Our animal spirits often get the best of us. When market highs are extremely high, we’re greedier than ever, and during the most oversold and opportune times we’re fearful of losing even more than we already have lost.
Daniel Kahneman’s thesis in the book Thinking: Fast and Slow is [more or less] that humans are innately bad at predicting the future. Much of our low brain near the stem is where the majority of our evolution has contributed to- what Kahneman describes as the ‘system 1’ brain. The output of this part of our brains is incredible. We can subconsciously react to threats efficiently before we even properly know what the hell is going on. On the other hand, the prefrontal cortex and upper brain, while it’s what differentiates us from other animals, isn’t as developed, not quite as necessary for raw survival (or it hasn’t had as much time to develop.) Kahneman also talks about the law of small numbers, which says that people think small sample sizes ought to represent the whole but too often do not.
What does this have to do with the cryptocurrency market?
The valuation of the cryptocurrency market (1.5 trillion) is not that large relative to other assets including real estate (20 trillion), gold (10 trillion), the US Stock Market (80 trillion), or the GDP of the EU (18 trillion). Turbulent waters can more easily rock the little tugboat (crypto) as opposed to the giant German Battleship Bismarck (NYSE), even though the allies finally were able to sink the Bismarck in May 1941 thanks to British intelligence and American torpedo technology. The law of small numbers tells us that the smaller the sample size, the more likely we are to get an extreme outcome. For instance: Iceland is statistically the happiest country in Europe. Iceland also only has ~400,000 people. It would be unfair to compare Iceland to the UK, France, Germany, or Spain, all of whom have populations greater than 50 million. Here are a few top reasons why FUD is especially impactful on crypto markets:
Retail investors are relatively skittish.
By volume, the majority of stakeholders in the crypto asset class are retail investors. Think a plurality of younger, tech-savvy people with disposable income having brokerage accounts with Robinhood, Coinbase, Kraken, Gate.io, etc, looking to turn profit. This is what worries me the most: speculation-based investing instead of utility-based investing. Although the anonymity of blockchain can’t give us data on who users are, I’d imagine the median age of an account holder on Coinbase is something like half that of a Charles Schwab, TD Ameritrade, E*Trade or other brokerage account customer.
Lack of institutional investment.
This is the other side of the retail investing coin. Institutional investors (I would suggest) are better able to control their animal system 1 brains and use critical thinking capabilities and modeling for a variety of factors- the first is that institutional investment time horizons are longer than that of retail investors– Yale’s endowment fund, for instance, will have a longer looking horizon than the 16 year-old who spends 8 hours per day playing Roblox who recently downloaded the Robinhood trading app. With institutional investment, think a plurality of older professionals who have weathered several financial hurricanes like Black Monday 1987 or the Financial Crisis of 2007-2008. These experiences have been burned into their memories and have actually helped them internalized sayings like ‘diversify your portfolio’ through experience and not just knowledge.
Lack of regulation.
Yes- lack of regulation. Please read my article about how regulation and trade within a law-abiding country can attract more investment than areas with no regulation. The frontier often outpaces the law- and to some degree, blockchain technology is still the wild west circa late 19th century- wild but becoming more tame. In the last year alone (2020-2021), we’ve seen the IRS adopt and publicize policies about how to treat income from blockchain assets, an SEC investigation into Ripple for their XRP coin, and a ban from the Chinese Communist Party on Bitcoin mining operations in China. This removes the ‘uncertainty’ part of FUD- one less letter to deal with. Now we know where the chips lay. I actually feel better about putting my money onto Coinbase since the company is now publicly traded- and thus has to bend itself every which way to comply with the demands of it’s public investors and SEC regulations. Coinbase is also American and thus subject to the well-hammered out commerce laws in the US.
A continued inability to understand that unexpected things happen constantly.
The individual probability of each unexpected event is small- say getting stung by a stingray while vacationing on the Gulf of Mexico (roughly 1 in 5,000). But when all of the minute probabilities are stacked together- weather, your health, your relationships, the economy, crime- there are plenty of unexpected things that could fuck up your day (depressing to think about). Likewise, plenty of unexpected things could make your day a lot better. This lack of anticipation on our behalf often leads us to panic or over celebrate when shocks enter the crypto market- like an Elon Musk tweet, or a government outlawing Bitcoin, or a headline that Michael Saylor purchased another $5 billion in Bitcoin.
We are a social species and take cues from each other.
Note the Crypto Fear and Greed Index which is partly based on captured sentiment on social media. If 90% of Tweets, articles, posts on social media are saying that this is the end of Bitcoin as a true store of value, we’re likely to follow that advice. The internet allows us to lock ourselves off into echo chambers and is a hotbed for confirmation bias. In order to outperform the market (Alpha), we have to go against the flow. By definition Alpha (the return you get that’s greater than market average return according to billionaire hedge fund manager Ray Dalio) comes when you bet against others (generating alpha) or challenge what the market generally believes. Current prices are relics of the thousands of data points that the market knows or believes.
The largest of these factors that subjects crypto to FUD turbulence is the fact that the asset class is so small. With more time and investment in the asset class, it will become more stable, the ship will grow, but will generate less alpha. If you’re interested in cryptocurrency as a technology now, know that you’re early. Some day you may be bragging to your friends and family about how you believed in blockchain technology’s power to create economic value where currently many inefficiencies exist. The more societal buy-in into an asset class, the more likely it is to stand the test of time- it actually doesn’t matter if the technology doesn’t prove to be as useful as Ethereum and Cardano co-founder Charles Hoskinson claims. Gold proponents often tout that for 5,000 years the human race has viewed it as a store of wealth- but what about the 995,000 years of the existence of the human race prior to that? We only have the human condition and our biases- far more powerful than whether the Queen has gold in her crown (yes, plenty). We see value in what we agree has value. I think gold proponents suffer from recency bias- thinking that the asset will continue to store value the way it has- and here we’re going back to that whole ‘humans are bad at predicting things’ subject. Crazy ideas are just crazy ideas until they become major breakthroughs.
On paper, theory would tell us that with the financial expertise and plethora of knowledge and tools we have available to us, we’d be able to adequately value something that can reduce transaction time, be untraceable, and most importantly, be decentralized. Perhaps we already have, or we’re just getting around to it. But then there’s the lower half of our brains. The irrational exuberance, the animal spirits, the cognitive biases- those things that helped us survive for a million years that both send financial markets to the moon and into unfathomable depths.