Monthly Archive for June, 2021

Cryptologic

Published
by
Steve Landsburg
on June 30, 2021
in Economics and Musings
. 7 Comments

Can you spot the flaw in this argument?

1) Over time, Bitcoin will become increasingly important as a global currency.

2) Therefore, over time, the price of Bitcoin must rise.

The first is a statement of (alleged) fact and hence not (in its raw form) susceptible to logical analysis. This is not a post about whether it is true, probable, possible, improbable or false. I’m just going to accept it for the sake of argument.

The problem occurs at the word “Therefore”.

I suppose that what underlies the “therefore” in some people’s minds is some instinct like this: “Prices have to equilibrate supply and demand. With supply fixed and demand growing, the price must rise”.

Here’s exactly where that argument goes wrong: Bitcoin has two relevant prices: The price of the asset itself and the transaction fee you pay every time you use it. If the transaction fee rises to equilibrate the supply and demand for transactions, there’s no obvious reason for the price of the asset to rise.

In other words: Yes, it is true that fixed supply plus rising demand implies a rising price. But when there are two prices, it’s not immediately obvious which one must rise.

I can easily imagine a world like this:

1) The demand for Bitcoin transactions is extremely high.

2) Therefore the transaction fee is extremely high.

3) Therefore people use Bitcoin only for large transactions. Large transactions tend to be foreseeable. (I don’t buy a car without first thinking about it for a while.) Therefore there’s plenty of time to acquire Bitcoin just in time to make my transaction. Otherwise, there’s no reason to hold it. (And plenty of reason not to, just as there’s plenty of reason not to hold any other non-interest-bearing asset. For example, if you’re hedging against inflation, you can buy interest-bearing inflation-indexed bonds.)

4) Therefore, at any given moment, the demand for Bitcoin is quite low, although the demand for transactions is quite high.

It seems to me that much of what I read about the supply and demand for Bitcoin starts from the assumption that we can model the demand for Bitcoin the same way we model the demand for dollars or euros. But neither dollars nor euros have transaction fees, and that seems to me to make a world of difference.

Am I missing something?

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Mamas, Don’t Let Your Babies Grow Up to Be Dollar Cost Averagers

Published
by
Steve Landsburg
on June 29, 2021
in Finance and Logic
. 22 Comments

If you’re a novice investor, looking to get into anything from the stocks to Bitcoin, someone is going to tell you that you can reduce your risk by Dollar Cost Averaging — that is, investing the same dollar amount every month. That way, this person will tell you, you are buying more of the asset when its price is low and less when it’s high.

Please do not take investment advice from this person.

I explained in The Armchair Economist why the above argument is just plain wrong, and why Dollar Cost Averaging is actually riskier than a Readjustment strategy where you invest (say) $1000 and then periodically adjust your total investment up or down as necessary to maintain its value. The logic is compelling. But the sort of people who Dollar Cost Average tend not to be the sort of people with much of an appetite for logic. So today let’s go down a different road. I’ve actually done some calculations to show you how the two strategies are likely to pan out.

Imagine a (very volatile) asset, currently selling for $1, which either doubles or halves in value each month, with equal probability. [I know, I know, the asset you’re looking to buy behaves very differently than this one. So feel free to make some other set of assumptions and re-do my calculations. You won’t get exactly the same outcomes, but you’ll probably get outcomes that are similar in spirit.]

Now let’s imagine one hundred Dollar-Cost Averagers, each investing one dollar per month for 10 months. At the end of that ten months, the average investor will be ahead by about $30. That’s not bad.

Let’s also imagine one hundred Readjusters who each invest $11.83 up front and then, at the end of each month, either withdraw or deposit funds to bring their investment right back to $11.83. Why $11.83? Because that way, these hundred Readjusters will earn, on average, exactly the same $30 that the Dollar-Cost-Averagers earn over the course of ten months.

Okay, both strategies do equally well on average. But of course, if you’re one of these investors, you probably won’t be average. So I set my computer to calculating the distribution of outcomes for each group. Here is the result, with the DCA investors on top and the Readjustment investors on the bottom:

The blue guys have actually lost money. The green guys haven’t lost anything, but they’ve gained less than the average $30. The yellow guys have done better than average, and the red guys have done better still, earning over $90, which is three times the average.

Here’s the good news for the Dollar Cost Averagers: Nine of them have earned over $90, whereas only one Readjuster has earned over $90. That’s pretty much the end of the good news. In the money-losing blue category, there are far fewer Readjusters than Dollar-Cost-Averagers — about 17 versus 48. That’s right; almost half the Dollar-Cost-Averagers lose money, while only about 1/6 of the Readjusters do. 61% of the Readjusters are in the very happy yellow category, earning between $30 and $90. Only 13% of the Dollar-Cost-Averagers make it into that bracket.

