I visited a palace recently (Germany is full of palaces and castles and such), and the main residence was surrounded by a moat. The waters were richly stocked with fish, and sitting atop the bridge over the moat were fishing poles.
As I absorbed the scene, my day-dreaming mind wandered to the basic premise behind fishing; the fish perceives an offer that's too good to be true and decides that they will be the one to take up that offer. Worms generally don't float at or near the top of the water line, visible to all passers-by, but the fish disregards the blatant non-reality of the situation and bites anyway.
Sitting on that bridge, my mind jumped to cryptocurrency.
Seemingly every day, we're hit with stories of the normal people whose lives have been transformed by crypto wealth. I also get excited by reading this stuff, but my rational quiet brain reminds me, "That's bait." Because it is. Just look at the incentives.
One of Charlie Munger's admonitions is to consider the incentives behind any investment. As described in Richer, Wiser, Happier:
Munger starts with a tendency of such importance that almost all of us underestimate its significance: the role that incentives play in "changing cognition and behavior." He quotes his hero, Benjamin Franklin, who said, "If you would persuade, appeal to interest and not to reason." Munger writes, "This maxim is a wise guide to a great and simple precaution in life: Never, ever, think about something else when you should be thinking about the power of incentives."
Let's work through the incentives.
- Crypto is created by programmers. The coin's advent is often accompanied by a white paper.
- Early adopters begin with the largest number of "coins", either gained through the creation of the coin itself or by buying very early.
- The early adopters are often the biggest proponents of the coins.
- These coins are traded for money, which has led to the creation of large exchanges where people could easily use their fiat money to buy these coins.
- The early adopters' wealth rises quickly as demand spreads. This - often very public - wealth creation spurs new demand, which pushes up the price, which makes the early adopters even richer.
- Crypto miners invest huge sums to facilitate transfers and earn new coins. Those coins are sold to pay for the costs of mining, which are very real and priced in fiat money.
- As new entrants see the wealth, they buy in, but their cost basis is much higher, which incentivizes them to also promote crypto.
- Recently, institutions have been tying themselves to the fate of cryptocurrency1 by buying it, transacting in it, or being an exchange for it.
Can you see the problem here?
Think about what happens when you buy crypto. First, you want to buy it because you heard good things about it. It can make you rich! Who told you that? Or maybe you believe the claims that it can solve this or that problem. Who told you that?
The early adopters are arguing publicly for the supremacy of crypto.
The institutions who've adopted it are saying good things about crypto.
There are lots of people out there saying good things about crypto. Journalists writing about the sudden riches are saying good things. Jack Dorsey and Elon Musk are saying good things. Thomas Lee and Preston Pysh are saying good things. Bill Miller is saying good things. Jason Debolt is dreaming of trips to the moon funded by today's Dogecoin purchases.
The crypto founders themselves are saying good things. Just read this copy from the Cardano homepage:
Making The World Work Better For All. Cardano is a blockchain platform for changemakers, innovators, and visionaries, with the tools and technologies required to create possibility for the many, as well as the few, and bring about positive global change.
Notice also that their website isn't even finished although Cardano's ICO was in 2017:
Even your family members might be saying good things about it. But that's also the case when your brother is trying to sell you Cutco knives or your mother wants to give a Tupperware party.
Next, who is selling it to you? This stuff isn't coming out of thin air (you missed out on that part of the story). Someone is on the other side of that trade, and why would you assume that you know more about that person regarding the relative merits of your purchase? You likely don't, especially if you're sending your dollars or euros to one of the early adopters. And naturally, the exchanges are happy to facilitate the transaction for a hefty fee.
All this adds up to bad incentives. All of those people are incentivized to say good things about crypto because they're all in on it. That may sound a little close to a conspiracy, but they needn't be colluding to all have similar incentives. For most people, they're just getting in, and they want their purchase to work out.
Crypto Solves That?
Crypto has several major flaws, but one flaw is the sand under its house: its price bears no relationship to any of the perceived benefits. You can argue that blockchain technology is cool tech. Yes. You can say that it can facilitate certain payments. Sure. You can say that it will disrupt certain industries that rely on outdated contract models. Yes.
But. What. Does. That. Have. To. Do. With. Its. Price?
Imagine if Apple let the Swift programming language trade on Binance. You could argue all day about the benefits of Swift and how its a game changer compared to Objective C. Those arguments would be irrelevant, however, to the purely speculative price it would be trading at. Meanwhile, crypto only has a price attached because it's been programmed to have a price attached. But just because it can have a price attached doesn't mean that it's justified.
And all the reasons for the price sound like post hoc rationalizations: it's a store of value, it's a hedge against inflation, it's digital gold, it's becoming scarcer, it's halving, it's based on network fees.
