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“The year is 2021. It is no longer safe to transmit information. Phones and computers are all vulnerable.”
—William Gibson: Johnny Mnemonic
If you went to the movies to watch Blade Runner in 1982, you might have thought it a bit of a stretch to arrive at this dystopian future from your 1982 world in thirty-seven years.
The movie is based on Phillip K Dick’s 1968 novel — ‘Do Androids Dream of Electric Sheep.’ Dick set the story in 1992, but Ridley Scott adjusted the temporal timeline to 2019 for the movie. Again not enough time.
An author with a more realistic guesstimate on the world of the near future is William Gibson.
Gibson, whose ideas in Neuromancer were reworked, along with the work of French philosopher Jean Baudrillard, into the movie The Matrix by the Wachowski brothers, has an uncanny ability to guesstimate the future.
In Neuromancer, published in 1984, Gibson wrote, “Cyberspace. A consensual hallucination experienced daily by billions of legitimate operators, in every nation…”
Walk through the streets of London in 2018, and you’ll see a lot of people walking ahead, eyes down, gripping portals into Gibson’s world.
In Ignitus, we talked about three other dystopian novels set in a future that’s looking more and more familiar.
Aldous Huxley, in a Brave New World, set the future governed by the ‘World State’ who had control over powerful technologies. George Orwell’s 1984 is a world controlled by fear, and in Ray Bradbury’s ‘Fahrenheit 451’ information is used a pacifier.
William Gibson wrote Johnny Mnemonic in 1995. He foresaw a future where those who control the information control the world. The date? 2021. Sound familiar?
If you’re interested in investing in blockchain technology, how do you make a choice? Is it possible, like Gibson, Huxley, Orwell, and Bradbury, to take a fair guess on what the future will look like, and is it still possible if you don’t possess any technical computer science skills?
Which technology do you back, what has the greatest chance of making it? How do you know, if you buy for the longer term, the investment you make has a shot at the big time?
Is your investment idea at the start of a new trend or a sugar rush?
Today most people rush. They rush to work, they rush home. Rush, rush rush. Have you thought about what drives them to behave like this? In certain countries, the drive to own your own property is a mantra drilled into you. Robert Kiyosaki wrote Rich Dad, Poor Dad in 1997.
Kiyosaki uses the construct of two fathers, one his own, and the other, the father of his best friend, to give a different perspective on how the world really works.
You might have heard of this book, and you might have even read it, but what you might not be so familiar with is the subtitle—
“What the Rich Teach Their Kids About Money — That The Poor And The Middle Class Do Not!”
Because of its success, this series has been rehashed many times. If you look, you’ll find the Rich Dad’s guide to just about everything, or at least it feels like it. But don’t let the rehashing distract you. One of the central messages in the original is all you need.
And it’s this.
What you think is an asset is really a liability.
Shock, horror. In some countries getting on the property ladder is seen as absolutely the best thing to do. Renting is looked down on. But it’s not that black and white.
If you were born lucky at a time when property prices are down, and you can purchase your first home for less than three times your annual pre-taxed income; then, buying makes sense.
But what if you weren’t?
What if a first-time buyers house is five times or even seven or eight times your income? What then?
Most save, or, as has been demonstrated in recent history, rely on the Bank of ‘Mum and Dad.’
The majority of people are risk-averse. They get a job, work hard, pay taxes, start a family, buy a house. Feel free to move a few of these around, adjusting the life order, but this is how most experience life — until it’s over.
Education, education, education. Sing it from the rooftops. But to what end? To get employed, work, pay taxes, support yourself and then your family. And it doesn’t come cheap. Today most students start out with debt. They get started with a negative balance.
In a recent survey targeting three age groups, Millennials (aged between 18 and 34), Gen X (aged between 35 and 54), and Baby Boomers (aged 55+), found 75% of Millennials had less than $10,000 in savings, and 42% had nothing saved at all. But more worrying, the next twenty years of life doesn’t seem to be much better. The survey also found 49% of Gen X’ers had less than $10K in savings.
