Since the beginning of the year, the stock market has dropped nearly 25%. That’s significant, but it doesn’t compare to the losses experienced by cryptocurrency investors. Dogecoin is down more than 90%, and smaller currencies like terra have lost essentially all their value. Even bitcoin and ethereum, which are much more established, have suffered big losses. Ethereum is down nearly 80% year-to-date, and bitcoin’s down more than 50%. From its peak last fall, bitcoin has lost about 70% of its value. Whether or not you own cryptocurrency—and whether it goes up or down from here—there are useful lessons for all investors.
1. A powerful myth. In psychology, there is a concept known as the “near miss effect.” Suppose you walk up to a slot machine, insert a coin and pull the lever. If you don’t even come close to winning, you might be discouraged and walk away.
But suppose instead, that when you pull the lever, two cherries come up. In other words, it’s a near miss. Psychologists have found that this type of result turns out to be encouraging to gamblers, who will think to themselves, “I was so close. If I try again, maybe I’ll win.” In fact, some have argued that slot machine makers know this and design machines to generate disproportionately more near misses to keep players playing.
This phenomenon impacts investors as well. If you see a friend or neighbor making quick profits with speculative bets, you might think to yourself, “I know him. If he can do it, I can do it.” There’s been a lot of that over the past few years.
Especially because of the extreme price gains following the 2020 recession, investing almost began to look easy. And the more speculative the investment, the easier it looked. From its low point in spring 2020 to its peak last fall, for example, bitcoin had risen tenfold. As a result, everyone, it seemed, knew someone who had done very well with crypto, meme stocks or similarly speculative bets. And that drew others in.
As we see these bets unravel, what’s the lesson? Just as slot machine makers use the near-miss effect against us, we should recognize that Wall Street does the same thing. Whether it’s with E-Trade’s talking baby or with other primrose path enticements, the industry’s goal is to make easy money appear to be just one click away. Recent experience should help dispel this myth. I’d ignore Wall Street’s enticements. And similarly, I’d ignore what your friends and neighbors are doing.
2. Why to buy. In 1994, fund manager Peter Lynch gave a talk in which he described the pitfalls investors face. He stressed that investors should “know what they own.” Too many investors, he said, buy stocks for no other reason than, as he put it, “that sucker’s going up.”
Logically, we all know that’s not a good reason to buy anything. But when frenzies get going, that’s the sort of thing that can, and often does, happen. In part, that’s due to FOMO—the fear of missing out. Also, as I noted last week, rising prices appear to validate investments. If investors see the price of an investment rising, they figure “the market can’t be wrong.” They assume there must be a good reason the price is rising.
That thinking isn’t entirely off base. The market, in aggregate, may reach more sensible conclusions than any one individual. At the same time, though, markets are also susceptible to herding behavior. In that way, market prices can lead us badly astray. Here’s a simple illustration: If Person A buys an investment, that puts upward pressure on its price. That will make it more attractive to Person B. If B buys, that puts further upward pressure on the price, attracting investor C. And so on. But nothing has fundamentally changed. The investment itself isn’t any better. In my opinion, that’s what’s been happening with cryptocurrencies.
As Bill Gates put it, cryptocurrencies are based on the “greater fool theory.” That’s another way of saying that cryptocurrencies lack intrinsic value. That means they don’t produce anything—unlike stocks, for example, which can produce dividends, or bonds, which can produce interest. As a result, crypto investors’ only hope for profit is to resell their currency to someone else at a higher price.
Cryptocurrencies aren’t the only investments that lack intrinsic value. But the current meltdown in prices illustrates an important lesson: When an investment lacks intrinsic value, its price is going to be much more volatile. More to the point, it’s going to be very unpredictable, because there is no underlying logical basis to its value. Unlike a stock or a bond or a piece of real estate, there is nothing supporting the value of cryptocurrencies, and that means they could theoretically even drop to zero—as unhappy terra investors have learned.
The bottom line: Never buy an investment just because it’s going up. Buy an investment because you think its price is lower than its intrinsic value, or because you think its intrinsic value will increase.
3. New things. The drop in crypto also teaches investors something about new and untested ideas. The reality is that this should have been bitcoin’s year to shine. Here’s why: The underlying structure of bitcoin allows for only a fixed number of bitcoins to ever exist. With bitcoin, there’s no equivalent of the Federal Reserve that could create more. For that reason, its supporters argued that bitcoin should be theoretically immune to inflation. But this year we’ve seen just the opposite. The dollar has been devalued due to above-average inflation. And yet, bitcoin has dropped relative to the dollar. It should have been the other way around.
The lesson: With new things, there’s often a gap between what’s expected in theory and what happens in reality. It’s okay to invest in new things, but not too much.
4. Craziness. The drop in crypto prices brings to mind an insight offered by veteran investor Jeremy Grantham. Over the past few years, he has been cautioning about a market bubble. To support his argument, he’s pointed to the indicators you’d expect, including higher valuations and accelerating price increases. But Grantham often talks about a third indicator. It’s harder to measure, he says, but in every market bubble there is “crazy behavior.”
As examples, Grantham cites bitcoin and stocks like GameStop, which gained a cult following for no rational reason. In hindsight, it’s clear that Grantham was right. The lesson: Investors should become cautious when they see market valuations rising but should become especially cautious when they begin to see signs of craziness.
5. A matter of perspective. If you own bitcoin, I wouldn’t blame you for being unhappy right now. But keep in mind the behavioral bias known as anchoring. If you owned bitcoin last year at $67,000, and now it’s at $20,000, it’s hard to ignore the loss. But if you purchased it two years ago, when it was below $10,000, you’d still be sitting on a profit. The same, in fact, is true of conventional market indices like the S&P 500. Yes, it’s lower year-to-date. But in thinking about your investments, don’t focus only on the high point. What matters is the long term.
6. Splitting the difference. In the past, I’ve recommended to bitcoin holders that they take at least some of their gains off the table—either by selling or by contributing to a donor advised fund. What about now—has that opportunity been lost? I don’t think so. Even though it’s down by half, or more, I would still give that advice. Take some off the table. Because bitcoin lacks intrinsic value, it’s anyone’s guess how low it might go. So it seems entirely sensible to sell some, even at today’s prices. In fact, I’d view it as a win-win. If bitcoin drops further, you’ll be glad you didn’t hold it all the way down. Alternatively, if it rebounds, you’ll be glad you didn’t sell it all.