Using probabilistic thinking to evaluate positions. None of this is financial advice.
Article contributed by Avran Wong
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A few weeks ago I wrote a piece on modern portfolio theory for cryptocurrencies. If you don’t have the required knowledge, most of what I said would’ve probably gone over your head. To be honest, I struggled to understand this initially as well. But one thing that anyone can adopt is the concept of probabilistic thinking.
For most crypto investors, we simply throw our money at the first shiny thing and pray it goes up. While this may be profitable/fun initially, we ought to grow and improve the way we think about our investments.
To adopt a probabilistic mindset is to evaluate an investment not only for its upside but also the likely hood of it occurring.
To start with a simple mental exercise, in front of you are two buttons. The red one guarantees you a million dollars, while the green one gives you a 50% chance for more. While a guaranteed $1 million is sufficient for most people, you also have the opportunity to outperform the red button 1000x half the time. Is the risk worth it?
Expected value (EV)
The goal is to make + EV decisions every day
If you follow any type of crypto-influencer whether, on youtube or Twitter, you’ll realize all they ever say is these 3 things:
- Price goes up
- Price goes down
- Price goes sideways
Which honestly, isn’t all that useful. But, if we take these scenarios objectively, we can form a mental image of the expected value of a position.
Formula of EV from wikipedia
In probability theory, the expected value is the generalization of the weighted average. Essentially, it’s calculated by adding up the product of the outcome and the probability of it occurring. In the context of cryptocurrency, it’s the sum of the expected gain/loss of a position.
BTC/USD chart from Tradingview and some top-class charting drawings
So let’s say you’re considering a position in BTC @42k. Looking at the current prices, these are the possible scenarios and the likelihood of it occurring (these numbers are arbitrary)
- Bull: 70k within 3 months (25%)
- Crab: Nothing much will happen, we will mostly move sideways before breaking out to ATHs again (50%)
- Bear: Pack your bags, we are going down to 20K (25%)
Calculating the expected value: (28k)*0.25 + (0)*0.60 + (-22k)*0.25 =1.5k. This means that on average, you expect the price to appreciate by 1.5k. Furthermore, 2 of the 3 scenarios you expect the price to eventually go up. Does it really matter if it takes longer or not? Of course, a positive EV value doesn’t guarantee you a win. Even if scenario 3 plays out, at least you already expected it and can be in a better position to re-evaluate. If we continue to evaluate every position probabilistically and repeatedly take + EV bets, it’s more than likely that we’ll come out on the other side.
The idea is simply to consider all scenarios as objectively as you can and act accordingly, every single day, regardless of what you’re feeling.
The bagholder mentality
However, things change, especially in a volatile space like crypto. As things develop, maybe your initial thesis doesn’t play out as planned.
“Individuals commit the sunk cost fallacy when they continue a behavior or endeavour as a result of previously invested resources” — Arkes & Blumer
The quote above elegantly summarises the bag holder mentality. You convince yourself that ABC token is a good hold just because you previously did the research and calculated its EV. Furthermore, everyone on Twitter is shaming paper handers and telling me timing the markets suck! With so much noise, it’s often easier to do nothing than to admit you were wrong. A good mental exercise is to always ask yourself:
If I have all my current positions are in cash, would I still allocate the same way?
Think about it now, let’s say you have $200 in BTC, $200 in ETH and $600 in XYZ shit coin. If you had $1000 in cash instead, would you buy back the same tokens? The answer is probably no.
By going through this exercise, it forces you to re-evaluate the EV of every one of your positions. It doesn’t matter how much time and effort you invested in the token. If its EV is negative, you shouldn’t be bag holding.
Being roughly right
“It’s better to be roughly right than precisely wrong” -John Maynard Keynes
One might argue that the weights may be estimated inaccurately since it’s mostly based on gut feeling. And thus can be swayed according to our emotions. But the point of thinking in terms of expected value is to force you to consider all scenarios, instead of just buying cos you’re excited. By going through this exercise, it allows you to be mentally resilient through periods of large volatility.
You’re the one pressing the buttons
You are human after all, right?
Going back to the initial image of the 2 buttons, by calculating the EV, we get:
Red button: 1.00*$1 million = $1 million
Green button: 0.50*$1 billion + 0.50*$0 = $500 million
If we base solely on EV, we should always press the green button. But for people that have a low-risk tolerance and cannot bear losing $1 million, maybe the red button is the right choice. Other than EV, we also need to tweak it based on our risk appetite and preferences.
Whatever it is, we need to be able to evaluate our situation and our options probabilistically, avoid emotional decisions and pick the decision that allows us to sleep at night.
Hopefully, this article has been useful in shaping your mindset in the world of Crypto. If you like the content do consider following me on my journey and sharing this around 🙂
Article contributed by Avran Wong
Follow him on Medium
https://towardsdatascience.com/probabilistic-thinking-the-one-critical-right-left-behind-by-most-people-2f78c2454fdf (Article on Probabilistic thinking)
https://en.wikipedia.org/wiki/Expected_value (Expected value wiki page)
https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/sunk-cost-fallacy/ (Explanation of sunk cost fallacy)
https://www.reddit.com/r/cryptocurrencymemes/comments/95j2yt/bagholder_bingo/ (bagholder reddit meme)