Getting an education is important, but what kind of knowledge will serve you best? The wealth survey found on average a fifty-year-old American with a median income of $70,832 is 78% in arrears when it comes to having enough to cover a comfortable retirement. Not a luxurious retirement. A comfortable one.
The number of people in the United States educated at a degree level or higher ranges between 30% and 40%, depending on the survey. If you look at the survey data, where most Americans under thirty-five years old have no savings, you could argue that this is due to kick-starting a career, paying down debt, and enjoying life. If so, you could also imply that as someone reaches their late thirties and approaches their peak earnings window, they have maybe twenty years of peak earnings out of a total of thirty productive years before they retire.
Again, most don’t worry too much about life in their twenties. It’s only when, sometime into their thirties, they have to make a choice. And after that choice is made, how do they best make the most of their $200 for passing Go? This is where education fails the majority. They are just not taught how to maximise their earnings potential.
The majority handoff these decision making processes to wealth managers, who following strict guidelines give advice on how best to invest their capital, but this is problematic because with the clock ticking, how can they maximise their investment returns using risk diversified investments? The simple answer is, most don’t.
Why are we talking about education and savings? What has all this got to do with cryptocurrencies?
It’s about motivation. What motivates people to invest in a particular asset class?
For all the education, very few learn about opportunity cost, and unless you studied a business career, like accounting, the concept of opportunity cost will probably be new.
What is opportunity cost? The simple version is this. How can you achieve the best and most efficient return on your money?
Most people think saving is the most efficient way of getting a deposit for a house. Very few think about alternative ways of solving this problem. For the majority, it’s the Monopoly board of life. Get $200 for passing Go, hope you don’t land on Old Kent Road or Whitechapel with a hotel on it, and save save save.
Most people think they can make good decisions about a purchase. Instead of cryptocurrencies, let’s use something you’ll be more familiar with — renting an apartment.
You’ve moved to a new city, and you need a place to live. Assume you have to rent for two years because that’s how long your contract is for, and you’re not sure if you’ll settle in this location.
The apartment you’re going to rent has a market value of $250,000 and comes with two rental choices. You can pick either of the two, but you have to pick one.
Choice 1: Pay the landlord 80% of the market value of the apartment as a deposit and pay no further rent over the two-year lease. And at the end of the lease, you get your 80% deposit back in full.
Choice 2: Pay the landlord 5% of the market value of the apartment as a deposit and pay $1,000 per month rent for 2 years, or 24 months.
In both cases, you get the deposit back in full at the end of the lease. Assume also that you have $200,000 in cash and you can afford either initial deposit. Also, assume the money held on deposit is insured and 100% safe.
Which box would you choose?
If you take choice number one, you pay the landlord $200,000 up front, but then pay zero rent for two years. At the end of the lease, you get your $200,000 back in full.
If you take choice number two, you pay the landlord $12,500 up front, and then pay $1,000 per month for the twenty-four-month duration of the lease. Over two years you’ll pay $24,000 in rent, but you’ll get your $12,500 deposit back.
Taking choice number one, at the end of two years, you get your deposit money back in full, and you’ve enjoyed living in an apartment for two years at zero cost to you.
But if you take choice number two, then at the end of the two-year lease you’ll have $24,000 less because of the rent payments.
With choice one, you start out with $200k in cash, live in an apartment for two years, and end up with what you started with — $200k in cash.
With choice two, you start out with 200k in cash, live in the apartment for two years, and end up with $176K in cash because you had to pay rent.
Most people go for choice number one as a no-brainer. (Assume you have the cash to do so.)
And this is another reason the 95%, the consistently inconsistent group of investors and speculators, struggle.
The 95% take choice number one. They see it as a way to live for free for two years. And it’s a mistake.
Blinded by the no-brainer opportunity to live for free, they don’t realise there is another opportunity involved in the transaction. One the 95% almost never think about.
The 5% club, the group who are consistently profitable, see what the 95% don’t — Opportunity Cost.
If you choose choice number one, you’ll have to pay a deposit of $200,000, (80% of the apartment market value) but if you decide choice number two, you only have to pay $12,500. (5% of the apartment market value)
The difference is $187,500.
