The Price of Foolish Expectations

On September 15, 2008, Lehman Brothers collapsed, marking one of the darkest days of the 2007–08 global financial crisis.

A month and a half later on October 31, 2008, Satoshi Nakamoto released the Bitcoin Whitepaper.

Until recently, Bitcoin’s entire existence was limited to the context of an economic recovery and boom.

The past two years have changed that fact.

As inflation mounts from the economic restrictions and subsidies intended to reduce harm from Covid-19, the still rock bottom federal funds rate, and the pent up dollars in bank reserves from Quantitative Easing policies following the 2008 crash, Bitcoin has entered new territory.

What many believed ought to have been a perfect storm for Bitcoin adoption appears at this time to be anything but.

But this is of no concern to the social media financial advisors who still beat the drums, encouraging people to “buy the dip” and “hodl”!

To them, Bitcoin’s price history has been nothing but an upward trend of bubble inflation, collapse, then rinse and repeat. It’s always been this way, therefore it always will be. Past performance guarantees future results, does it not?

Before 2007, there had never been a widespread, significant collapse of the housing market. And then there was.

Good thing for Lehman Brothers, they were too big to fail. Are you too big to fail? Can you afford to find out?

The Information in Prices

Prices are the mutually agreed upon rates of exchange determined through the coordination of buyers and sellers in a market.

From this it may be extrapolated that prices convey information relating to the valuations of consumers and producers in a market, enabling the efficient allocation of resources towards producing the most valued goods and services.

But despite its popularity, that extrapolation is flawed.

If a man values a drink of water, it is not because the water is objectively valuable for being water, rather, the water is valuable to the man as he expects the drink of water to satiate some desire of his.

It is the expectation, not the desire, that leads him to value the water and act upon that valuation.

Expectations are, by virtue of man’s limited nature, imperfect.

If a man expected a drink of salt water to satiate his thirst, he would drink it, and doing so, cause himself more harm than good.

If a man did not know that water would satiate his thirst, he would not drink it, and go without alleviating his thirst.

Absent expectations, values and desires are mere whims of the mind, wholly isolated from the world.

Given mistaken expectations, values and desires remain unsatisfied by actions, or worse; past actions may be revealed to actively work against the values and desires that drove the individual to act in the first place.

Some actions, such as investments in capital, may have long periods of deployment and commitment such that actions taken on mistaken expectations become particularly troublesome to the individual over time.

Consider the homeowner, newly underwater on their mortgage because the housing market crashed.

Prices, then, do not convey information about people’s values, rather, they convey information about their expectations of what actions or chain of actions will best fulfill their values.

As an academic point, this is the answer to whether or not man is a rational actor within economic analysis. In fact, man is rational, but his expectations may be, and often are, flawed to at least some degree.

The Expectations of Price Movements

What expectations drive people to buy or sell?

This is the question that wise investors ought to ask, and ask again on a regular basis.

Consider, if the vast majority of trading decisions are made on the expectation that price will rise or fall because price has previously risen or fallen, is any real information added to the market regarding the underlying value of the asset?

This self-referential speculation brings no new information to the market even as it affects market prices, turning past signals into future noise. Such activity hinders sound economic calculation, distorts entrepreneurial decision making, and ultimately directs resources toward less valued ends.

This is called low information speculation.

A market consisting almost exclusively of low information speculative activities will create price movements indistinguishable from random noise, with spikes and crashes explainable not by fundamentals in the market, but by the fickle and manipulable psychology of money chasers.

This may please those well positioned to take advantage of price volatility, but it is not a healthy condition for a market. Under such conditions, it would be foolish to rely on price as an indicator of true value in the market.

Not all speculation is bad.

When speculators base trading decisions on their expectations of how a fundamental change in the market will affect prices in that market, their trades incorporate the information they are acting upon into the prices they are speculating upon.

If their information was sufficiently correct and complete, they profit as the market adjusts with the proliferation of this information. If incorrect, they take losses.

This is called high information speculation.

High information speculation improves the quality of pricing information, making it easier for entrepreneurs to make sound investment decisions.

Other high information activities include the purchasing decisions of consumers as they act on sound expectations of which goods or services will best fulfill their values at the given price, and the entrepreneur’s decisions to increase or decrease production to maximize profits.

