Why Cryptocurrencies May Not Be Such a Gamble

J Scott
J Scott
Aug 22, 2017 · 6 min read

As a cryptocurrency enthusiast these days, there is one question that I seem to be getting a lot from friends and other wannabe crypto investors:

“Isn’t crypto in a bubble, and isn’t it just pure gambling trying to make money from it?”

Well…about the first part, they’re probably right… Cryptocurrencies likely are in a bubble right now. Much like Internet stocks were in a bubble back in the late 1990s. And much like Internet stocks in the late 90s, there’s a big possibility for a downward correction. But, also like Internet stocks back in the 90s, even with a short-term correction, there is most likely room for tremendous growth.

For example, Amazon.com stock (AMZN) dropped nearly 50% in the Spring of 1999, during the first dot-com bubble. It was a significant hit to the stock, but fast-forward to today, and prices are more than twenty times higher than 1999 prices. If you believe in the underlying technologies behind crypto (blockchain, specifically), even with a short-term correction, long-term values could dwarf the current values of these currencies and the companies that created them.

Now, where I disagree is the part about it crypto investing being pure gambling. Sure, the fact that it’s in a bubble makes any short-term investment a gamble, but it’s far from PURE gambling. As I keep saying, it’s not difficult to make a good return on cryptocurrency investing before the bubble pops — and certainly longer-term. All you need is a little bit of common sense, some willingness to do some research and a bit of self-discipline.

Again, I’m not saying there’s no risk involved. I wouldn’t say that about ANY investment…ever. In fact, if anyone ever tells you they have a no-risk investment that returns greater than 0%, they are either lying to you or trying to sell you something. Probably both. So, my disclaimer for all this crypto stuff is that there is risk…there always will be risk…and no investment is a sure thing.

With that disclaimer out of the way, I want to jump back to the big question:

Why isn’t crypto investing pure gambling, and why is it possible to make relatively easy money in crypto these days?

The answer lies in this idea of what we call “efficient markets.” I’m going to try to avoid any economics talk here, but there are a few basic concepts that are important to understand. And the idea of an efficient market is one of them. Basically, an efficient market is just a place where all the participants in the market — all the people buying and selling in the market — have access to all the information about what they’re buying and selling.

For example, the stock market tends to be pretty efficient: all the people buying and selling stocks on the open stock exchange have access to the same information about the companies they are buying and selling and a very high percentage of them use this information to drive their purchase and sale decisions. In an efficient market, it’s nearly impossible to “beat the market,” because at any point in time, there are so many other investors that all have the same information you do and those other investors ensure that the price of anything in that market will always be right about where it should be.

Continuing our stock market example, in the stock market, there are literally tens of thousands of people who buy and sell the stocks of major companies every day. These people all have the same information, most of them act rationally on the information, and so, if the price goes out of whack by even a penny or two (for whatever reason), there are good investors who will swoop in, gobble up that penny or two of profit, and bring the price back to where it “should be.”

You’ve probably heard of day traders. They make money by being able to find the brief periods of inefficiency — where the price of a stock is out of whack — and then buying or selling that stock to take advantage of the inefficiency. But, day trading stocks is REALLY hard! Typically, any inefficiencies in the market are very small — both small amounts of money (often just a penny or two) and small amounts of time (generally, these inefficiencies only last for seconds or at most, a couple minutes). Unless you are a smarter and more informed stock trader than 95% of the others out there — or you have inside information on the companies you’re trading — you probably aren’t going to make any money as a day trader. And unless you’re better than 99% of them, you probably aren’t going to make a lot of money.

That brings us back to crypto currencies…

The crypto currency market these days is extremely irrational. Prices of coins are generally “out of whack” by large amounts (often by many dollars) and for long periods of time (often hours, days or even weeks).

This is true for lots of reasons:

1. There are relatively few investors these days. With so few investors, trade volumes are relatively low (the markets aren’t highly liquid). This is typically bad for those who want to do quick trades, but if you’re looking to trade relatively small amount (hundreds or thousands of dollars), there is still enough liquidity in crypto markets that you won’t get stuck with any of the more popular coins.

2. Most investors aren’t very knowledgeable. Most crypto investors these days are speculators. They don’t understand the underlying technologies behind cryptocurrencies, they don’t understand the products that crypto companies are creating and they don’t know what differentiates a good crypto company from a bad one.

3. Companies are artificially affecting the supply/demand of their coins. This is a big one. The way that many of the companies are releasing their coins to the market (often called an ICO, or “Initial Coin Offering”), the number of coins available to investors, or the number of investors eligible to purchase coins is much lower than the demand for these coins. So, we often see new coins get released to the market and then surge in price in the days/weeks to follow. If you have the ability to purchase coins before they are widely traded, it’s often not too difficult to get a several times return on your investment very quickly.

4. Market caps aren’t efficient. Few investors these days are looking at the market capitalizations (the overall company value) when making their purchasing decisions. Yet, these valuations can often provide a quick and reliable measure of whether the company is undervalued or overvalued compared to other companies in the space. Between companies will eventually gravitate to an appropriate market cap, if an investor can find a company that is significantly undervalued compared to others in the space, it can be a quick and easy opportunity to make some money.

5. There is a lot of irrationality among traders. This is another important point to consider. When other traders are acting irrationally with respect to their investments, it often just takes a little bit of rationality on your part to benefit from it. Herd mentality is strong in the crypto world these days — investors see other investors moving their money into a particular coin, and they start to pile on. If you can get in early in these situations and then get out quickly without being greedy, it’s often possible to take advantage of the irrationality without being (overly) irrational yourself.

Again, there’s no such thing as free money when it comes to investing. And that mantra certainly continues to apply to cryptocurrency investing. But, with some basic knowledge of the underlying technologies, some basic research into the companies that are creating coins and a bit of discipline when it comes to deploying your capital, cryptocurrencies are potentially a great opportunity to take advantage of irrational investors and an inefficient market.

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J Scott

Written by

J Scott

J Scott (he goes by “J”) is a full-time entrepreneur and investor, living in the suburbs of Washington, DC.

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