Never invest in something if you have no idea what it’s worth. That’s what’s going on with cryptocurrencies right now.
In the equities market — stocks — every company has a value: its market capitalization. The share price is proportional to that value.
There are two things that drive share prices.
One is the beauty contest, also known as the expectations game. This is people betting the shares will go up or down based on whether they think other people will drive the price up or down. In the short run, this is actually the only reason that prices go up or down — it’s the definition of a market.
The second is value. Every company has a value. Ostensibly, this is based on the “discounted stream of earnings” of the company. Basically, if a company’s earnings will go up (based either on sales growth or better profitability), the share price should go up, while if the earnings go down, the share price will go down.
Value also depends on what an acquiring entity would buy the company for. For example, when Facebook bought Instagram for a billion dollars, Instagram had no earnings at all. But Facebook CEO Mark Zuckerberg figured that he could make so much more money from Facebook owning Instagram that it was worth a billion dollars to him. And he was right about that.
And value also depends on assets and liabilities — does the company have cash in the bank, factories, patents, and valuable relationships, or does it have debt and pending lawsuits?
Analysts are experts at determining valuation based on all of these factors. When a Bear Stearns analyst says that a company whose shares are selling at 35 could go to 45, they’re making a calculation based on their estimate of future streams of earnings, assets, and value to acquiring companies. This is a rational calculation. You can argue with the correctness of any such calculation, but it is based on some view of reality.
The short-term fluctuations in share price depend on the beauty contest and the expectations game, not the ultimate value. But in the end, share prices always come back to some measure connected with reality. This is why Gamestop shares surged when retail investors were having some fun, but has come back down to earth. Companies have a value based in reality.
Cryptocurrencies and bubble investing
If you invest based solely on expectations, you are taking quite a risk. Expectations surge and recede — often rapidly — based on factors that are impossible to predict or even know.
When an asset goes up simply and purely because people believe it will go up — with no other reasons — that is a bubble. You can make a lot of money quickly in a bubble, because asset prices go up in a hurry. You can also lose everything in a bubble, because there is no actual support for the value of the asset — what goes up comes down with a painful thud once expectations reverse.
Cryptocurrencies are a bubble. There is absolutely no way to assess the correct price of Bitcoin, or any other cryptocurrency, other than based on what expectations people have. There is no way to calculate the value of the underlying asset.
I thought of this as I read the comments of crypto investor Eric Nghiem on Facebook. A little context here: BTC is bitcoin, DOGE is Dogecoin (a sort of parody cryptocurrency that is gaining some adherents), and ETH and MATIC are other cryptocurrencies or technologies.
May 9 at 12:25 PM
DOGE coin is a great reminder of why pigs get fat and hogs get slaughtered.
In the crypto space, it’s important to always secure your profits on a speculation play. Whenever this is a dramatic rise in a coin, pull out your original investment and some profit and let the rest ride if you so choose. This is called creating a moonbag.
This way, you are always protected from both the downside by pulling out your capital and can participate in the upside if it goes to the moon.
A week ago, I felt regret selling out my speculation position of $DOGE at $.30 cents to move into $MATIC when I saw it rocket to $.70.
But then I remembered that I secured my profits and I didn’t lose money.Remember that it is easy to look back in hindsight and say things like, But if you invested your stymie check in ETH in 2020 you would have $100K, or if you bought BTC in 2015 you would be loaded etc. This is flawed thinking.
This kind thinking leads new investors(and experienced investors) to overexpose themselves to risk that does not need to be taken.
It’s also kinda like in business. When I hear an entrepreneur tell me that they reinvest all of their profits into their business, I advise them otherwise. Always pay yourself FIRST. Nothing in life is guaranteed besides death and taxes.
Remember, it’s your hard earned money. Regardless of what others say, like diamond hands, or hold the line, now one else is responsible for your gains or losses than you.
This is the right advice if you admit that cryptocurrencies are a wildly fluctuating bubble.
When you invest in an asset with an actual value, you may buy and hold that asset based on that value. You make money in the long run if the assets you invest in increase in value based on the activities of the people who manage them. You may dump the asset if you lose faith in the people who are trying to create value from it.
When you invest in an asset with no underlying value, your only guide to what will happen is what other people think will happen. Bubbles are volatile. To make money in them, you need to pull money out when they go up. Just like Nghiem says.
There are two sides to every trade. For everyone who makes money, somebody loses money.
Who will be losing money in the crypto bubble?
True believers, who will stick it out until the expectations game ends and the bubble bursts.
And people who got in just before the crash. (And of course, there is no way to know when that is — it could be fifteen minutes after you put your money in.)
I’m too risk averse to invest in assets with no underlying valuation. How about you?