokerage with offices in New York, has agreed to buy LGO, a French crypto exchange primarily serving institutional investors, as the company expands to Europe.

The transaction requires regulatory approval, which the parties said they expect to receive by the end of this year, along with the token swap. The value of the deal will depend on the value of Voyager’s shares, and the firms’ tokens, at closing; at current prices, it would be in the low seven figures.

As such, this deal is dwarfed by this year’s blockbuster crypto M&A deals such as Binance’s acquisition of CoinMarketCap, estimated to be worth $400 million, and FTX’s $150 million deal to acquire Blockfolio.

Read More: ‘They Have the Users’: Binance CEO Explains Why He Bought CoinMarketCap

What makes this deal unusual is that the two companies’ utility tokens, VGX and LGO, will be swapped into newly minted tokens featuring decentralized finance (DeFi) functions such as community governance and staking at an initial interest rate of 7%.

“We think this is really taking the old-school mergers and acquisitions to the token world, which hasn’t been done before,” Steve Enrlich, Voyager’s co-founder and chief executive officer, told CoinDesk.

Upon completion, Voyager, which is publicly listed on the Canadian Securities Exchange, will issue one million shares for the acquisition and operate in the European retail market with LGO’s Virtual Asset Service Provider registration with the French Financial Markets regulator (AMF). All activities will be conducted under the Voyager brand and LGO will discontinue its institutional services on Oct. 31. Shares of Voyager closed at C$0.67 ($0.51) on Wednesday. 

Read More: Voyager to Pay Interest on DeFi Tokens to Gain Brokerage Clients

Hugo Renaudin, co-founder and chief executive officer of LGO, told CoinDesk that the French company made the deal after it decided to shift its focus from institutional clients to increasing value for its token holders.

“The key decision-maker is what will bring the most value to our tokens,” Renaudin said. “So we have this token. We have token holders and they’re mostly retail [clients].”

LGO launched an initial coin offering (ICO) in February 2018, according to its website, which raised 3,600 bitcoin (worth about $36 million at the time). The company’s white paper shows that 60% of the tokens were distributed through a pre-sale process, while 20% of the supply went to LGO’s founders and advisors.

At its peak in April 2018, the LGO token’s market cap was nearly $40 million, according to data from CoinMarketCap. On Wednesday, that value was calculated to be $1.5 million. 

Renaudin told CoinDesk that the company’s other option would have been focusing on better serving its institutional clients, which means its spot exchange would have to provide new and exotic derivatives products. After consideration, he said that the team had decided to change its focus to retail customers instead.

The merger comes during a time of regulatory crackdown on crypto derivatives trading around the globe. Popular crypto derivatives exchange BitMEX was charged by the U.S. Commodity Futures Trading Commission (CFTC) with facilitating unregistered trading activities, while in the UK, the Financial Conduct Authority (FCA) has banned crypto derivatives for retail consumers.

This is not the first acquisition by Voyager, which went public in early 2019 in a reverse merger with the shell of a Canadian mineral exploration company. Previously, it acquired wallet startup Ethos.io for about $4 million.

Read More: Voyager CEO Says Revenue Growth Accelerates 8-Fold as DeFi Trading Surges

Voyage’s revenue in the most-recent fiscal quarter, which ended Sept. 30, surged to about $2 million, compared with $1.1 million during the fiscal year ending in June.

“We are becoming the financial service firm of the future, which means I will look at acquisitions that can add products, customer assets to the platform, or tokens and other communities that can be accretive to what we are trying to do,” Enrlich said. “And adding these pieces together we are going to either do it organically or through more acquisitions.”

Disclosure

Source: https://www.coindesk.com/voyager-acquires-lgo-token-merger

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