And this is what the 95% don’t realise — Money today is worth more than money tomorrow.
You have to discount the deposit difference of $187.5k to account for the lost investment opportunity. In choice number one, you’ve given $187,500 more to the landlord, over what you'd have given if you took choice number two, and this difference could have been invested elsewhere.
It’s all about this: If you took choice number two, you have to pay $24k in rent over two years. But if you take choice number one, what rate of interest would you have to get to make up for the lost investment opportunity of $187,500?
The 95% almost always take choice number one. The 5% don’t. They figure out what rate they would need to receive on the $187,500 if they didn’t give it to the landlord, and instead invested elsewhere.
The answer is 6.2%. 6.2% represents the opportunity cost you are giving up when you take choice number one.
The 5% understand when you pay the landlord $187.5k more choosing choice number one over choice number two, you’re giving up $11,630 of income on the $187.5k in year one and $12,350 of income in year two for a total of $24,000 of lost income over the two-year rental agreement. This is precisely the same as paying $24,000 in rent, at $1,000 a month.
And the point is this — if the 5% club can achieve an investment return greater than 6.2% on the deposit difference of $187,500, then taking choice number two is clearly the better strategy.
So what? At this point, you might be thinking what has all this to do with cryptocurrencies and blockchains?
The “so what” is this — In the financial world, the 6.2% opportunity cost is known by another name — The Discount Rate. And understanding the Discount Rate is key to figuring out the motivation behind big money moving into or out of a particular asset class.
It’s because the discount rate allows you to calculate the present value of money you’ll receive in the future. If you take choice number one and give the landlord the $200,000 deposit, you’ll get it back in two years time, but in finance, money today is worth more than money tomorrow. The discount rate tells you what the cash flows you’ll receive in the future are worth today, and when you know that you can calculate the intrinsic value of the investment idea.
Realise this is how the large Wall Street investment banks value companies and ideas. They estimate the intrinsic value of the investment and compare this value to the asking price.
The 5% club understand the most important variables the financial world uses to figure out the likelihood of money flowing into or out of an asset class. One of the variables to be considered is the opportunity cost — aka the discount rate. Knowing the discount rate is the key to unlocking intrinsic value. And if the 5% have an estimate of the intrinsic value, they can compare it to the asking price.
Show Me The Money
The 95% focus on the money — on how much they could make if they are right. But the 5% focus on risk and one of the variables of risk is the price you pay.
In blindly taking choice number one, the 95% don’t understand one of the main drivers of the financial world — what is the deposit received back in full in two years time worth today? The discounting of money, received in two years, to today's value is called the NPV — the Net Present Value, and the 95% are typically blissfully unaware it even exists.
The 5% club don’t just use technical analysis as a magic predictor of futures prices. They do use technical analysis as a trigger, but they also factor in conditions that are most likely to benefit longer term investment into an asset class.
If you trade over the short term, you might not care about what happens to the technology you’re investing in over the next one to five years. If you take positions based on intraday charts, then your time horizon will be limited to the time setting used to generate the signal. If you take a position using a sixty-minute chart, you can only expect to monitor that position over hourly periods.
But what if you’re interested in investing long term? Which blockchains or coins have the highest probability of long-term success? Which technologies have a shot at crawling out of stage three of the hype curve, the trough of disillusionment, and move up the slope of enlightenment?
If you are only using short-term charts to take positions in the cryptocurrency markets, you’d have to take a scattergun approach to invest in longer-term positions because the short term charts you’re using can't give you anything but a short-term viewpoint.
Which coin do you buy when the cryptocurrency markets start to trend? Because, most likely, unless there is a decoupling on the day you get a buy signal from the top coin you’re looking at, you’ll get a buy signal from the other top coins as well, so how do you choose?
In October 2018, the cryptocurrency markets are in a lull. While the 95% are trying to find a guru that agrees with their technical charts, the 5% are busy looking for factors that will attract big money into blockchain investment.
The cryptocurrency markets are highly correlated. In October 2018, most of the top coins and tokens have the same technical chart behaviour. The charts represent the overall interaction of supply and demand, and from this, it’s clear the general public has lost interest leaving the crypto markets waiting for a catalyst.