With stocks and bonds, there's an eventual day of reckoning that proves or disproves the thesis. Or at least there are days of reckoning for enough stocks that there's a theoretical framework to hang valuations from.
Thus far, that doesn't exist for crypto. That might eventually emerge, but right now, the best argument proponents have is that it's a new asset that's gone up a lot, which means it might continue to go up a lot, so you should hop on or else you can "have fun staying poor".
Intelligently Taking the Bait?
I've wondered, and maybe you're wondering, if we can take the bait intelligently. As in, we know it's all a hustle just like Elon said on SNL, but we figure we can get in and get out without getting the hook.
First, I think we have to be honest with ourselves that we likely aren't incredible traders. I know I'm not. And since the stories about 2000 and 2008 tend to focus on the many who were ruined rather than the few who got out in time, we should assume the base case is that we're likely part of the many rather than the few.
Second, we have to be aware that sitting on a winning trade will change the way we think about it. How well will you remember that it's all a big hustle when it's tripled in a few weeks? When you've applied the glowing eyes to your profile pics, will you secretly remember? After all, as William Bernstein points out in The Delusion of Crowds, the biggest charlatans are also often the biggest believers.
Even for the few months I was holding Bitcoin and Ethereum, I could watch my opinion changing. Motivated reasoning is a hell of a drug.
Third, unlike credit card rewards where you're skimming the points from faceless corporations, and unlike the smart fish carefully plucking the worm from the hook of a predator, if you did successfully sell your holdings to someone, you'd be leaving someone else with the bag. You might secretly believe that you're selling a database entry that's worthless for a profit, but someone is buying it from you. Selling your position is not getting a refund.
There's a scene in Margin Call, where the CEO played by Jeremy Irons decides to sell their worthless holdings to the same people they'd been selling it to for years. But the difference in that scene is that they knew it's worthless. Kevin Spacey's character points out, "But that's it. They'll never buy from us again," because what they're doing is obviously wrong. Now, when you sell on Coinbase, they don't show you who's buying it. But someone out there has bought into the dream, even as you've decided to wake up.
Yes, that's what makes a market, but if you're convinced that it's worthless, you don't have to get involved in the first place.
I sold my tiny holdings a few weeks ago, and I'm disappointed that I ever took part in this thing. It all feels incredibly dirty, and our charitable giving will more than wipe out the small profit I made. I couldn't ever shake the feeling that I was gambling, and the profit I made is a small consolation for the stress. It wasn't investing (long term expected positive return) or even speculation (uncertain future return based on little evidence). It's gambling (long term expected negative return) because the odds are so clearly against me. As I was deciding to sell, I could hear the voice saying, "Maybe it'll keep going up," but I had nothing to base that on other than the hope that I'd gamble and win even bigger.
Reading the aforementioned Richer, Wiser, Happier, I was struck by another bit of Munger wisdom. Quoting from the book (paperback pages 214-15, italics mine):
Munger often remarks on how critical it is to partner with honorable and unselfish people, while avoiding those with "perverse incentives." He was appalled by the greed that precipitated the 2008-09 financial crisis, with Wall Street's best and brightest engaged in exploits such as repackaging subprime mortgages to create pestilent bonds with pristine credit ratings. It's easy to rationalize tawdry behavior, especially when it's legal and others are feeding from the same trough. But Munger recommends a higher moral standard, which involves saying, "This is beneath me."
The incentives are perverse. The adherents have glowing red eyes and speak about non-believers as if we're all a bunch of idiots, unable to see the obvious technological miracle before us. They pump and pump, and somewhere, someone is dumping. The base case throughout human history is that these manias end badly.
Maybe this time is different, but more likely it's not.
PS: Things I'm Not Saying
That blockchain is going nowhere. Like paper money, the internet, radio, railroads, cars, airplanes, and globalized trade, I can imagine that blockchain is here to stay and will have measurable benefits to society. But like paper money, the internet, radio, railroads, cars, airplanes, and globalized trade, it seems impossible to bet which platform will actually deliver long term profits to investors early in its advent.
That I can't be proven wrong. I can acknowledge some scenarios in which I'm wrong. I won't go into that list now, but it's possible a future me might acknowledge that buying these coins could have been a great idea.
That the aforementioned people who are pro-crypto are bad people. Although I don't like the incentives, I don't necessarily think those guys are bad guys. But I do find their motivations around this subject suspect.
That I'm the first guy to say this. The Twitter handle known as Jesse Livermore had a similarly scathing take the other day. Stephen Diehl as well. And the fishing metaphor... emails looking for suckers are literally called "Phishing" attempts, but I'm telling the truth that crypto came unbidden to me on that bridge.
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Disclosure: I'm currently long PayPal, which has recently begun offering crypto trading on its platforms. ↩︎
