I’ve always loved math. I find reassurance in its orderliness. Complete the proof, make both sides of the equation match, and everything objectively makes sense. Beautiful.
It might come as a bit of a surprise, then, that when people ask what formulas I’m using to value cryptoassets, I don’t have a clean answer -- and that’s not for a lack of thinking about it.
I see a lot of investors in crypto working on equations to calculate things such as the future network values, token price targets, and the like. Many of these folks are brilliant and some of them will undoubtedly make major contributions to the emerging field of crypotoeconomics. But a lot of them will be catastrophically wrong.
The shortcomings of the efficient market theory from traditional markets is an interesting example of the dangers of overreliance on math, especially in areas that are not yet well understood. Charlie Munger addresses this in his brilliant 1995 speech on the psychology of human misjudgment. “What made these economists love the efficient market theory”, he says, “is that the math was so elegant”. Of course, Munger (nor Buffet for that matter) does not believe in perfectly efficient markets. He goes on to note that Berkshire Hathaway’s overwhelming success over the past several decades is evidence of the flaws in this theory.
Amazingly, research shows that even nowadays, hedge funds that do more research outperform others - and this information is publicly available. Reading SEC filings should not be a profitable, or a source of alpha. And yet, here we are. Even the stock market, which is much more mature than crypto, is not even close to being perfectly efficient.
In a market that’s as poorly understood and inefficient as crypto is right now, my take is that formulas offer little value (and worse, can even lead you astray entirely). We don’t understand how things like token velocity, community, and thousands of other factors will interplay. For instance, I believe that much of bitcoin’s success can be attributed to a quasi-religious fervor in its early community. That effect is real - but I have no idea how you accurately quantify it. Along the same lines, how do you neatly package the strength of ethereum’s developer community into your equation?
One option is to treat it as a company, and arrive at a valuation based on “cash flows”, or transaction fees paid to the network. Or, we could decide whether we think it’s similar to gold and derive a value based on a multiple or fraction of that market cap. Or, we could turn to monetary economics and employ the M V = P Q formula. Ultimately I find that any of these methods is incomplete.
We end up measuring things that are easiest to measure — often omitting things that are critical but difficult to quantify. And these are not fools’ mistakes; this happens to the smartest minds around. (For an interesting example of this in action, see Rana Foroohar’s recounting of the Whiz Kids and the dangers of a purely data-driven approach in Chapter 2 of Makers and Takers).
The math gives the illusion of certainty and unfortunately often leads to thinking you’re more clever than you are. It’s easy to become dogmatically attached to the math and think that your formula must be right - when the evidence says otherwise.
Personally, I don’t really care about having a formula at this point in time. I’m comfortable with a degree of uncertainty. The swings in crypto are so large that the market comfortably supports this approach. In a few years the market will have tightened and we’ll better understand the dynamics at play, so formulaic investing will start to make more sense, but that’s a ways out. So for now, I hope to be imprecisely, directionally right, than precisely wrong.
Thank you to Mike Maples for reviewing and suggesting the title.