Bitcoin, gold & public market

15 February 2023

Coming from scientific & engineering training, going through entrepreneurship and then switching to the dark side that’s called venture capital investment, today I hold this quote of his dear to my heart:

“Science may be described as the art of systematic oversimplification.”
― Karl Popper

I learned this first during my semiconductor engineering years. During the 12 years of this first career of mine, I helped design and ship hundreds of millions of chips. I designed analog, mixed-signal and radio-frequency circuitries, which were sometimes called Black Magic in the field of semiconductor.

In the beginning of my career, like any young engineer coming out of schools, I believed everything we do should have sound scientific or engineering theories and explanations.

Over time, I realized that a lot of the times something didn’t work despite being built on perfect theories. However you tried to improve the design while believing that the theories should hold true, the resultant circuits just wouldn’t work as planned.

On the other hand, there were many circuits that worked well, giving predictable results and performances over generations of designs, despite that we never were able to satisfyingly explain why they worked.

As an engineer, you keep what work however mysterious they are, and throw away what don’t work however prefect their theories are.

You do not get reward by shipping malfunctioning products based on perfect scientific & engineering theories. You get fired.

And this is what Karl Popper tried to tell us with that quote: scientific theories that have beautiful closed-form equations are usually built on systematic oversimplification. The beauty lies in the abstraction, but so does the evil.

You need these theories as frameworks to work on the problems you’re trying to solve, and more importantly to build new theories to expand the human knowledges and solve more problems. But you should not hold these theories as the Ten Commandments. They are after all, just theories.

And if (real) engineers, whose works are repeatable and verifiable, do not hold the theories as invincible, people who work in finance, which is far from being repeatable and verifiable, should never even put that much faith into any financial theory.

Bitcoin as gold

During the grand adoption of bitcoin over the past few years, some very smart people argued that bitcoin is basically like gold. A form of digital gold.

Gold does not generate cash flows, therefore by financial theories it does not have intrinsic values. But financial markets keep trading gold, not for industrial or medical uses, but for purely asset allocations. They do it coz’ others are doing it. As long as everybody believe in it, there’s value in gold.

This probably stemmed from human beings’ thousands of years of history using gold as a transaction medium due to its fungibility (low melting point and relatively ease to determine purity). But whatever the most convincing theory there is to explain this collective belief in its value, gold historically exhibits a relatively low correlation to the public equity markets. So the theory built upon observing this was that one can use gold to hedge against the volatility of public equity markets, or to diversify the portfolio.

Bitcoin also does not generate intrinsic cash flows. By financial theories, it therefore does not have intrinsic values. But people kept trading bitcoins, coz’ more and more people are trading it. Over the past few years the investor base has expanded from nerdy anarchists, to technology futurists, to crypto-crazed consumers and finally to financial portfolio managers. There’s no doubt that bitcoin has become a genuine asset class in finance.

And due to its many similarities with gold, many argue that it would function like gold, as a low-correlation hedging tool to the equity markets (and Fed policy, inflation, etc)

Until that it’s not.

Bitcoin was swept up in the recent market anxiety over Ukraine, falling 2.7% on Friday. Proponents of digital assets often tout an uncorrelated relationship with broader markets, yet the asset class continues to mimic movements in equities, particularly technology stocks. The correlation coefficient between Nasdaq 100 futures and Bitcoin currently stands at 0.4, with 1 representing parallel moves.

Bloomberg, February 14, 2022

In this recent Bloomberg article talking about bitcoin prices rebounding as positive news came out of the Russia-Ukraine fronts, the author highlighted the fact that the correlation coefficient between bitcoin and Nasdaq is now 0.4.

A correlation coefficient of 0.4 in any scientific experiment would have been considered quite significant, worthy of publishing papers or getting another Ph.D. In the highly random financial market? You might as well call it a sync.

“But that doesn’t make sense! Bitcoin is not equity. It is decentralized. Nobody controls it. Why would it correlate with the equity markets?” You might angrily argue, provided that you unfortunately lost money in this recent bitcoin retreat (before the rebound), throwing all the typical (but irrelevant in this context) arguments for bitcoin.

But deep down inside you know, more than anything, that it’s much better to make money (or not lose money) despite things going against your theory, rather than seeing your money vaporize while defending the theory.

Just like there’s no reward in insisting on circuit designs that don’t work despite sound theories, there’s absolutely no point to go broke holding on to a financial theory, let alone a bitcoin one.