Mining The Ever Diminishing Alpha

Bitcoin mining, which has become increasingly hard nowadays, is in some ways quite similar to active investors seeking to beat the market – generating alpha

I would like to explore this analogy in this article.

Bitcoin

Bitcoin is a cryptocurrency which can be sent peer-to-peer bitcoin network without the need of intermediaries. It is decentralized meaning it does not require a central bank to facilitate transactions.

All bitcoin transactions are verified by a network of nodes via cryptography and recorded in a public distributed ledger known as a blockchain.

Bitcoin by the time of this posting is currently trading at $9,721.29 USD. Wouldn’t it be great if we could just mine some bitcoin?

Bitcoin Mining

With digital cash, it is easy for me to make a copy of a token and send it to you for payment while keeping the actual token with me. This is known as double-spending.

In order to prevent such fraudulent transactions, the bitcoin miners’ role is to verify all transactions in a block. Each block is 1MB and may contain several thousands bitcoin transactions.

Once all transactions in a block are verified, the bitcoin miners will have to solve a complex mathematical problem known as the ‘proof of work’ (PoW) as a prerequisite to add it to the blockchain.

The PoW requires miners to find a number called a nonce, such that when the block content is hashed along with the nonce, the result is numerically smaller than the network’s difficulty target

Antonopoulos, Andreas M. 

Which basically means the miners need to find the input number to a hash function (SHA-256) which generates an output number that is same or smaller than the target number.

The PoW is purely guesswork – the computer is running various random numbers through the hash function to arrive at the target number. This process takes some amount time depending on the difficulty and the computing power.

Bitcoin miners are rewarded with bitcoin for going through this process but the catch is only the first miner to solve the PoW will be awarded.

The amount of new bitcoin mined for each new block added to the blockchain is called a block reward. The block reward is halved roughly every 4 years.

The other thing to note is that the PoW difficulty increases as number of miners increases. This is to ensure the time taken to solve remains roughly at 10 minutes even as the number of miners increases.

Additional reading: Investopedia has a good article on the process of Bitcoin mining.

History and Evolution of Bitcoin Mining

In the early days of bitcoin, when there were fewer miners, mining bitcoin could be done easily with a normal desktop computer.

As it gained popularity, the miners changed to faster computational graphics cards (GPU) which spits out a higher number of hashes per second to ensure that they had the competitive edge over normal desktop computers to mine bitcoins.

In 2013, more miners used custom computers designed just for mining bitcoin. These are called Application Specific Integrated Circuits (ASIC) which costs several thousands to build which are much better than GPUs in mining bitcoin.

Today, even if you are using the most up to date ASIC you still might not be able to compete against mining pools. A mining pool is a group of miners who combined their computing power to mine bitcoin and the reward is split between the miners. A large majority (80%-90%) of bitcoin today are mined by mining pools.

The costs in electricity consumption exceeds the revenue generated from Bitcoin mining thus making it hard for individuals to profit.

Only the most efficient mining pools are able to profit. The mining pools are commercial ventures and they keep costs low by operating deep in the mountains where it is freezing cold (those machines generate a lot of heat) and have access to cheap sources of energy.

Before Google banned all cryptocurrency ads, I often saw ads on YouTube featuring a random guy with a Russian accent calling for investors to invest in his huge mining pool operation located deep in the mountains. Hence, when I think about mining pools, I often think about huge operations run by Russians deep in the remote mountain areas.

History and Evolution of Investing

Similarly, early investing started with a handful of individual investors and back then not everyone had access to the latest information and not everyone was a savvy investor. It was easier to profit from other investors’ mistakes. The lack of information back then also meant that there were many mispricing opportunities for arbitrage.

Slowly, as more institutional investors and professional fund managers got into investing, suddenly profiting from mistakes were much harder because the dumb investors were quitting the market and only the smart ones were left.

Technology advancements in telecomunications meant that information became more readily accesible and instantly available. Every professional investor and investment firm today are using the latest technology to get information faster and making trades in fractions of a second to get an edge over the rest.

Why Active Investing Underperforms

#1 Diminishing Alpha

Just like the block reward for bitcoin halving every 4 years, the market has become more efficient such that the alpha is getting smaller. There are lesser inefficiencies to exploit in the market today.

#2 Intense Competition

Due to more bitcoin miners, it is increasingly hard to mine bitcoin. Many commercial enterprises had set up mining pools to mine bitcoin using the latest hardware. Similarly in investing, many investment firms are hiring the best people, buying the best technology, building the best models to beat the market. Individuals like us have very little chance of beating them.

#3 High Costs

It is expensive to mine bitcoin due to the enormous energy consumption it takes. Similarly, fund managers, analyst teams, trading hardware and software costs a lot. Not to mention that it takes hours to analyze and pick the right stocks. The returns generated must exceed the high costs invested in order for this to make sense.

Conclusion: It is a Zero Sum Game

In conclusion, active investing is a zero sum game where only the best few profit from the majority who play the game.

Similar to how bitcoin mining works, only the largest and most cost efficient mining pool is able to profit at the expense of thousands of other mining pools and miners.

I am not as good in the game as the other professionals. I will happily leave active investing to them and stick to passive investing.

Remember, someone has to buy or sell a stock at the wrong price for the stock to be mis-priced.

I do not want to be that someone.

Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

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