The Investment Risk in Taking a Punt on Cryptocurrencies

Most investors would be thrilled with the returns from indexes in the bull run of the past five years. At the end of February 2022, the S&P 500 index was boasting returns of an incredible 85 per cent for the past five years, well above the five-year average of 43.6 per cent from any other time period.

You know who wouldn’t be happy with that sort of return? Crypto investors.

Despite falling from its most recent high, Bitcoin has still delivered a massive gain of 3,600 per cent in the past five years. Likewise, Ethereum has enjoyed inordinate returns of 16,467 per cent over the same period. Cryptocurrencies have created many multimillionaires, as well as billionaires.

While this may seem like an opportunity for emancipation, I can’t help but think that the opposite is true.

Unfortunately, many crypto investors lack a basic understanding of what they’re getting into and are vulnerable to traps like not your key, not your bitcoin. However, it’s difficult not to be dazzled by potential returns of this magnitude, so this situation cultivates perfect conditions for investor scams. 

“ScamBook”

Australia’s competition watchdog (ACCC) is now suing Facebook’s parent company, Meta, for publishing scam crypto ads on its social media platform, many of which used fake endorsements from celebrities. It’s now being fought in the Federal Court, where the ACCC alleges Meta breached both consumer and securities law.

This is a world-first action that could have global ramifications for Big Tech. ACCC Chair Rod Sims even went as far to say that the model of using algorithms to seek out the most vulnerable was “a key part of Meta’s business”.

Regular readers of my Eureka column are well aware of my calls for long overdue regulation of social media. It is beyond ironic that Meta is able to use their facial recognition technology to immediately identify faces of over a billion people but are somehow unable to spot a scam ad or stop unauthorised use of celebrity faces. If you think Meta can stop the ads, but just doesn’t want to, then trust your instincts. As investors, we should hope that the ACCC wins the case to protect tomorrow’s cohort of emerging investors.

But the problems of crypto investing run far deeper.

Let me be clear on one thing: cryptocurrencies are incredible. The technology underpinning them, like blockchain and DLT, is brilliant and has many use cases.

It is here to stay. I believe all sovereign countries will move to their own cryptocurrencies, like US-crypto or AU-crypto. Of course, a few ‘indy’ currencies will survive, like Bitcoin and Ethereum. My bet is they’ll eventually trade as a kind of digital commodity, like precious metals, oil or grains are today. The other 10,000 crypto currencies will become the penny stocks of tomorrow.

Speculation is Inevitable

When fortunes are made seemingly overnight, FOMO is inevitable. This in turn leads to risky speculation. After discussing cryptocurrency in my 2014 book The Great Fragmentation, of course I wish I had made bigger bets on it. Crypto has risen 100-fold since then. Like any burgeoning technology though, it must first go through a speculative boom-and-bust phase before it can settle into the economic infrastructure. Whenever an asset is priced for the first time, abnormal gains are made. The same happened to oil and even land, when fences were first erected. Crypto is currently going through its first-time asset valuation period. At some point, it will stop – and normal returns (if any) will return. It’s here that the danger lies.

Remember the dot-com boom of 1995-2000? Any IPO touting the word ‘.com’ had investors lining up around the block. Share prices of companies bearing neither assets nor customers, and armed only with a loose idea of how they were going to change the world skyrocketed. In five short years, the Nasdaq rose 570 per cent. A bust then started on 11 March 2000. It didn’t get back to those highs for 15 long years.

It’s usually during these down years that we sift out what the market really needs, leaving behind the frenzy created by opportunistic hucksters taking advantage of the human instinct to gamble.

Where is Crypto Now?

Bitcoin has lost around 37 per cent of its value since November 2021 and, at one point, was half its peak price. Cryptocurrencies have lost a combined $1.4 trillion in value. As brokers like to say, there is ‘blood on the floor’.

