Cryptocurrency Investing, explained to a friend
Should you invest? How? How much?
Disclaimer: This review is not intended as investment advice. It is for reference only. Buying crypto-assets is very risky and you should seek the advice of a licensed professional before purchase.
tl;dr: Guessing whether Bitcoin is a bubble is hard. The only way to get out of this conundrum is to apply Taleb’s Black Swan strategy, and invest what your can afford to lose completely as an optionality play — assuming you understand what drives currency value (and believe in it).
Recommended read beforehand: Bitcoin, explained to a friend.
Escaping the Conundrum
There are several good reasons that explain why Bitcoin has reached its current value, and may appreciate more over time. But there are also clear signs of a bubble: the frenzy, the speculation and people who invest just to follow a trend. We know how these stories end.
Because Bitcoin is now a currency (ranking 14th, ahead of Saudi Arabian Riyal), and that currencies are no longer correlated to any underlying asset, it is almost impossible for us to know when a currency is too high, or whether the market is wrong. There is definitely a greater volatility on Bitcoin, but does that mean you should stay away?
I studied financial theory for three years, worked in investment banking for three years, and closed / invested in deals totaling >$30bn, but I have never learned as much about investing as when I read Nassim Taleb’s two books, The Black Swan and Antifragile. Taleb comes with several important concepts, one of which is useful in this case: “Seek Optionality”.
In the face of Black Swan events (unpredictable events with major implications), it makes sense to make small optionality bets that do not have any impact on your life in case you lose your bet.
Explanation: if I am worth $100k, and that I invest 99% across secured assets, bonds, ETFs and real estate, I could dedicate 1% to high-risk-high-reward investments, because that last $1k has a lower utility than any other $1k before it. If, as everyone expects, the Black Swan does not occur (99.5% chance), losing 1% of my worth won’t change much to my life. However, if the Black Swan occurs (0.5% chance), my $1k investment could represent a significant upside (additional $200k+ if traded correctly). It’s insurance, upside down.
In short, if you identify a Black Swan event as probable, and you find a way to build optionality for upside exposure, you may want to dedicate a discriminate amount you are ready to lose completely to take the bet.
The Bitcoin Black Swan
There are several cases that could lead Bitcoin’s value to soar. While the highest probability scenario is that the bubble will pop, I identify three scenarios that would constitute a positive Black Swan.
Scenario 1: The World Goes Full-Crypto
The simplest and most effective way is to get a positive exposure to the event of a rise in cryptocurrency use is to buy its central currency, Bitcoin. Bitcoin’s network effects, and it’s $300bn market cap, also mean that it will certainly become the first cryptocurrency stabilize over time. Because Bitcoin is the currency that is currently at the center of all attention, it drives surges first.
Therefore, if you are looking for gains on the short term, Bitcoin is probably a better bet than spreading your investment across hundreds of cryptocurrencies that may not create network effects in the next couple of years.
If you compare price progression over the last three months, Bitcoin appreciated 5x ($3.8k on Sep 17th to 19.5k on Dec 16th) whereas Ethereum appreciated 2.4x and my portfolio of 35 carefully-selected cryptocurrencies appreciated 1.9x
Scenario 2: Bitcoin replaces Gold
Bitcoin is more accessible, easier to store, easier to protect and easier to sell than a bullion of gold. Just as gold, Bitcoin’s value is not derived from the underlying use of the asset, but on what we consider the price to mine it.
Also, Bitcoin can no longer pretend to have any other use than to store value, because for all other plays, there are better cryptocurrencies with dedicated blockchains and smarter code. Investors are thus less worried that Bitcoin’s value would go down because of competition.
Explanation- Assume you see Ethereum as a smart investment because you can benefit from a double upside: you could store value as it keeps appreciating through speculation, and the market of smart contracts is immense, so there is a good use for Ether. What happens the day EOS or Cardano create a stronger blockchain with better code? Investors who invested in Ether to store value are now exposed to downside related to competition, and therefore have to pull their funds, creating a downward spiral.
