Musings on Token Offerings

There is absolutely an irrational exuberance happening right now in the market for cryptocurrencies. As I write this, the market capitalization for tokens and cryptocurrencies (for simplicity, I refer to the terminology "token" to represent both types of digital currencies) is roughly $111 billion, which for scale, lies somewhere between the market caps of Starbucks ($87 billion) and McDonald's ($125 billion). Whereas I can leave my Manhattan apartment now to pick up a coffee or burger from the latter two public companies, the derived value of tokens is largely propped up by speculation (greed), blind optimism (faith), and enticing storytelling (myth). There are, of course, legitimate companies using tokens as a mechanism to bring a decentralized network effect to their product, but even then, the valuation is not aligned to the value (current or expected). There is no better person to quote about value than Warren Buffet.

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

The message is simple: it's entirely possible to overpay for shares in a business, even if it's a spectacular business, because it will never be able to grow into the already sky-high valuation. While tokens don't represent equity ownership (at the moment), they are supposed to represent the future value of the underlying protocol or product. Right now, token holders seem to think that the future value of the protocols and products will be $111 billion. While I have no doubt that the market capitalization of decentralized protocols and applications will exceed that amount in the future, I do not believe this current iteration of tokens will be the generation to generate this kind of enormous value (to be explained in a future post).   

I will now admit to one other fact, and then give some miscellaneous and possibly confusingly organized list of thoughts on token offerings. Starting with the fact. I am an investor, and sometimes speculator, in tokens. This may confuse you, given what I mention in paragraphs above, but do not let it prevent you from missing the point of this piece: in this market, tokens are mispriced, misunderstood, and will inevitably crash at some point in time that I have no way of predicting, knowing, or attempting to explain. Having said that, the reason I partake in this highly inefficient and irrational market is threefold.

First -- you can start developing skills in token investing that will come in handy for second-generation tokens (after this bubble pops). Second -- having some sort of skin in the game makes you more likely to stay attuned to what is going on in this space. To quote the notorious Jesse Livermore, "the game taught me the game." The only way to play the game is to actually play it. Reading about tokens will only get you so far. The third and final reason -- purchasing tokens provides for good fun. You can buy and sell tokens seven days a week, twenty four hours a day. That's not always a good thing for an investor's psyche (friends may ask why you are suddenly anxious during a casual Saturday dinner), but it sure is entertaining. 

Now for the musings. Below are a collection of reflections I have gathered in the past few months after investing and speculating in various tokens. I do not aim for this to be comprehensive, fully correct (we are all figuring these things out as we go...anyone who thinks they have this stuff figured out is either delusional, lying, and possibly both), or any type of investment advice. 

  • With many newly minted token millionaires, it's easy to assume they have things figured out. As the recent Uber news showed us, success hides problems. Many token millionaires made their money not due to skill, a systematic process, or deep experience, but through the sheer luck of being at the right place at the right time. Don' be fooled by their randomness. Here, it's helpful to read the work of Michael Mauboussin on base rates. Just a short quote: "...when luck dominates the best prediction of the next outcome should stick closely to the base rate. For example, money management has a lot of luck, especially in the short run. So if a fund has a particularly good year, a reasonable forecast for the subsequent year would be a result closer to the average of all funds."
  • I believe the best investing analog for tokens is seed and angel investing. In seed and angel investments, the investor often has nothing to go by except a simple deck and an idea. Since these investors give founders money before product / market fit, they're really just betting on the founders' ability to execute. In short, they're betting on the team. Similarly, many token offerings raise money before any product is created. The only data points a token investor has before making the investing are the whitepaper, various code commit histories and community engagement, and the team (I do not recommend investing in undisclosed teams). The market, however, seems to over-index on the importance of whitepapers rather than on the importance of teams. The seed and angel analog for whitepapers would be pitch decks. I encourage you to look at the pitch decks for a few large companies / unicorns and compare their initial proposition to what the companies actually do now. You will find similarities in the originally stated goal of the company and the reality today, but most often, you will find many more differences. At all stages, but especially at early ones, a company needs to be flexible and course-correct when needed. Automobiles are course-corrected by the driver. Companies course-correct by the founders. My most profitable token investments have been those where I invested based on the strength of the team, not the whitepaper. How I evaluate teams will be a post somewhere down the line. 
  • It is my experience that the best investors often invest unemotionally. My biggest losers have been token investments that appealed to me emotionally. These investments would probably not have appealed to me in a rational state of mind. My biggest losers have also come from the investment choices I made when following the crowd. Academically, it is easy to digest that you should buy when others are fearful and sell when they are greedy. In practice, things are not always so simple, since you are fighting against the fear of missing out. You can read about these mental and emotional investing fallacies your whole life, but without actually riding the rollercoaster you won't fully absorb them. Charles Mackay knew this over 150 years ago: "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." I am very happy I have the freedom to make these mistakes in this generation of tokens rather than the second, much more lucrative generation. 
  • Bifurcation of tokens is the first necessary step. There are two types of tokens: those you want to buy and hold for the long-term, and those you may want to trade for short-term profit opportunities. For the latter, token markets are inefficient. For the most part, you are not dealing with sophisticated traders, which can make the competition quite surmountable, if you do your reading. Although I am still developing the mental model I am about to describe, I think it works well enough to use in practice. There are two sides to every market: buyers and sellers. Buyers can be sellers, and sellers can be buyers, but the level of sophistication of each person varies. I have noticed that the markets for certain tokens skew either higher or lower as to the average level of buyer, holder, and seller sophistication. Specifically, I look for token markets where the average level of buyer and holder sophistication is low, which gives me the ability to sell back into the market at higher prices. Ether, for example, had a run up in price as a result of retail investors flooding in after reading about initial coin offerings and not wanting to miss out. While ether has some very sophisticated buyers and holders, this flood of new and unexperienced investors lowered the average level of sophistication of the buyer and holder. What this means in practice is that the average holder of ether will react more slowly to news, giving you an edge to trade against. On the contrary, certain tokens have very sophisticated holders, some of which are whales with inside information. In an effort to skew the probabilities of winning in your favor, I recommend you avoid competing with them. 

I am still learning about the business of token investing, and I have no plans to stop. All markets contain information asymmetry, but this is especially true for new markets such as the one we spoke about here. I find that writing about my investment strategies helps me better think about and improve on them, so you can say I write this out of selfishness. Feedback is welcome; feedback to refute the above points even more-so.