In this series, I’m going to start with high level investing concepts in part 1 and get increasingly specific and detailed through part 4.
Part 1 is an exploration of why extraordinary investment opportunities exist in cryptocurrency. To an engineer, that might seem like an obvious and uninteresting question, but professional investors generally start with the premise that it’s nearly impossible to find the kind of returns that we’re seeing. This is the essay that uses traditional financial theory to explain to your broker or pension fund manager why such a great opportunity exists.
Professional investors think of markets as mostly efficient most of the time. This comes from both academic research and experience. While market inefficiencies certainly occur, there are thousands of brilliant traders and investors competing to immediately exploit and eliminate those inefficiencies. It’s hyper competitive. This makes it extremely difficult to beat the market consistently. 90% of mutual fund managers and hedge fund managers underperform a passive index, and these are mostly brilliant and very hard working people. Competing in public markets is like playing in the NBA – you’re competing against a field of amazing athletes in what is effectively a zero sum game: for every outperformer there has to be an underperformer (and usually many more than one because of expenses).
But what if instead of playing in the NBA, we had the option of playing in a middle school recreational basketball league? What if we found a league where the best basketball players in the world couldn’t, or wouldn’t compete against us?
My personal investing idol is Seth Klarman of Baupost group – one of the best performing, most insightful, and most ethical investment managers. Klarman notes that investors are compensated by the market for taking on market risk (i.e. beta), and for illiquidity. Many investors stop there, but Klarman notes that we’re also compensated for complexity, operational challenges, and “psychological risk.”
Why do such compelling investment opportunities exist?
1. They’re complex along many axes: understanding the technology often requires a degree in cryptography and engineering (for which I depend on a growing network of professional blockchain developers). They’re also complex economically; similar to investing in Facebook before there was any serious monetization plan. Few people have thought seriously about how to value a cryptocurrency fundamentally – there’s no textbook to reference, and currently no consultants to query. And lastly, they’re complex in execution. Consider Initial Coin Offerings (ICOs) – every ICO is unique, but they increasingly require submitting customized data to an Ethereum “smart contract.” This complexity – in technology, in economics, and in execution, scares off much of the competition.
2. They’re operationally challenging. There are no established regulations, operational procedures, or accounting standards to deal with investments in cryptocurrency. Best practices for securely storing cryptocurrency are constantly evolving and the storage cannot be delegated. Storing cryptocurrency in a way that is both extremely secure, but redeemable in case I’m incapacitated, is a very time consuming process. These operational challenges discourage many potential investment managers.
3. They entail “psychological risk.” In 2008, many of the largest US bank stocks lost 80% of their value, some lost 100%. The stocks of big US companies are risky, but we don’t perceive them as such – if you lose your money owning Citibank or AIG, you won’t feel all that foolish and as a professional investor, you probably won’t be fired. In contrast, cryptocurrency investments are risky, but if we size the position appropriately for our portfolio, they’re no different from any other volatile asset. The main concern many people have is psychological. If someone ran a pension fund and lost 15% of their portfolio in financial sector bonds in 2008, they were “unlucky.” If that same pension manager loses 2% of the fund in a cryptocurrency pool, they fear they will be fired for being foolhardy. As investors, we’re surprisingly well compensated for the risk of appearing foolish. it’s a risk that most of the biggest money managers refuse to take, and thus they leave many of the best investment opportunities on the table.
Investing in cryptocurrency is currently like playing basketball in a middle school rec league. Most of the best basketball players aren’t yet in the game. This allows us to earn outsized returns by providing capital to the best cryptocurrency projects. In a few years it will be far harder to earn such returns because there will be a great many talented investors competing to provide capital to the same projects. As we see in the traditional venture capital industry today – this competition drives up the entry price, and drives down expected returns.