Facing the Greater Fool
By: Evan Feng
Tags: Investing, Philosophy, Messari Analyst, Cryptocurrency, Bitcoin

Exploring the claims behind the persistent criticism commonly leveled against cryptocurrency, and why the Greater Fool Theory fails to make its case convincingly when scrutinized.

Early investor / adopter of cryptocurrencies, circa 2019 (colorized)

Introduction: The Many Faces of the Greater Fool

There’s not a specific definition or even attribution of the origin of the Greater Fool Theory (hereafter abbreviated to GFT), probably since the concept of investment mania divorced from fundamentals has existed for as long as trade and commerce. While definitions are extremely important, the lack of a formal origin means we’ll have to settle for the slightly more imprecise language of convention. Perhaps no source is more conventional than the Investopedia article on the Greater Fool Theory, which just so happens to lump Bitcoin in as an example of the theory in action, making it a great place to start.

The two main prongs of GFT incorporate the following components of a “foolish” investment thesis: 1) investing in an asset solely with the goal of selling later at a higher price to a “greater fool”, 2) especially when the current price of the asset is overvalued compared to its intrinsic value. Commonly cited examples of GFT in media include those found in Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds, namely the Tulip, Mississippi, and South Sea Bubbles. Similarly, critics of cryptocurrencies often try to draw similarities between the folly of investing in digital assets and the historic speculators who ultimately ended up as bagholders once the hype cycle died down for flower bulbs and mysterious state-affiliated exploration companies, respectively.

Ultimately, I believe both premises of GFT can be argued successfully against, weakening the applicability of the theory. Method one argues that all non-yield-based investing requires a belief in net capital appreciation over time, since if an asset was not predicted to outperform, investment capital would flow elsewhere into other alternatives — thereby making this prong of the GFT overly inclusive, and thus meaningless. The second component in the GFT, which casts doubt on the soundness of an investment when price exceeds intrinsic value, is weakened by the problematic reference to the concept of “intrinsic value” as a fundamental parameter of an asset — we’ll soon examine how the commonly used term is actually an appeal to authority (a type of logical fallacy), and that true intrinsic value doesn’t exist independent from human subjectivity, which is always contentious and debated, not absolute.

Rebuttal 1: All Investing Includes Risk and Expected Gains

The first rebuttal point is easy to make — all investors of any financial asset expect the possibility of selling it for a higher price, and specifically have entered into the speculative position because their underwritten investment case implicitly incorporates positive expected value from the trade. These purchasers of financial assets generally anticipate being able to sell that asset in the future at a higher future price. The decision of which asset to hold in the investible universe, all else being equal, comes down to weighing the pros and cons of a particular investment versus all other alternatives. Even in cases where a position is entered into for hedging purposes, the investor gains value from the improved risk characteristics of the pro forma portfolio when compared to the previous, status-quo version. This example is a brief introduction into the idea of praxeology (of humans fundamentally acting in support of their goals), an underlying methodology of Austrian Economics, which I encourage readers to read up on if they’re interested. At the same time, there is no such thing as investing that is free from speculation, in the same way that there is no true “risk-free” asset. Stocks can miss consensus estimates, corporations can miss interest payments, and even government bonds which are supposedly risk-free can suffer principal loss when new geopolitical events affect market perceptions of the underlying riskiness of the asset.

In this way, we expose one of the errors of GFT’s first prong — specifically the fact that it’s overly inclusive of the entire universe of investing, completely diluting its power. Even the initial purchasers of sovereign century bonds or negative-yielding assets likely incorporate scenarios where rates go further negative, thereby resulting in capital appreciation on their investment. In fact, this is probably the upside scenario that is specifically underwritten from a business case perspective for the investors who have purchased and are currently holding these assets right now. As soon as money is exchanged for any asset (instead of a consumable good), then there’s a directly resulting long position in the asset established, with the corresponding hope and expectation of being able to sell for a higher price. To be clear, reality differs from these expectations, such that investors who are worse at anticipating all the variables do suffer investment losses, though that is not their intention.

Ultimately, it is precisely the actions of individuals who have identified and seek to exploit short-term mispricing of these financial assets which drive the resulting emergent phenomenon of efficient markets in the longer-term. Said another way, this is the apocryphal Benjamin Graham quote (per Warren Buffet) about how the market is a voting machine in the short run, but a weighing machine in the long run.

Rebuttal 2: Intrinsic Value Does Not Exist Independent of Human Subjectivity

We now examine the question of whether intrinsic value exists in any real form, since GFT crucially relies on assets being overpriced relative to this ill-defined baseline. It is interesting that nailing down the concept of intrinsic value can be thought of as both an ontological (the study of existence, not the Chinese token project), and epistemological (relating to the study / theory of knowledge) question at the same time. As part of the process, we’ll walk through some exercises in the following paragraphs, but I posit that when people say “intrinsic value”, it’s actually a short-hand for agreed-upon methods for valuing an asset to then compare against a trading price. Some of the thought experiments will reveal major gaps in the colloquial definition of “intrinsic value” wide enough to drive a truck through, with the resulting imprecision making its usage in the context of GFT essentially a strawman argument, set up only to be knocked down. This, in turn, dramatically weakens the power of GFT as a fair criticism, including when it’s used as to argue against investing in digital assets.

More specifically, the very idea of intrinsic value as an immutable property of a given asset is paradoxical. As a thought experiment, let’s try to value the Empire State building. “Easy enough”, you might say, and point to the roughly ~$2–2.5B range, as informed by earlier deal precedents, or by looking at where the public REIT stock trades at today. Now imagine the world just after the most recent ice age (~10,000 BCE), when modern humans were exploring the Great Rift Valley in Africa. How much was the same plot of land worth back then, intrinsically? Similarly, how much would the Empire State be worth if a virus wiped out all humans a year from now?

