*Note: if you haven’t read my introduction to cryptocurrency, do that first. Once you have a solid understanding of what crypto is, come back and read this article explaining the cryptocurrency bubble.
As I write these words in February 2018, crypto prices have lately been falling sharply. This seems to confirm what crypto-pessimists have been all-too-eager to tell anyone who will listen. Skeptics argue that the massive price rises observed over the last quarter of 2017 were nothing more than an inflating cryptocurrency bubble.
If you are reading this several months or years after these words were written, you will be able to place this drop in its proper historical context – was it a blip, or did crypto prices stay depressed for a long time?
It’s impossible to say for sure as I write this. A bubble can only be definitively confirmed as being a bubble in hindsight.
What Is A Cryptocurrency Bubble?
A speculative bubble is what happens when the price of an asset rises dramatically higher than that asset’s intrinsic value. Exuberant investors see skyrocketing prices and rush to get in on the action. They very likely don’t understand a thing about what they are investing in – and nor do they care. Instead, they are simply buying on the expectation that they will be able to sell later for an even higher price. Bubbles are self-reinforcing feedback loops, meaning that so long as more people keep buying, the price keeps balooning, thus confirming to speculators that they should buy even more. Eventually, bubbles tend to ‘pop’, and the overinflated prices come crashing down as everyone tries to get out as quickly as possible.
Bubbles are nothing new. They have been an observable phenomenon in the financial world for centuries – well before crypto existed, and will continue into the future so long as people harbor the ambition to make a quick, easy gain. Human nature being what it is, bubbles will endure forever.
Advice From One Of The World’s Richest Men
As any savvy investor knows, a brilliant project can still be a terrible investment if the price is too high. The multi-billionaire CEO of Berkshire Hathaway once famously said:
“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett
Buffett is no fan of crypto – he famously sticks to investing in things he understands. This attitude has also meant Buffett missed investing in Internet companies like Google and Facebook, along with missing out on their outsized gains.
Regardless, would-be crypto investors would be wise to heed Buffett’s wisdom when it comes to fear and greed. If you are worried about a crypto bubble, here is a decent rule of thumb: look at the level of hype.
- If prices have recently plummeted and everyone is pronouncing the death of crypto, it might be the perfect time to invest. Be greedy when others are fearful.
- If prices are up by 10x in a matter of months and everyone – including your taxi driver – are making out to be crypto experts, then things are likely overheated. It might be best to wait on the sidelines for a better moment. Be fearful when others are greedy.
Fast-Rising Prices Could Be Justified
“Cryptoassets have two drivers of their basis of value: utility and speculative”. – Chris Burniske & Jack Tatar, Cryptoassets
But just because prices have risen very quickly doesn’t necessarily mean that a speculative cryptocurrency bubble exists. If crypto represents the architecture upon which we can replace large swathes of trusted third parties, then the explosive price growth may be due to intrinsic value reasons. If so, prices may have justifiably risen quickly.
Imagine buying Amazon.com stock in their early days – back when it was just an online bookstore, and e-commerce hadn’t really taken off. Back then, people labeled Amazon.com a bubble too. But Amazon.com has since become one of the world’s most valuable companies because it has firmly established itself as the world’s preeminent online shopping destination, with a hugely defensible market position. Similarly, any crypto which comes to occupy some equivalent position within its niche may find that there is plenty of price growth yet to come, even if has already risen in value by 10x in very short order.
Even so, it must be acknowledged that the dot-com boom (and bust) that birthed Amazon.com also had its fair share of duds. Plenty of companies rode the hype wave, receiving outlandish valuations with very little to show for it. For instance, the November 1999 initial public offering of Webvan.com valued the company at over $4.8 billion, when it had only made a cumulative revenue of $395,000 and cumulative net losses of over $50 million). If you see this sort of thing happening, it’s another red flag that a cryptocurrency bubble could be afoot.
No-one can say with perfect foresight which specific cryptos are the future “Amazon.com” cases and which are the equivalent of “Webvan.com”. Still, as of the time of writing, there are scores of initial coin offerings which look a heck of a lot like Webvan.com. Question projects with very little traction, as they may be taking advantage of a cryptocurrency bubble to raise big money at an over-inflated valuation.
The Price Isn’t Everything
While investors naturally enough gravitate towards tracking the price, it must always be remembered that the price of a crypto and its utility are not the same thing. Recall the words of Burniske & Tatar about value being both intrinsic and speculative. Be cautious about reading too much into the price.
Crypto speculation has nothing to do with the technology, and everything to do with human greed. Just because prices may have got ahead of themselves (or recently crashed) isn’t a strike against the technology.
Unfortunately, most people don’t want to understand this sort of nuanced view of a technology’s development, especially when it is so easy to instead fixate on a single number. When prices collapse, they pronounce that “crypto is dead”, when in fact it is more likely to be the speculative value disappearing. The intrinsic value is still there. The dot-com bust of the early 2000’s didn’t represent the end of the Internet – far from it. The Internet is still here, and stronger than ever.
As you continue to learn about crypto, you will start to become familiar with the slang that the crypto community uses. One acronym that crops up repeatedly is “HODL”, which is short for “Hold On for Dear Life”. As in, don’t sell at the worst possible moment (when everyone else is selling).
If you truly believe in the long-term future of crypto, then this is one of the most important mantras. Don’t worry too much about a cryptocurrency bubble. Do not get seduced by short term price movements. Ride the ups and downs. People who have been in crypto for years have seen it all before: Mt. Gox, Silk Road, interventions by the Chinese government… all events that were supposed to spell the end of crypto, yet crypto still endures.
Where does all this leave us?
- There are no set rules in financial markets. Sometimes asset price rises are bubbles that pop, but sometimes asset price rises can be justified, because they are genuinely world-changing (like Amazon.com)
- Asset prices comprise both intrinsic value and speculative value. It’s impossible to exactly know how much of each, but be wary when things seem over-hyped.
- Over the long-term, asset value should tend towards intrinsic value. So look for crypto tokens which have usefulness, community and a defensive position. If you do that, don’t concern yourself too much with the short-term gyrations of boom and bust.
The best advice might be those four little letters. HODL.