All Fall Down

SINCE THE START OF the year, the stock market has dropped almost 24%. That’s significant, but it pales next to the losses suffered by cryptocurrency investors, with the shellacking continuing into this weekend.

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 around 75% year-to-date, and bitcoin has fallen some 60%. From its peak last fall, bitcoin has lost more than 70% of its value. Whether or not you own cryptocurrencies—and whether they go up or down from here—there are useful lessons for all investors.

1. A powerful myth. In psychology, there’s 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 that, when you pull the lever, two cherries come up—a near miss. Psychologists have found that this type of result turns out to be encouraging to gamblers, who 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 folks 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.” There’s been a lot of that over the past few years.

Thanks to the extreme price gains following the 2020 recession, investing 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, bitcoin had risen tenfold. Everyone, it seemed, knew someone who had done well with crypto, meme stocks or other speculative bets. 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 a click away. Recent experience should help dispel this myth. I’d ignore Wall Street’s enticements, and I’d also ignore what your friends and neighbors are doing.

2. Know why. 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 happens. In part, that’s due to FOMO—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 for the price gain.

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, and that can lead us badly astray. Here’s a simple illustration: If A buys an investment, that puts upward pressure on its price. That will make it more attractive to B. If B buys, that puts further upward pressure on the price, attracting 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. They don’t produce anything—unlike stocks, for example, which can generate dividends, or bonds, which pay 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 will be much more volatile and unpredictable, because there’s no underlying logical basis to its value. Unlike a stock, a bond or a piece of real estate, there’s nothing supporting the value of cryptocurrencies, and that means they could theoretically 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 in 2022, 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’s been cautioning about a market bubble, pointing to higher valuations and accelerating price increases. But Grantham often talks about another factor. It’s harder to measure, he says, but in every market bubble there’s “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 around $18,000, 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 bitcoin is down by more than 70%, I’d still give that advice. Take some money 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 price. 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. What if it rebounds? You’ll be glad you didn’t sell it all.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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