At the outset, everyone should understand that cryptocurrencies fundamentally differ from stocks. Stocks have intrinsic value — they represent a real piece of a physical business. In the short term, stocks can swing up and down for no apparent reason, but long-term, as a company’s intrinsic value increases or decreases, the stock tends to move in the same direction. By contrast, cryptocurrencies have zero intrinsic value — they’re just computer code. That makes future token prices hard to predict.
However, I believe there’s a fundamental economic principle we can use to our advantage. It’s the principle I used when deciding to buy bitcoin and Ether (the tokens for the Ethereum network) in 2018. And it’s the same principle anyone can use to today to guide their thinking about any cryptocurrency investment.
Supply and demand
In economics, few principles are as basic as the law of supply and demand. Price is determined by how much of something is available (supply) and how much people want or need it (demand). When it comes to cryptocurrencies, supply differs in each case. Bitcoin’s supply is well-known, and bitcoin aficionados argue this proves its future value.
However, supply is only half of the equation. Remember Beanie Babies? Ty, the company that made them, periodically «retired» certain Beanie Babies, limiting their supply forever. This limited supply motivated some collectors to buy the toys hand over fist, causing their value to soar in the ’90s. Some even fetched thousands of dollars. However, Beanie Babies prices quickly plummeted after their brief heyday — most still sell for a fraction of what they sold for in the ’90s. But supply hasn’t changed; they still don’t make the discontinued ones. Demand changed. People don’t want them as much anymore, so they’re worth less.
Many cryptocurrencies have known supplies. That’s extremely useful. But an educated opinion of future token value requires a prediction for future demand. Thinking through both supply and demand led me to buy an equal amount of bitcoin and Ether over the thousands of other options. In my opinion, they’re the two most likely cryptocurrency candidates to be in demand going forward and the ones I would buy today (but more on that in a bit).
Why I bought Ether
I bought Ether because the Ethereum blockchain has real-world utility. While tokens can be used for digital payments, more practical things like smart contracts and applications can be built on top of the Ethereum blockchain. Think of it like a tank of gas. Sure, the tank of gas has value. But it also has a practical use. Continuing this analogy, some cryptocurrencies are just tanks of gas in engine-less worlds. But Ethereum’s blockchain is a gas-powered engine.
Ethereum isn’t the only blockchain network like this, but it’s arguably the best known. That’s important because blockchain networks benefit from a network effect. In other words, the more people use one system, the more likely it is more people will use the system. To me, if people were going to build upon existing blockchain technology, Ethereum is surely among the top candidates.
Many businesses already see the value of using blockchain technology. And some, like DocuSign, are already building upon the Ethereum blockchain. To execute a transaction on the blockchain, you’re charged a fee in Ether. As more real-world applications are powered by the Ethereum blockchain, there will likely be an increasing demand for Ether to make it run. This could keep sending its value higher — its value is already up about 350% in 2020.
Why I bought bitcoin
Bitcoin has less utility than Ethereum, but that hasn’t stopped it from maintaining its title as the most valuable cryptocurrency in the world. Some believe it could become a one-world currency, creating extremely high demand. But to me, that sounds far-fetched. People don’t seem to be using bitcoin for transactions but rather as a growth investment or as a digital store of value.
In my opinion, bitcoin’s demand as a store of value is far less than what it would be as a currency or some other everyday utility. That said, bitcoin’s upside could still be great given its supply is far more limited than that of Ether. Consider there can only ever be 21 million bitcoin tokens. By contrast, Ether and many others have no ultimate ceiling. Ether has annual mining limits, which keeps new supply somewhat in check. But bitcoin’s mining process is even more limited.
Every time there’s a transaction on the bitcoin network, decentralized computers process it and the fastest computer is rewarded with new bitcoin tokens. However, every few years the bitcoin reward is cut in half, most recently in May. This means miners are rewarded with 6.25 bitcoin tokens right now, as opposed to 12.5 earlier in the year.
Because there’s less bitcoin coming into circulation now, the price of bitcoin could go up if demand remains constant. A surprising development this year is new demand is suddenly pouring in from corporate entities. For example, Square just bought over 4,700 bitcoin tokens. And growing corporate demand, coupled with the new supply being cut in half, has helped drive the price of bitcoin higher in 2020 — up over 160% year to date.
What to do
After considering the issue of supply and demand, here’s my cryptocurrency investing thesis: Both bitcoin and Ether have high chances of being used in the future. And their supplies are limited enough to send the value of these tokens higher as demand surges. I believe that applies as much today as it did when I bought bitcoin and Ether in 2018.
When I bought, I committed to holding for at least five years. I made that commitment because, with two very speculative investments, I recognize this will likely be a volatile ride and I want to ensure I’ve given enough time for my thesis to play out. However, because this is speculative, I recognize the value of cryptocurrencies could plummet to zero. Accordingly, I only invested a small amount. And even though it appears my thesis is playing out, I won’t consider adding more even as prices rise. Since cryptocurrencies don’t have intrinsic value, the risk is simply too asymmetric for me.
If you like the promise of cryptocurrency but don’t want the outsized risk, there are other ways to invest in the trend. Specifically, there are stocks benefiting from blockchain technology. This allows you to purchase shares in real businesses generating real revenue from cryptocurrencies, rather than speculating on things outside of your control.