A Primer on Cryptocurrency

The number one requested topic among users of Winners and Losers is: cryptocurrencies. Aswath, tell us more about cryptocurrencies and how you price and/or value them. The first thing is you cannot value currency. You can price them. Real quick – difference between value and pricing. The difference between value and pricing is value you try to estimate what you get as cashflow.
So when you value a business you project out what the business will generate as cash flow. So you can value cash flow generating assets. But gold, currencies, Bitcoin are not cash flow generating assets. You ask me what the value of gold is. I don’t know but I can price gold and we price currencies relative to each other. And that’s, I think, the opening to think about cryptocurrencies and why they’ve risen so much over the last few years.
If you think about gold, let’s think about gold – the alternative to paper currencies for hundreds of years. When people lost trust in paper currency because all you have is a piece of paper, it’s all based on trust. Doesn’t every fiat currency eventually collapse throughout history Fiat currencies vary widely. In France if you gave me a Venezuelan Bolivar I’m probably better off just using it as toilet paper than trying to spend it.
So when we talk about fiat currencies not all fiats are equally trustworthy. So when we lose trust in currencies, we go elsewhere. For the longest time the place we went was gold. I think what’s changed is for younger people the place they go when they don’t trust paper currencies is now cryptocurrency. But help me – I understand, theoretically as an old guy you go to gold and it can be used for fillings or jewelry.
What is the underlying guarantee and limit of a cryptocurrency? Let’s face it, the people who bought gold didn’t want to use it, they wanted to sell it to somebody else at a higher price. It’s a pure pricing game. The reason people have historically bought gold is not because they think gold has a physical use but because they think it’ll have enough of a pricing attached to it that they can sell it to somebody at a higher price.
So it’s the illusion that it’s become a store of value. Exactly. Okay so help me price Bitcoin and Ethereum. I think the key to think about is if you have enough of the population losing trust because we lost trust in governments and central banks and who can blame people for losing trust in them and if you’re 35, 30 or 25, you have no interest in pricing gold and playing the gold game, you actually think you have an inside track on playing the pricing game with Bitcoin and one of the things that always strikes me when I talk to people in this space who are cryptocurrency fanatics is they think they know more than they do.
They think they understand everything about block chains and who owns what and where the pricing is going and that’s always a piece of the pricing game: people who are overconfident about the capacity to forecast price. We don’t need very many people for the pricing to kind of do what it’s done which is if four or five percent of the population has lost trust and is paranoid. So Trump is the best thing to happen for cryptocurrencies.
Collectively, globally. You could argue that governments across the globe… It’s I think a problem. So you think in any sort of crisis, more missile tests coming out of North Korea, cryptocurrencies similar to gold go up, people stick cryptocurrencies under the mattress.
In fact one of the most interesting things about this bull market is it’s a very differentiated market. Half the market thinks that everything is cheap, the other half thinks everything is increased. I’ve never seen a divide as large as I have in the market that we’re in which is between the Bulls and the Bears. There’s almost no connecting point and it’s very political. It’s more political than economic. Tell me who you voted for in the last election, I can tell you whether you’re bullish or bearish. That’s how much of a correlation there is between politics and what you think about the market now. which is not a healthy place to be.
So I think that even though markets have been going up, the subset of people who think that markets are overpriced is a fairly large one and it’s very intense and they believe this for three, four, five years and that’s the group that’s increasingly leading stocks and they’re saying well I can’t go to bonds, I’m getting 2%, what am I going to put my money in where I can make some money in the future? A 25 year old has a hundred bucks. Mock portfolio – just create an asset allocation for me and a 55 year old. The tool is very simple: you want to spread your bets. Time is your ally.
So the 25 year old, don’t try to time the market, don’t tell me the markets you know, too high, too low, it doesn’t matter. You’ve got 40 years to play this game, just take your money, make your asset allocation. So you want a portfolio that looks like this. If I took the market cap of every traded asset in the world put in a pie chart I want the pie chart of your portfolio to look very much like that.
Diversification and low cost. Exactly. 55 year old. 55 year old you gotta worry more about this, especially about the fact that if you have a shock to the market you might not be able to make that money back before you need it for retirement. So 55 you know, the first question I would ask is hey do you still have an income? If you’re already retired at 55 the kind of advice I’m going to give you is going to be very different than you give a 55 year old with an income stream still coming from working because let’s face it, a lot of 55 year olds have 15 years of work life still left in them.
So I think that you’ve got to get more cautious, but the old know once you get to be 65 everything’s got to be in cash. You got to rethink because a lot of 65 year olds are still making enough of an income that they don’t need to touch their portfolios yet. So it really is a question of do you depend on your portfolio for your cash needs and if the answer is yes then I’m going to increasingly shift your weight from any kind of risky asset class because there is no safe place in the world where you can put your money in, make an 8% return and still draw cash every year and not worry about your principal being affected.
Thanks very much, Professor Aswath Damodaran. And more information at Damodaran.com.