Crypto-currency - Extraordinary Popular Delusions and the Madness of Crowds

Crypto-currency- Extraordinary Popular Delusions and the Madness of Crowds

Time and time again throughout history, we have seen some very curious things happen to asset prices when the crowd all agrees on something. It is human psychology alone that drives the prices of assets that we are unable to value with any accuracy. Anyone familiar with the more speculative end of the stock market will note, that when a company has no earnings or revenue, but it seems to have a good idea, it’s perceived value is hard to determine and often that creates the recipe for some explosive price action. 
 
Of course money can be made trading these companies short-term, but all too often the vast majority of bubbles in the speculative end of the market wind up doing the same thing time and again. Reality catches up with the realisation that what you just paid for the asset is in fact far more than it’s intrinsic worth.
 
So what is the intrinsic worth of a Bitcoin? Where is its fair value? It’s impossible to say and that’s the beauty of it. You could say the same for gold, although supply and demand fundamentals effect the price, and it has a much longer track record of maintaining purchasing power and being a store of wealth for thousands of years over every civilisation.
 
So what would you feel comfortable buying 1 Bitcoin for? Does $10,000 AUD each sound fair? Well that is basically where the price is sitting at the moment, which puts Bitcoins total value or Market Capitalisation at an astonishing US$123 billion.
 
There are now over 60 crypto currencies with a market cap over $100 million, and plenty more with less than that. So no doubt some substantial money has gone into this market. 
 
The trouble with financial bubbles is that they are often hard to identify, especially by those participating in the euphoria who are invested. Many other psychological flaws that are present in all of us can kick in. Including Cognitive Dissonance and Confirmation Bias, which leads to overconfidence. It is true that once you have placed a bet on a horse, you can become much more confident that it will win. Similar to buying a lottery ticket, once purchased you often rate your perceived probability of winning much, much higher than your actual known probability. 
 
This is often similar in investing, whereby you feel much more confident in the future performance of the asset after you’ve bought it, or that you find confidence in assets that have already risen dramatically in price.
 
To protect themselves from their own biases investors will often diversify across a large number of asset classes that they are interest in, as opposed to lumping all eggs in one basket. The worst thing someone can do when they find themselves in the midst of a euphoric asset bubble, is to continue to relentlessly buy more. 
 
It is true that financial bubbles always start will a good idea. But it is only when this idea leads to fantastic price action, which breeds further indulgent behaviour, do things start getting out of hand. Some recent bubbles have all had good ideas. The birth of the internet lead to the Nasdaq bubble in 2000, the long term case for Silver saw the 2011 bubble, and the recent positive outlook of some Chinese listed companies lead to the 2015 bubble in the Shanghai index, all charts below respectively:

All bubbles have one thing in common and that is they get to the point where price-action itself in the main driver of higher prices, and they often take a parabolic chart pattern when they peak.

Many of the recent crypto-currencies to go to IPO have market caps over $500 million, but there are many starting to look like they’ve burst. A few examples below:

Bitcoin seems to have more staying power than many of these younger sprinters, but you can’t discount the possibility that what we are seeing is yet another great example of the irrational nature of crowds. Whether or not Bitcoin itself is a bubble is yet to be seen, but it certainly shares all the characteristics of previous financial bubbles, and the level of cognitive dissonance amongst the community of holders (evident in online forums etc) seems well above par when compared to other asset classes.   
 
In financial markets, yesterday’s winners are often tomorrow’s losers, and there is nothing wrong with taking profits and reallocating funds to a diversified portfolio. During the peak of a financial bubble the euphoria can lead to delusion and the entire focus becomes how much prices have risen. For example "prices have gone up X percent in 30 days" or "if you had bought X amount, X years ago, it would be worth X today’.
 
When the price action itself becomes the main selling point, it is usually time to rethink what it is you’re invested in, and whether it could be due a breather. As you never know, Bitcoin could become the worlds default global currency, completely upending Central Banks, or you might find the market wakes up one day and asks ‘did I just pay $10,000 for a digital coin that I’m never going to use?’
 
Only time will tell. I don’t think there is anything wrong with allocating a percentage of your investable assets into something you truly believe in, but going all in on one asset class can have devastating impacts on you financial position down the line. 
 
The fact that Crypto-currencies combined market cap is currenlty US$200 billion should not breed confidence that all is well. The Nasdaq Index at it’s peak had a market cap around $6.6 trillion and the Shanghai composite more than $4 trillion. When crowds get things wrong, we tend to get them wrong in a big way.

By John Feeney, ABC Bullion