But as any crypto acolyte will tell you, this has happened before. Big drops are not uncommon. Their advice would be to buy during the dip -- not because there is any underlying economic reason but only because they saw a similar pattern last time. However, as any sophisticated investor will tell you, it doesn’t mean that the same pattern will emerge next time.

No one really knows if the price will go to a million dollars per Bitcoin, or just one dollar. Every day, we see crazy gains from at least one cryptocurrency. Today it was Revolotto, which rose 797 per cent in a single day. Tomorrow it will be a different cryptocurrency.

When it comes to the future of crypto prices, people are just guessing. Guessing is not investing.

Scarcity is Not Enough

Sure, there will only ever be 21 million Bitcoins, but Revolotto and every other crypto is scarce too. Scarcity is not a valid argument for investing. Scarcity its own doesn’t create value. Things of value require utility or yield. When you buy shares in Apple, Alphabet or Amazon, their prices may well be depressed for a period, but it doesn’t stop people buying iPhones, or searching and ordering online. These companies are not just financial constructs, they actually bear fruit. Likewise, it doesn’t matter what the currency of the day is or becomes. They’ll still trade in it.

If cryptocurrencies want to be a store of value or economic utility, then they can’t rise in perpetuity. They must stabilise at some point. If they don’t, they become a Ponzi scheme.

Currencies are Natural Monopolies

There are many cryptos aiming to be the currency of an industry sector like energy, social media, data storage or logistics. But it doesn’t make sense to have so many different cryptocurrencies. Currencies are what we call a natural monopoly. People need a single reference point to transact in, otherwise it’s just too complex.

We are paid in dollars and we pay for goods and services in dollars. We need to know what something costs us when we buy it, in the currency we earn. Remember how confusing juggling multiple currencies is when you travel overseas? Believing we’ll end up with multiple cryptos is pure folly, because it doesn’t take into account human behaviour. Hundreds of years ago, regional banks around the world had their own currencies, as did small villages. But it became too complex once we started travelling and trading on a grander scale, so we reverted to precious metals and eventually fiat currencies. History matters.

The Youth Target

If you’re under the age of 30 as many crypto investors are, I can see how their massive gains are attractive. It’s a chance to get in the game, to revolt against the system. We often hear how Boomers stole the future and priced an entire generation out of the housing market. It’s understandable. However, the growth of cryptocurrencies is unsustainable. The average per annum growth of shares and property over hundreds of years are both around 10 per cent. Anything above that long-term average is an anomaly. We need to be wary and pass on this knowledge to the young people in our orbit.

Every Saturday, the Australian Financial Review runs a full-page advertisement from the currency exchange app Crypto.com that exhorts “fortune favours the brave”. It sounds more like gambling than thoughtful capital allocation to me. One thing we need to remember about exchanges and brokers of all stripes is that they make money when people are trading. It matters not to them whether prices are going up or down.

We can add to this gambling ethic the recent example of crypto exchanges sponsoring football teams around the world. AFL, NRL, Premier league, NFL – cryptos are the latest way to have a wager. Those encouraging it are well aware of how crypto sits in the minds of many young adults, so they have swarmed to where the gamblers are – football. The timing is perfect, as it appears that the social and political pressure on the AFL and other sporting bodies to quash gambling advertising will eventually eliminate it from broadcasts. Crypto is ripe and ready as a perfect substitute.

Gambling or Investing?

My view is pretty clear. The lesson is this: unless you understand where you are putting your money and why, you are gambling. There are many people who became wealthy through gambling. It’s easy to believe that the institutional money flowing into the sector justifies the prices, but the GFC too was underpinned by so-called wise institutions.

Maybe you want to take that risk, but unless you’re happy to lose what you play with, I wouldn’t go there.

Capital allocated to high-risk assets should never exceed 5 per cent of a balanced investment portfolio. Remember, for every single investment you lose your money on, you need ten successful investments (10 per cent ROI) just to get back to where you started. That’s a sobering thought.