Does that prove that Dollar-Cost-Averaging is inferior to Readjustment? Of course not. It all depends on what you’re looking for. Dollar-Cost-Averagers are more likely to lose money, and more likely to earn below-average returns, but in exchange, they get a 9% chance of extraordinary success while their Readjusting neighbors have only a 1% chance. Maybe that’s a gamble you want to take. That’s fine. In other words, it makes perfectly good sense to choose Dollar Cost Averaging in order to increase your risk. The guy who told you to use it to decrease your risk is still 100% wrong.

There are, of course, various real world considerations that got left out here. Different investment strategies, for example, have different tax consequences, and you might want to modify your strategy for that reason, but there’s no reason to think that after those modifications, you should be doing anything like Dollar Cost Averaging.

I want to reiterate that even before I did these calculations, I knew (at least roughly) how they were going to come out, because I trust the underlying logic (which, again, can be found in The Armchair Economist). The larger moral is that logic is trustworthy.

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Concealing Your Privates

Published
by
Steve Landsburg
on June 8, 2021
in Current Events, Musings and Technology
. 17 Comments

Okay, so according to the news, the FBI has recovered the bulk of the Bitcoins paid as ransomware by the Colonial Pipeline Company, by acquiring the private key to the address where those Bitcoins were stored.

No news source I’ve seen has offered anything approaching an answer to the question: How did the FBI get ahold of that private key? Did the criminal masterminds behind the ransomware attack just leave it, unencrypted, on a hard drive or a piece of paper in a place where the FBI was likely to look?

At first I thought the most likely answer was that the FBI must have traded something for that key — say some sort of immunity (either from prosecution or, maybe, from something like a beating). But on second thought, it occurs to me that maybe hiding a private key from the FBI is trickier than it sounds.

I know plenty of good ways to hide private keys from thieves. You can write your key on a piece of paper (or better yet, etch it in metal) and store it in a safe deposit box. Or, for extra security (say if you’re worried about bank employees accessing those boxes), put half of it in one safe deposit box and the other in another, at a different bank. Or, if you’re worried about one of those banks being reduced to rubble in an earthquake or a terrorist attack (in which case no criminal could get your key, but neither could you), you can break the key into three parts, store parts A and B at Bank One, parts B and C at Bank Two, and parts A and C at Bank Three. Any one bank can disappear and you can still recover your entire key.

That secures your keys and makes them safe from criminals, but it does not make them safe from the FBI, which has the power to issue subpoenas to all of your banks and recover the contents of your safe deposit boxes. So maybe hiding your keys from the FBI is harder than it appears.

So let me try again: After etching them on metal, store parts A and B at Location One, parts B and C at Location Two, and parts A and C at Location Three, where you expect to have access to all of these locations (and only really need access to two of them) but none is particularly tied to you — i.e. not your house, not your car, not your safe deposit box. Maybe underground locations in the woods, though that feels a little sketchy to me. And then of course you might want to keep some sort of written record of those locations, which the FBI can find when they search your house or safe deposit box, whereupon they might wonder what’s so interesting about those locations that you felt the need to keep track of them….

You might think the safest thing is to memorize your key (or a mnemonic English phrase from which the key can be derived) and leave no record of it anywhere except in your own brain. That’s fine until dementia starts to set in, or until you’re hit by a bus (in which case your heirs are out of luck, though you might or might not care about that). Or you can leave written clues to the mnemonic that only you will be able to decipher, like “Word 9: The secret nickname I had for the girl I had a crush on in third grade”. This is of course also subject to the dementia problem.

So. Suppose you’re a master criminal, storing your ill-gotten gains as Bitcoins, which you want easy access to at all times for yourself (and maybe your heirs), but you want to keep completely inaccessible from law enforcement agencies with unlimited subpoena power. What’s your plan?

Update: More recent news reports indicate that the coins were seized from a custodial account — based in the United States, no less. In other words, my sarcastic reference above to “criminal masterminds” was not nearly as sarcastic as it should have been. It’s not that these guys failed to think of a clever scheme for hiding their keys; it’s that they never even bothered to try. The more interesting question, then, is how does Bitcoin fall 10% on the “news” that if you let someone else hold your private keys, you can lose your Bitcoins. (“Not your keys, not your coins”, as the saying goes.) The best answer I have (not just for this event but for a lot of Bitcoin volatility in general) is that anything even slightly unsettling leads to a small drop in prices, whereupon heavily leveraged investors fail to meet their margin calls, which leads to big selloffs. But that’s not a full answer until someone fleshes out the part where more sophisticated investors fail to jump in and take advantage of this buying opportunity. So maybe the dip, despite the coincidental timing, had nothing to do with the seizure.

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