High information activities guide markets into establishing the best price given the underlying conditions of the market.

High information activities in a market lead to better allocations of resources, while low information activities distort the market away from making good investments, even misleading them into making bad investments believing them to be good.

Responding to Bad Pricing

If you can’t trust the information in prices, what should you do?

The answer depends on whether you wish to merely profit off of foolish people’s decisions, or to create sound investments that create value and improve the world.

In the first case, play the markets according to the psychology of the participants, do not invest more than you can afford to lose, and don’t be too greedy. Eventually the low information market will collapse, and you don’t want to be left as the greater fool holding the bag.

Beyond that, I have no advice for you. You will be contributing to the noise in the economy, further distorting the ability for markets to allocate resources efficiently in the pursuit of personal profit. For my own part, I see only foolishness and the destruction of real wealth on that road. If you feel otherwise, good luck to you.

However, if you wish for your investments to contribute to the production of real wealth and better direct the economy towards more valued ends, then my general advice for you follows.

What you should do depends on the scale of the information problem.

During large scale distortion events such as economy wide bubbles driven by monetary inflation, it is very difficult to plan for long term financial optimization without undermining your foundation of real wealth (i.e. housing and other capital).

Under such circumstances, it is usually better to focus on riding the economic boom while living beneath your means, converting financial success into real resource wealth. Acquire real capital in the form of durable and repairable goods, and invest in your own skill set. Further, use the good times to build valuable relationships with family, friends, and business partners. Create a solid foundation upon which you can weather the coming bust, and provide security and stability for those around you. In the bad times, endure.

During more localized distortions, more options are available. As a general rule, speculation in such environments is risky and must not be overextended. Never invest more than you can afford to lose.

Beyond this, seek out valuable information, especially about those assets that are either adored or shunned by low information speculators. Explore them in depth to see if there is hidden knowledge that may be acted upon and will alter the future state of the market.

In some cases, underappreciated investments may have developments that will bear fruit in the future, while over-appreciated assets may be riding a high that will collapse, with malinvestments surrounding it that will deepen its inevitable crash.

Bear in mind, no investment is a sure thing. Putting up resources for others to use in the hopes of future returns for yourself always carries risk. Risk is inevitable in the market process, as market prices are always moving according to the information and expectations that market participants are acting upon at that moment.

Markets can “forget” even the most valuable and obvious facts if sufficiently distorted.

It is through these variations away from the “right” price, that price which is best justified by the real conditions surrounding the market, that allows high information speculators to profit, and for entrepreneurs to fill unfulfilled needs in the market.

Never make the mistake of treating the current market state, even when the market is healthy, as ideal. The market doesn’t “decide,” but it keeps deciding with every new exchange.

You can help it to make good decisions, or contribute to its bad decisions.

The Cryptocurrency Markets

We return now to Bitcoin, and all the offshoots from it.

Bitcoin has only existed within the context of a global financial recovery and boom. Only now are we seeing the turn into what may become a global economic crash.

Yet the crowds chant that Bitcoin’s price always goes up into ever higher bubbles. All you must do to get rich is to hold BTC for long enough! Diamond hands, everyone. Sell your house and buy, buy, buy!

Speculate on the memecoins, the ICOs and the JPEGs. Above all else, fear that you’ll miss out!

Be decentralized! You can even create your own definition of “decentralization” that pleases you, and yes, that crypto definitely has it, just so long as you buy it.

Look! See the number go up? Don’t you want to taste some of that juicy profit? Care not from whence it comes, or for what it is used. You could be RICH!

After all, the market has decided. You aren’t smarter than the market, right?

We’re all gonna make it, so long as you just join in. You wouldn’t want to not make it, right?

But look, there’s someone who isn’t going to make it. Tell him to have fun staying poor. You don’t want to be poor, right? Go on. Tell him.

After all, it’s only your life savings. It’s only your family’s future. What is that but a trifle to gamble with?

These prices, as you can see, will always go up, because they always have gone up, if you only hodl for long enough.

Before 2007, there had never been a widespread, significant collapse of the housing market. And then there was.

Before 2022, Bitcoin had never experienced a widespread, significant economic crisis.

What happens next?

Can you afford to find out?