What’s the Deal with Cryptocurrencies?

One of the trendiest subjects in the financial and technological world is cryptocurrencies. According to Wikipedia, the definition of cryptocurrencies is a digital asset designed to work as a medium of exchange using cryptography to secure the transactions and to control the creation of additional units of the currency. Cryptocurrencies are part of a technological revolution, but the scope of this post is to determine if they are part of an investment revolution.

Many people are talking in favor of investing in cryptocurrencies and are definitely in favor of mining those, while others claim it’s just a bubble. I’m not here to judge, and I have to admit that I don’t really know if it’s a bubble that is about to burst, or perhaps the Ethereum will replace the Bitcoin, which will replace the dollar as the main and de facto currency on earth. Anything could happen.

Given the little that we know, I’m just trying to understand if cryptocurrencies can be considered a good value investment.

Value Investing in Equities

Some investors invest based on technical sentiment, for instance, “the trend is your friend” types, while others are interested in easy money and zigzag between stocks. Some have their favorite companies and just want a share of them.

I try to consider investment opportunities for the long term. Strategic investing, or value investing, is arguably the best alternative for investments in the long term. The metaphoric hall of fame of investors is fully booked with value investors, such as Warren Buffet and Benjamin Graham. Many want to be true value investors, but to be one, you need to come up with one simple, yet profound analysis—what is the value of the vehicle you want to invest in?

An in-depth valuation analysis for financial vehicles can be conducted in various ways, and most of them will differ in the results, but one truth applies to every single one: there is a value. We just need to find it. Therefore, when we consider buying a particular stock, we have solid ground to lean on, and we have a target we try to reach, but that’s true for stocks (and also some other equities).

Value Investing in Currencies

Currencies are different from equities. Currency valuation is much harder, as currencies do not provide any dividends or cash flows, and their value is much more abstract than the value of a company. Essentially, the stronger a country’s economy, the stronger its currency, but many other factors are also important:

  • Interest rates—Changes in interest rates affect currency value, as increases in interest rates cause a country’s currency to appreciate, since higher interest rates are more attractive to foreign capital
  • Inflation—The currency of a country with higher inflation is depreciated since the value of each currency measurement unit is worth less, but higher inflation is often accompanied by rising interest rates
  • A country’s balance of payments—A balance of a country’s economic trade between a country’s residents and residents from the rest of the world. If a country exports more than it imports, the supply of foreign currencies will increase in its market, and the value of its local currency will appreciate (exporters will convert foreign money they receive into local currency)

These are probably the most important points to consider in trying to anticipate a change in currency, but some other economic factors, such as the stability of the economy, amount of debt, and political climate, can also affect a country’s currency. Many of these factors have contradictory effects, which makes foreign currency markets extremely unpredictable.

Just an anecdote from the last few months: The U.S. dollar has gained momentum since Donald Trump won the presidency, and in early 2017 it appeared that the USD would equal the euro (1:1) in a few weeks, especially as the Federal Reserve projected an interest rate hike, whereas in other developed countries the interest rate is approximately zero. A few months later, though, the euro and other currencies have gained momentum against the USD, hoping the European economy will recover (and perhaps disbelief in Trump’s ability to fulfill his plans—plans that were supposed to support the USD). The interest rate in the U.S. indeed hiked and is expected to hike again soon, but the trend over the last two months has definitely been against the USD. Here is X-Rates.com graph of the Euro/USD in the last 12 months:

This anecdote shows the unpredictability of the market, which many experts and analysts try to predict without much success.

It should be noted that currency trading is a zero-sum game, as one side’s profit is the other’s loss, which is much different from profits in equities, which can accumulate and make the lion’s share of investors richer (at least on paper).

Value Investing in Cryptocurrencies

So, there is value investing in equities but not so much in currencies. Could there be any value investing in cryptocurrencies? I will discuss some of the difficulties in treating cryptocurrencies as value investing.

First, the name “cryptocurrency” is a bit misleading, since cryptocurrencies are clearly not standard currencies. They are an odd mixture between equities and currencies. Cryptocurrencies are not regular equity, since they do not reflect ownership in assets in the conservative way, but they are also not standard currencies, as they are not tradable and regulated to the same extent as standard currencies (e.g., USD, euro). When trying to decide whether or not to buy a cryptocurrency, you don’t really know how to value it. Equity valuation is not possible here, and even currency valuation (or misevaluation) is also out of reach. There is neither an interest rate nor a central bank that controls the currency; there is neither national debt nor a balance of payments. So how can we estimate the value?