When the markets finally break, they’ll most likely break together, either up or down. So, how do you figure out which cryptocurrency asset has the highest likelihood of being successful over the long term?
The 5% make investment decisions by comparing the intrinsic value of an investment to its asking price.
If you were in the market to buy a house and did your due diligence, you’d check the median house prices in your area, you’d check local records for the actual recent sales prices, and you’d notice how long properties take to sell.
If the median house price in your area were $400,000, you’d need a very good reason to pay $500,000 for it, yet this is what the 95% do with investments. They often don’t do their due diligence and instead invest out of FOMO. In the 4th Dimension, we discussed the primary driver of the 95%. Fear.
Finding intrinsic value in a house or even a publicly listed stock is relatively easy, but how do you find the intrinsic value of a blockchain?
Another method the 5% club use to zero in on investment opportunities is by comparing the future potential returns to the discount rate or opportunity cost.
The 5% understand if the discount rate is 6.2%, this means that investors will expect a 6.2% return on investment, but to the provider of the service 6.2% represents the cost of raising capital.
Risk can’t be removed it can only be moved around — what represents a return to one party, represents a cost to another.
The 5% club use a baseline. The line represents the intrinsic value of an investment, or it represents the discount rate.
In a simple example using real estate, represent the baseline as an intrinsic value using the median asking price. If the asking price is above the baseline then don’t invest, and if the asking price is below the line invest.
The baseline can also represent the discount rate. The US stock market return has averaged 9.8% per year since 1928. If the potential returns have a high probability of being above the line, the 5% will look to invest, but if the baseline is already high, then it will be difficult to obtain even higher returns.
The baseline for government bonds varies around 3-4%. The baseline for small-cap biotech stocks could be as high as 25%. Compared to the stock market or even biotech stocks, the 5% club know that investing in blockchain technology in 2018 is the Wild West of investing and because of this, the discount rate is high.
The 5% know there’ll be a high causality rate. Many blockchains and cryptocurrencies will fail.
The 5% club use a framework, a simple line, to represent the discount rate. They are patient and are waiting for the moment in time where the returns to investors and conversely the cost of capital comes down or becomes more predictable. A high investment return to investors represents a high-risk cost of capital for people who launch the technology. The 5% take notice of the market conditions that have the potential to adjust the baseline.
One site places cryptocurrencies into the following categories: Currency tokens, privacy tokens, platform tokens, utility tokens, exchange tokens, and decentralised exchange tokens. Another uses a different set of categories: Store of value coins, platform cryptocurrencies, fintech cryptocurrencies, payment cryptocurrencies, privacy cryptocurrencies, and application-specific coins.
Others have even categorised blockchain assets into periodic tables, with Bitcoin taking the place of hydrogen.
If you’re new to blockchain technology, it’s very frustrating. No one seems to be able to agree on the classifications.
How do you know if the technology you’re investing in has any intrinsic value, and how do you know what exogenous events will affect the valuation going forward?
One effective (and simple) way to approach this problem is to use seven categories.
In First Order, we discussed where the value will most likely be created with blockchain technology. The Internet uses a version of the seven layer OSI network model called the TCP/IP stack. The value was released in the seventh layer, the application layer. Developers created intrinsic value by creating applications that could use the TCP/IP stack like a global network.
But the TCP/IP model has flaws, and one of those flaws is speed. In a decentralised blockchain, the TCP (Transmission Control Protocol) is too inefficient and will generate a massive amount of network traffic (think of this as chatter) establishing the connections.
While it’s true, there’s a connectionless protocol in layer 4 called UDP, (User Datagram Protocol) the protocol layer is in the process of being redesigned to accommodate blockchain interoperability more efficiently.
In short: Value using the internet was released in the application layer. Value using blockchain technology will most likely be released in the protocol layers. Layers two, three, and four.
Let’s say you use a fintech category for some blockchains and a platform category for another.
When you do this, you make it more difficult to figure out the market conditions and events that will affect the value of the blockchain.
