- Investment Workshop 59: Are Robo-Advisors Compatible With FIRE? - June 22, 2020
- Reader Case: Grounded in Vancouver and Dreaming of FIRE - June 19, 2020
- Real Estate Agent Gets Crushed by Real Estate Math - June 8, 2020
After last week’s rather amusing debate about crypto-currencies, I thought it’d be interesting to keep the conversation going by examining two rather interesting reactions that came out of that in the comments: FUD and FOMO.
What are FUD and FOMO?
FUD stands for Fear, Uncertainity, and Doubt. I first heard this term from salespeople in the high tech sector, who used the strategy of spreading rumours about rival companies (“I heard their chips catch fire all the time”) in order to make their companies’ products look better by comparison, but it also applies in the investment world too.
Basically, when nasty rumors or unsubstantiated claims about a company gets shared via social media, this may cause enough people to freak out and sell their holdings in that company, which could drop the price of the stock. This is known as “spreading FUD,” and was what I was widely accused of doing on my last Monday article.
FOMO stands for Fear Of Missing Out, and was first used to describe people looking at their friends’ posts on social media documenting their awesome lives and then feeling anxiety that their life isn’t nearly as interesting (“Why can’t I be at Coachella? Life is unfair!”)
In the investing world, FOMO is what happens when an investment rockets up in value and people get anxious that they’re not participating in that upside.
At the end of the day, though, FUD and FOMO are simply two different manifestations of the same emotion: Fear. FUD is the fear that something you own will go down, and FOMO is the fear that something you don’t own will go up. People who feel FUD or FOMO fear not only the monetary losses (or unrealized gains) in their bank accounts, but often fear the imagined ridicule they will face by not acting on that information. “Everyone else is making a fortune, and they’re going to point and laugh at stupid ol’ me because I didn’t have the balls to come along.”
Why Are FUD & FOMO Bad For Your Finances
If that doesn’t sound like fun, that’s because it’s not. Fear is an extremely powerful emotion, and studies have shown that investors feel the sensation of fear about twice as strongly as they feel the sensation of greed or hope.
In fact, there’s an entire field in economics that studies this phenomenon known as Behavioural Finance. Classical economics theory is based on the Efficient Market Hypothesis, which is basically the idea that all traders in the stock market act perfectly rationally, and once information about a stock becomes available, the market always correctly and perfectly prices in that data.
But we of course know that bubbles can and do form, and when they pop it can lead to a very painful correction. Behavioural Finances tries to explain why this happens, and here’s an explanation of what they found, re-enacted by cats.
For a bit of background on the following pictures, we were at a cat cafe a few months ago, and there were a bunch of cats lazing about, as cats do. There was this paper shopping bag lying on the ground and FIRECracker decided to open it up and stand it upright.
One cat took notice of the now-totally-interesting paper bag.
Soon ALL the cats were crowding around it.
A fight breaks out…
And finally one cat emerges victorious, the proud owner of a paper bag that they had now decided to use as a house.
Behavioural finance calls this “herd mentality.” Basically, the behaviour of one trader tends to mimic the behaviour of the herd, so when one cat got really interested in this previously-worthless paper bag, FOMO set in, causing a stampede to own it.
Similarly, when FUD propogates into enough people, they panic and run for the exits.
This also, by the way, happened in our cat cafe example, because soon after these pictures were taken, another customer accidentally stepped on the bag not knowing there was a cat inside. The cat yelped, realizing that paper bags are NOT effective houses, and ran away. None of the other cats wanted anything to do with the bag after that. Sadly, I did not get that on camera 🙁
Anyway, the point was that herd mentality, caused mostly by FUD and FOMO, hurts investors because it encourages the wrong behaviour. People ran in and bought things when they were pricey (since everyone else was doing it), and sold when they were cheap (since everyone else was also selling). In other words, they bought high and sold low. This is the opposite of good investing.
The most successful investors, they found, were able to successfully tame their reactions to FUD and FOMO, and in some cases were able to do the opposite that their lizard-brain instincts were telling them to do. And speaking from previous experience, this is incredibly hard to do.
I still vividly remember what it felt like to have nearly all my net worth invested when the stock market crash of 2008 happened. The stock market was falling so rapidly that I would put in $1000, only to have my balance go down by over $1000 the next day. It literally felt like I was lighting money on fire. The media was screaming about the collapse of the global financial system, so you literally couldn’t turn a corner without getting FUD smashed into your face.
But I ignored my emotions, and continued buying into the storm. A year later I had recovered all my money, and almost a decade later I quit my job with a million bucks to travel the world.
