FOMO, Bitcoin & Other Digital Currencies

Behind the greed that fuels every bubble is a kind of fear: the fear of missing out (FOMO). During periods of widespread speculative contagion, it is difficult to ignore the rallying cry that everyone jump aboard the bandwagon or miss out on something remarkable.

I think it’s likely that FOMO is leading to the meteoric rise in price of many digital currencies. Unfortunately, Millennials, a generation that’s already at a financial disadvantage, will bear the brunt of the consequences.

It was FOMO that fueled the roaring 20s (which ended with the Great Depression) and the period prior to the financial crisis of 2007-2009 (aka the Great Recession). It was also FOMO that was responsible for the dot-com bubble in early 2000, which closely resembles the digital currency market today.

In the 90s, investors were banking on the promise that the Internet would utterly transform the economy (which was completely true) and, for a while, things certainly seemed to be moving quickly.

Today, digital currencies are moving at a similar pace.  Many legitimate companies, countries and other entities have begun accepting forms digital currency. The most powerful company in the world has recently entered the race by registering domain names with the term “Bitcoin” included.

But that doesn’t mean investors should run blindly into digital currencies without regard for price.

At one point in the 90s, investors were happily paying over 175x last years earnings for a basket of tech stocks (the average price of a stock throughout modern history is about 16x earnings). Most had no idea they we’re paying so much. They saw their friends make money in the market and dove in without asking questions. The one’s that were more knowledgeable about market dynamics justified their insanity with the excuse that what will happen in the future has never happened in the past. That growth will be so extreme and consistent, we’ll move forward into some type of economic prosperity that humanity has never seen.

Of course they we’re wrong.

This type of thinking is chemical. Investors tend to project only the very recent past (good or bad) into the future and lose sight of the long view. Warren Buffett calls this the “rearview mirror” mode of investing and behavioral scientists call it the “recency bias.”

What happens is that as the price of an investment increases, its expected return decreases.  This not only means that the probability of losing money increases (as well as the amount on the line) but that investors reduce their requirements of a probability of positive return in hopes of achieving a lesser-probable outcome with a higher potential payoff. As Howard Marks says there’s “Nothing is as seductive as the possibility of vast wealth.”

Think of the relationship between risk and reward in this way. Every investment decision requires an investor taking one of two different risks: the risk of losing money or the risk of missing out on an opportunity.

When an investor buys something, they risk losing money for not risking missing out on potential return. When an investor passes up on something, they risk missing out on potential return for not risking losing money.

The trick in investing is balancing these two and shifting one’s decision toward making an investment when the probability of making money is relatively high, and shifting towards not making one when the probability of making money is relatively low. This is called risk management.

Now this may sound like market timing, but I’m not promoting investors should forecast. I’m rather talking about taking the temperature of a market and determining if the probability of making money is high or low. And while investors try to accomplish this using a multitude of  analytical tasks, there’s one metric that stands above the rest: price!

I discuss in my book The Millennial Advantage: How Millennials Can (And Must) Be The Next Great Generation Of Investors that “High risk comes primarily with high prices.” This is because psychology fuels irrational bubbles and the most significant investing errors come not from factors that are informational or analytical, but from those that are psychological. I’m talking about FOMO!

The truth is that no one knows what the value of 1 bitcoin is worth. This is because it’s a commodity or a currency, not a cash-flow generating asset. Generally, investors value investments as the present value of the future cash flows they’ll receive. But with digital currency, like gold (or any other commodity) there are no cash flows. So, its valuation is both simple (supply and demand) and incredibly difficult to ascertain. It comes down to whether someone else is willing to exchange $ or any other currency for your unit of digital currency (demand) going forward.

Of course this is based on trust that they will be able to transfer it to the next guy for the same (or higher) value.

But will people trust something that millions of others can create themselves? Individuals can’t create their own Dollars or Euros but individuals can create their own units of digital currency. Even if it requires high-tech hardware (which costs thousands of dollars) to do so, their is too much room for error. And when that error does come, which will probably happen once investors have incentive to see price declines (when a cost-effective ability to short comes available), it’ll completely wipe out the value digital currency has for being both a store of value and a medium of exchange. Will it recover? Likely. But it’ll take time. And when it does, they’re will be a lot of intelligent investors waiting on the sidelines with cash. Wealth will transfer from the speculators to the investors, which is what has always happened and always will.

If  you’re in digital currency to make a “buck”, ask yourself this: if some form of digital currency were to become a leading payment system, what would cause its value to appreciate? Why would I pay you 5 iPhones for your digital unit when it was worth 2 iPhones yesterday? If it’s a medium of exchange, then how can its price appreciate?  

Also ask yourself if you’re able to pick a winner? As with the dot-com bubble, Thousands of online start-ups appreciated rapidly in value based on the premise that the Internet will change the world.

It did, but most of the companies ended up worthless.

Overall, I believe that the technology underlying digital currencies will be an integral part of our system going forward. However, things won’t progress as quickly as most think. Eventually, a way will come out to cost-effectively short the market and people will have incentive to see downward pressure in price. Who knows what that’ll bring.

I advise my younger clients invest 2% of their portfolio in digital currencies as a long-term speculative play. For allocation reasons, I can’t imagine substituting digital currency for something that humans have romanticized about for thousands of years. You know, that shiny yellowish metal called Gold!

As always, investing is a loser’s game and the best investors win by not losing. So, remain patient. Control your FOMO and when digital currencies are out of favor, jump in like a shark.