Some crypto sites have produced cryptocurrency periodic tables, and while useful, they complicate things by placing blockchain technologies like Ethereum in the Platform category and Stellar in the Fintech category.
This level of abstraction means it’s more difficult to compare the two technologies.
The stock market is organised into broad indexes. The Dow Jones Industrials, a grouping of thirty household name companies bundled together as a benchmark index. Most people have heard of the Dow Jones Industrial index, but few understand how companies within the Dow are weighted. It’s not by market cap, but by price. The SP500 is another well know benchmark index, this time weighted by Market Cap. But within the stock market companies are categorised into sectors and sub-sectors.
Because it makes it possible to compare performance. You can’t compare the balance sheet of a bank with that of a biotech company because the internal structure of their operations is entirely different.
And so it is with blockchains. Behind all the tech speak, all the complicated white papers and technobabble, big money investment needs to know the where, how, and why of value creation. Which technology has an advantage over its competitors and how robust is the edge the technology enjoys?
It’s all about finding a toll bridge. And if you start separating technologies into different sectors, it will make it more difficult to do a comparative study.
The 5% club attempt to find the location of value. Think of it as finding the HCF, the highest common factor. Imagine two competing blockchains being represented by two numbers 24 and 36. The common factors of 24 and 36 are 1,2,3,4,6,8, and 12. The HCF is 12, but somewhere down the chain of lower factors, there might be a bottleneck. A place where one technology has an edge over another.
Some readers might completely disagree with the seven categories above. They might, for instance, argue there is no privacy coin category or no fintech category, but to argue is to miss the point.
The overall goal is to be able to isolate, as quickly as possible, the coins or tokens that have the edge over their competition.
Using a single currency category, you can ask more general questions, and this allows the advantages and disadvantages to stand out. For example, the two questions to consider within the currencies group are: Is the currency a medium of exchange or is it a store of value? Or could it be both?
The privacy of one coin could be compared to the pseudo-privacy of another and the overhead of the advantage and disadvantage compared.
The 5% use simple models like a baseline to compare technologies. They use a small number of categories to allow them to use efficient comparative techniques to recognise value.
Ethereum and Stellar are both development platforms. By placing them in the same category, the 5% can use similar methods to estimate the intrinsic value of their networks. One technique taken from demand-side economics is the network effect.
The network effect is where an additional user of a product or service adds to the value of the product or service. In other words value increases as the number of users increases.
An example of the network effect is a mobile phone network. If you bought a mobile phone in the late 1980’s, you might have used it as a status symbol because you were the only person in your group of friends and business partners who owned one. But as mobile phone usage became more mainstream the value to you, and everyone else, owning a mobile phone increased. This is even more positive when someone buys a phone without the intention of providing value to others.
The network effect is also known as the bandwagon effect. It’s a positive feedback loop. Facebook and Twitter are examples of services that benefit from the network effect. So will platform category blockchains.
Mobile phones, Facebook, and Twitter are examples of a positive network effect. What about a negative network effect? Does this exist?
It does. Do you ever get frustrated by the speed of home broadband connection?
Your Internet Service Provider owns a pipe. You connect to the Internet via this pipe, and so does all of the other customers. Think of this pipe as being broken down into lanes. As more and more people join the ISP service, there is more and more competition to use a lane inside the pipe. The ISP uses something called contention to allocate lanes more fairly, usually based on how fast a service you’ve purchased.
As more and more people use the service, the worse your experience is. This is a negative network effect in action.
Another metric the 5% use is Metcalfe’s law. Metcalfe’s law states that the value of a telecommunication network is proportional to the square of the number of users. This law applies to platform category blockchains too.
Sugar rush or a real trend? The 95% listen to other peoples opinions. The 5% search for value and understand the metrics that attract big money. The discount rate, opportunity cost, and intrinsic value are all variables taken into consideration.
By placing blockchain technology into a small number of categories, the 5% use economic techniques like the network effect to estimate the value of future technologies. And once an edge is found the 5% use the price cycle and the hype cycle to time their investments.
This is how the 5% club get glimpses of the future, like William Gibson’s 1995 conduit to 2021.
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