Investors who want to store value chose Bitcoin because you can’t do much with it. Single use play.
About $6 trillion of gold is used today to store value in vaults (or inside grandma’s mouth, for many countries I lived in), representing 20x Bitcoin’s market cap today.
Scenario 3: Bitcoin replaces liquid assets located in Tax Havens
The same rationale applies to liquid assets currently held in banks located in tax heavens (c.$7 trillion), because anyone would prefer to have no government recourse on these assets.
In other words, moral and physical persons holding liquid assets would naturally prefer to place some of these assets on a blockchain that no person, organization or jurisdiction can coerce.
These events have little chance to happen. But if one of them occurs, and you are surfing on the currency, it may be one of the best waves you took.
Cryptocurrency Portfolio Diversification
If you happen to consider investing over $5k for a long period, it may make sense to add some diversification to your portfolio. Each cryptocurrency tries to solve a problem Bitcoin could not solve alone.
- Ethereum has created the option to add more code into the transactions, thereby opening the possibility to write complex contracts tied to the transaction. Several other currencies, based on Ethereum’s open-source code (ERC20), have been created to develop new markets — more on these later. Contender: EOS. My Bet: Cardano.
- Litecoin increases the number of transactions that the blockchain can perform per second, which places the currency as one of the strongest contenders to become a currency for large peer-to-peer payments. Contender: BCash. My Bet: Stellar Lumens.
- ZCash developed additional cryptography on the blockchain to anonymize transactions, while also being able to verify information such whether you hold enough funds to make a purchase. Contender: Monero. My Bet: Cardano :)
The profusion of cryptocurrencies was permitted by Bitcoin’s open source code, as other cryptocurrencies were created based on its source code, with the underlying principle that these new cryptocurrencies be open source themselves. Open source enables the community to innovate at a darwinian scale.
The profusion of cryptocurrencies was necessary due to scalability issues. Blockchains are databases decentralized across tens of thousands of servers across the globe. Blockchains, because they are secure and decentralized, have difficulty to scale. Visa can process thousands of transactions per second because it has only one version of the credit cards database. Blockchains deal with a whole additional level of complexity: they have tens of thousands of versions of the same database, all open to the public and accepting new transactions.
Explanation: In order to be secured, the history of all transactions on the blockchain needs to be copied on all these servers and condensed into blocks that everyone accepts as valid. This decentralized database pursues a tenuous effort to update the various versions of itself while it is processing several transactions at each server location every second, and while making sure there is no inconsistency across all the transactions: blockchains prevent you from simultaneously buying a cryptokitty in NYC and paying for poker in Macao with same Ethereum coin using two servers.
There are already over a thousand cryptocurrencies available for trading today. Several of these currencies are scams, and most of them may not reach the status to become ubiquitous. Nonetheless, there are many applications that make sense and this ICO revolution is making it possible for you to take part in a potentially tremendous technological change powered by code and algorithms.
Blockchains can be used to replace whole markets and marketplaces. Blockchains could replace all stock markets, insurance companies and retail banks in the next decade. Blockchains could replace every centralized organization you trust today into a decentralized algorithm that is more efficient, fair, and that rewards everyone who contributes to it. Facebook could be, should be and (I hope) will be replaced by a social media blockchain that you can use as your virtual identity database, your relationships database, and that would also reward you for your contributions to the community, as well as the time you spend watching those ads.
The article continues here: The Blockchain Disruption, explained to a friend
If you would like to apply all this, look at this post, written by a Finance Professor at U Oregon. You will find where to buy your first fraction of a Bitcoin (coinbase.com), how to convert them into other currencies (bittrex.com), where to learn about other cryptocurrencies (coinmarketcap.com, podcasts, medium blogs) and how to store your coins securely (I recommend Exodus).
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