Second, value investing should consider such financial factors as volatility, which is measured well by the standard deviation, which is a measure that helps investors determine the anticipated return. The higher the standard deviation, the higher the yield you would expect to gain. It also helps those who hate risk (most of the world) realize what investments they should avoid.

The biggest cryptocurrency in terms of total capitalization is the Bitcoin. It’s the most traded one, the most famous, and even regulated to some extent in Japan. Yet, the Bitcoin standard deviation is astronomical. In the twelve months between July 2016 and June 2017, the Bitcoin weekly standard deviation is approximately 400%, and its daily standard deviation is above 1100%. If we compare it with blue-chip stocks, the standard deviation of Bitcoin is about five to twenty times higher. When people invest in Bitcoin, are they evaluating this factor?

Ethereum is the second-ranked cryptocurrency in terms of market capitalization. Many believe it will be ranked first before long. On June 21, the Ethereum price crashed within minutes from $300 to $13 and then went right back to the previous range. For those who didn’t sell, it seems that it didn’t matter much, but in a world with plenty of stop-loss orders, many selling orders came through, and many sellers lost a lot of money.

The Bitcoin and Ethereum yield in the last twelve months is compensating for the flying-high standard deviation, but looking at June 2017 alone, the yield of both currencies did not compensate for the standard deviation. And why I am specifying June 2017? Because many new investors have recently come to the cryptocurrencies market anticipating that prices will keep rising. They do not fully understand the market, though, and they do not fully understand the risks they are taking. They might be winning with cryptocurrencies in the long run, but their thesis will be losing eventually.

No Free Lunch

Value investors have to take risk. It’s part of the game, and that is the way to attain potential high returns over time, but the risk has to be calculated and tempered. Risk takers have to take into consideration liquidity and variance of their investments and even more importantly fully understand what they are investing in. Many new investors in the cryptocurrencies world do not fully understand cryptocurrencies and are just jumping on the wagon. When “silly money” enters a new vehicle, it can very well collapse. Even if the new vehicle has a bright future, those who invest should realize what they are doing, and that’s definitely not a solid investment.

Frankly, I have no idea if it’s a good investment, and I feel that if I can’t really project if a potential investment is good, then I probably shouldn’t do it in the first place. With this notion, I might be losing the best deal of my life, but I will definitely not have the worst deal of my life.

There is a But

Decreased volatility can create a new path to the market. What might strike us as strange is that the rise in the number of buyers in the market has not stabilized the market at all. Perhaps there is an incremental volatility in cryptocurrencies caused by limited legitimization and regulation of them. The rate of adoption is definitely hampered by security breaches and dramatic fluctuations. Lately, though, we have seen that cryptocurrencies, especially Bitcoin, have made steps towards a more regulated environment, which will definitely drive less volatility. For instance, a request to issue an ETF tracking Bitcoin was issued to the SEC, and potential approval could drive more unspeculative money (perhaps even institutional money) to the market.

Solid investors should wait and see if the volatility of cryptocurrencies decreases and becomes more stable before investing a large amount. Value investors would probably not be satisfied even by lesser volatility based on the reasons discussed above, and in times of low volatility in the markets, value investors have much better opportunities.

 

2 comments On What’s the Deal with Cryptocurrencies?

  • Hi,
    Really liked the artical, you touched some good points.
    I wanted to comment about one of your sections:
    “Frankly, I have no idea if it’s a good investment, and I feel that if I can’t really project if a potential investment is good, then I probably shouldn’t do it in the first place. With this notion, I might be losing the best deal of my life, but I will definitely not have the worst deal of my life.”
    Its funny how growth could be infinite (of course somehow) where lose is alwayes limited to the 100% you invest. I just want to make the point where a small investment could potentiolly yeild the best deal of your life, but it wont be the worst for sure.
    Loved the blog and the artical.

    • Hi Senia,

      Thanks for the compliments and for your great comment.

      I totally agree with you, and that is why a small investment in cryptocurrencies could definitely “spice” your portfolio and increase its upside.
      As I mentioned, I’m not against investments in cryptocurrencies, I just think that it can’t be considered a value investment.
      However, I definitely favor portfolio diversification and buying various financial vehicles (definitely ones with low or negative correlation to the rest of the portfolio).

      Again, I’m glad you liked the article and I hope to see your comments more often here 🙂

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