In both of the hypothetical scenarios, the answer is pretty clearly zero given the absence of demand for the land, even though the current arrangement of our world results in the Empire State building deriving value from the tourism, commercial activity, and general economic value that is associated with the usage rights associated with the same plot of land. To further clarify, this suggests a major difference between “intrinsic value” and the tangible physical properties of an asset or object (the dirt at the land site in all three scenarios doesn’t change color or consistency depending on whether humans are there to observe it). So we arrive at an interesting realization — that “value” is never actually intrinsic to an asset, but rather is just a short-hand (or heuristic, as referred to by behavioral psychologists and economists) for the sum total of the usage/sales/other rights associated with the land/property. For the Empire State specifically, these are enumerated in the investor disclosure, e.g. the 10-K for ESRT (the NYSE-listed ticker for the Empire State Realty Trust), but for digital assets, those commonly-agreed upon heuristics are still works-in-progress that muddy up the waters, thereby helping unfairly support the Greater Fool Theory.

Continuing the analysis from the bottom-up direction — what is meant by the intrinsic value of a stock? Is it the discounted cash-flow value of the free cash flow thrown off by the business? The EBITDA multiple (which forward year)? An Earnings-per-share multiple? For most stocks, the “right” metric varies depending on which company you’re looking at, which industry you’re looking at, and even who you ask, since there’s still room for debate even in the most liquid and well-covered equities; it is precisely because of the fuzziness of the math, since valuation is truly in the eye of the beholder, that traditional markets see such a frenzy of buyers and sellers, and why I’m not worried about the tribalism and conflict within the cryptocurrency universe going away in a future when the asset class has scaled up.

At the same time, investors and analysts that focus on cryptocurrencies are slowly arriving at some agreed-upon heuristics for looking at certain metrics of Bitcoin and other cryptocurrencies, e.g. ratios based on transaction volume, realized capitalization, or relative to other money or commodity assets. This should result in expected variance (on a percentage basis) in target prices (vs. trading prices) from market speculators narrowing as the cryptocurrencies mature, since the front lines of debate shift from larger details to smaller nuances over time as consensus methodologies are discovered and agreed upon. However, I believe we’re still years away from all of that playing out for digital assets, despite having decades of agreed-upon methods available to plug in for equities, one reason for the distortion and confusion around this whole topic. In the future, it’ll be easier for the retail and institutional investors alike to talk more confidently about the “intrinsic value” of a particular cryptocurrency, but we should be careful not to mistake the absence of a lexical consensus today as evidence of its absence in the future.

A Lesser Greater Fool Theory: What’s Left?

At this point, we’ve examined some serious problems with the Greater Fool Theory when commonly applied to cryptocurrencies. Specifically, the inaccuracy in thinking that a desire to resell an asset for a greater price suggests foolishness on behalf of the investor, when in fact almost all purchasers of financial assets expect net capital appreciation. Second, we explored why the reliance on intrinsic value, as a basis to be compared against the market price, is also a problematic concept given the 1) lack of consensus valuation methodologies in the world of cryptocurrencies compared to traditional assets, and 2) lack of philosophical rigor in the daily definition of intrinsic value in all asset classes, where even when applied to traditional arenas such as stocks and real estate, the word as commonly used refers to a set of heuristics instead of an innate asset-level parameter.

Once GFT loses validity of its two constituent components, then its power as a fair critique of a contemplated asset investment is dramatically weakened since the entire argument at that point rests on two weak premises. To be clear, with respect to getting comfort, GFT is not the only argument that one needs to get over, as there are still plenty of actual investment risks that are unique to cryptocurrencies that remain imperative to diligence. These include learning about the technology, the addressable market, regulatory risk, key-man risk for centralized projects etc. In addition, prospective investors still have to accurately discount for the opportunity cost of capital compared to alternative investments (though traditional asset classes make the comparison easy in terms of risk/reward), and deal with operational issues like securing your keys, keeping a low personal profile. Nevertheless, defusing one of the most common (and in my mind, lazy), phrases used to dismiss further honest debate around cryptocurrencies is a worthy step forward in the broader mission for mindshare and adoption.

Conclusion: Fools Are Sometimes Right, but Often Early

In the classic Hans Christian Anderson fable The Emperor’s New Clothes, it is the foolish child, unburdened by the obligation and fear felt by the rest of the adults in the crowd, who is able to overcome the inertia of the status quo to reveal a truth that ultimately was felt, but not articulated, by others. Although more apocryphal and symbolic than historically accurate, the trope of the court jester (or fool) who is one of the few willing to speak the truth to the monarch, is also applicable here, in the same way that the Greek tragic figure, Kassandra of Troy, was blessed with the power of prophecy but cursed to have no one believe her.

I continue to believe in the inexorability of mainstream cryptocurrency adoption, but have refined that view to think that our journey up the S-curve will largely be an outward-in phenomenon, where those on the fringes of the existing system are still the ones who will more quickly accept the paradigm shift offered by cryptocurrencies, while the majority of the population will only come around later. However, what is currently accepted as normal and quotidian today was once unimaginable, and lampooned as foolish by contemporaries at the time, whether it was the early writers and engineers who dreamt of traveling under and across the sea, soaring through the air, visiting the stars or even creating and enjoying virtually-created digital worlds. If those outlandishly “foolish” ideas turned out to be not only possible, but vital to our society’s commerce and leisure today, what else might we be missing today that will turn out to be vital to the shared future of tomorrow?