Crypto Memery part I
or
Schelling games in asset valuation
Special thanks to Robert Drage, Dan Lee and @0xFran for feedback.
Overview
In this article series I will argue that most investors are confused about asset valuation.
Why “value investing” or “fundamental analysis” are bad valuation models when used outside yield bearing assets, and why thinking about assets as having some “intrinsic” value is flawed.
In this first part I will lay the groundwork for the schelling games paradigm.
Schelling point
simple definition (from wikipedia):
Schelling point is a solution that people tend to choose by default in the absence of communication.
general example (from wikipedia)
question:
“if you are to meet a stranger in New York City, but you cannot communicate with the person, then when and where will you choose to meet?”
answer:
the most common answer was “noon at Grand Central Terminal”
Schelling game
Well, what are markets other than price discovery mechanisms that coordinate around price?
An asset price at a particular time can be thought of as a Schelling point.
Let’s transform the Schelling point question from above to better apply for asset valuation:
“What price should an asset trade at?”
This most basic question, although true can be better transformed to:
“How will you determine the price of an asset? What models and inputs will you use?”
This question below is practically the same as above and quite easy to answer given agents use roughly the same models with the same inputs.
In yield bearing assets both inputs to the model (e.g. company report) are the same for all participants (disregarding insider trading here) and everybody uses different flavors of the same discounted cash flow model.
In investing though, investors are not trying to coordinate with other investors but rather every investor is trying to front run every other investor by guestimating the future Schelling point of an asset price.
Thus a better question is:
“How will other investors determine the price of an asset? What models and inputs will they use?”
We will call this game of guessing the future Schelling point of an asset price a Schelling game.
Dictionary
- YBA — yield bearing assets. Stocks, bonds and other assets that give its holder potential yield.
- “fair” price — price, or price range that an individual investor considers the asset will approximate in the particular time in the future, hence he is motivated to buy below the price, or sell above it. Important to note that price is “fair” only from the perspective of an individual investor and this price may not be expected from other investors.
- DCF — Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows. source
- Dominant strategy — a dominant strategy is a strategy that gives a player the best outcomes, regardless of the actions of the opponent. source
- Nash equilibrium — In a Nash equilibrium, each player is assumed to know the equilibrium strategies of the other players, and no one has anything to gain by changing only one’s own strategy source
Maps and Models
Most investors are thinking about assets as if they had some “inherent” or “fundamental” value, buying the currently undervalued ones. I will argue that this paradigm is highly misleading in the context of crypto and applicable only to yield bearing assets such as stocks and bonds.
What is usually meant by “fundamental” analysis in investment context is some kind of guesstimation of future cash flows of a particular project discounting them to present value and deriving its value from there. It has dominated the investment field for the last 50+ years and for a good reason. It was roughly right. But if I am arguing it is wrong,
“Why has fundamental analysis been working so well?”
In a trad market when an investor is evaluating a stock, his main question is: “how will the company fare in the future?” what do they mean by this is “what will be the future financial results of the company” or “what will be the its future cash flows?”.
To reduce this problem of finding a future Schelling point into a subproblem of guessing inputs to a function (evaluation model) is possible only because the function is constant.
But if there isn’t a stable model and ideally other investors are using evaluation models that will not be the future Schelling point, that’s when you can make a killing.
The important question is,
“Why has fundamental analysis been the dominant Schelling point in trad investing for so long?”
The (only) dominant one
Short answer:
YBA(Yield Bearing Assets) is the only asset class with a dominant strategy.
Long answer:
YBA are a special type of asset where a dominant strategy exists. Players that have a preference to hold for a long time horizon (decades) can collect their gains just from interest payments and dividends alone, disregarding the future Schelling point.
To collect a profit on any other asset, somebody will need to value it and be willing to pay for it.
Put in investment jargon, even if the market is “irrational” in the traditional sense of the term, stopped valuing companies’ cash flow and were to follow completely different schelling points in the future such as memetic potential of companies’ CEOs a long term investor can still collect his profits just from the dividends, without the need to sell the asset.
Ok, but how many investors (in terms of capital) are ready to hold an asset on a multi-decade horizon? Is it 1% is it 5%? Whatever the number, we can safely assume it is a very small amount of the overall capital deployed.
So why would it have such a disproportionate effect and in fact determine the Schelling point for YBAs?
Because the mere existence of a singular dominant strategy in the sea of pure memes makes this Schelling point stand head and shoulders above all other meme based ones.
In other words, if we discover a new planet full of martians with a thriving economy and have no knowledge of social or economic interaction within, we could still use DCF since it would not matter that “no one else except me gets it”.
Tying it back to crypto
To illustrate the point, a good analogy from crypto is that the existence of BTC maxis like Michael Saylor who will buy or at least not sell no-matter-what makes all other crypto investors more comfortable holding BTC in times of strife. The mere fact that historically BTC held value better than other crypto makes it hold value better in the future.
Where the analogy breaks is that although BTC may seem like a dominant asset, it has no dominant strategy. If in 10 years people no longer believe BTC has any value, they will make it so.
Circling back to YBAs, long term value investors are the Michael Saylors of stock market. They will hold their favorite asset no matter what the market believes. However, unlike Saylor they will be able to collect their profits even if the market turns against them.
Missing forest for the trees
If investors play on the field of well established trad markets, they may in fact live and die looking for the fundamental value and invest successfully.
Good analogy from the world of physics comes to mind. We know that Newton’s physics is wrong on a fundamental level, since it breaks once we zoom into the particle world, but we use it for most practical use cases anyway since it is “good enough”.
As with investors in traditional markets, physicians before the 1900s thought that their model of the world does not approximate reality, but actually describes it.
Drawing on this analogy we could say that investors are trying to use “Newtonian physics” for everything, but are currently struggling because they use it in a new domain(crypto) where traditional laws of physics don’t apply.
A funny trivia from history of physics that highlights the need for simpler models and Occam’s razor approach is the period after Copernicus published his heliocentric model, but before it was widely accepted. His model became widely used by his antagonists also, because it was much simpler to calculate movement of celestial bodies using his heliocentric one, than the geocentric one which was heavily overfitted to reflect the actual planet movements.
Before Kepler, the heliocentric model wasn’t actually better at predictions but it was much simpler to use.
Hence I would argue even if both models of valuing assets; the “fundamental value” and “Schelling points” models have the same predictive power, the one making less assumption should be used, both because it makes less assumptions and because it can explain “irrational” market behavior such as Gamestop saga I will go over in the part two.
Part II
However, as I will argue in part two the predictive power of the Schelling game paradigm shines when it comes to crypto — an asset class without clearly established Schelling points.