Being able to control your emotions in the face of extreme FUD or FOMO is one of the keys to being a good investor.
So Shouldn’t I Ignore FUD When It Comes to Bitcoin?
Some of you are probably thinking “Well then OK, tough guy. If you’re so good at ignoring FUD, why don’t you ignore the FUD when it comes to Bitcoin and buy into it huh? HUH?”
That’s actually a fair question, so let me address that.
Being able to control your emotions in the face of FUD or FOMO is one of the keys to being a good investor, but it’s not the only key. You still have to understand how to evaluate what an investment’s worth. If you just blindly do the opposite of what everyone else is doing, you’re still being controlled by the emotional whims of the masses. So let’s talk a little bit about how to figure out an investment’s value.
In the world of finances, there are two basic ways to evaluate an investment: Technical Analysis and Fundamental Analysis. Technical Analysts are known as “chartists” because they sit around all day and stare at charts. “Stock ABC is exhibiting an Inverted Head-And-Shoulders pattern while Stock XYZ is starting to form a Death Cross! Buy ABC and Sell XYZ!”
These people look for patterns in stock price movements and use that to gauge investor sentiment. Each support and resistance level in Technical Analysis acts like a voting mechanism where competing traders argue about the price of a share. Sometimes a breakthrough happens, meaning one side overwhelms the other causing the share’s price to either smash through a support level downwards or bust through a resistance level upwards.
In other words, Technical Analysts stare at charts and use patterns to try to predict when enough FUD or FOMO will build up to cause a major change in price, and they in turn use that information to profit.
It’s an interesting field of study, but I don’t think it works for average investors like us.
We don’t have access to the news feeds, the supercomputers that calculate and trade on this information, or the time & energy it takes to stare at a chart all day trying to outguess a moving line.
Instead, I evaluate an investment based on Fundamental Analysis, which measures a stock’s value using metrics that measure the health of the underlying company. Metrics like price-to-book (P/B) ratios, price-to-earnings (P/E) ratios, and dividend yields.
These actually look at the long-term value of the underlying asset, rather than the short-term gyrations of its price. And what I’ve concluded is that the index funds of major economies like the U.S., the E.U., Australia, Canada, etc. have really, really good Fundamentals. That’s because they invest in many different companies, some of which may soar and become the next Apple and some of which may crash to zero, but on the whole the index continues to profit and grind higher and higher.
Index funds, in other words, own so many companies with so much intrinsic value because those companies generate so much profit that it’s practically impossible to lose owning them.
Cryptocurrencies, on the other hand, have no instrinsic value.
What Is a Bitcoin Actually Worth?
Cryptos have fascinated me because unlike most investments, they are purely speculative.
Every other investment out there has some instrinsic worth. A stock in a company is worth a multiple of how much it earns. A house is worth the rent saved by living in it. Even gold can be melted down and turned into really overpriced HDMI cables.
But a Bitcoin? It has zero instrinsic worth. It’s just a series of bits that represents a solution to a mathematical equation. I can’t use it for anything, nor can I exchange it for a sandwich.
As a result, I can’t evaluate it’s worth based on any fundamental analysis technique. Forex traders of fiat currencies can use purchasing power, or interest rates, or whatever to assign a value to a US dollar, Euro, or Malaysian ringit. None of those techniques work, so from a fundamentals point of view, a Bitcoin is worth zero.
But if I were to go to an exchange right now, they would report that a Bitcoin is worth about $7000 USD.
But what they’re reporting is its speculative value. A Bitcoin is worth about $7000 USD not because it’s actually valuable but because another trader on the crypto markets thinks it’s worth $7000 USD.
So that means if Fundamental Analysis doesn’t apply, the only valuation technique that works for Bitcoins is Technical. This is why FUD and FOMO have such huge effects on the price of cryptocurrencies like Bitcoin. Without any way of valuating underlying value, market sentiment and investor emotions make up 100% of the Bitcoin’s price. And since investor emotions are, by nature, extremely volatile, that’s why Bitcoin’s price is equally volatile.
I wrote last week that the lack of regulation on the exchanges was why I completely abandoned the crypto space. But one day that might change. A government may step in, formally recognize crypto as a currency and properly regulate it. Countries such as Japan and Malta are already starting to do that.
However, even if that day comes that crypto can be safely traded without fear of hacks or exchange failures, I still don’t think I’ll be coming back. Because I can’t figure out how to valuate the damned things!
All my investing success thus far was because I was able to ignore the FUD and FOMO, whether it was during the stock market crash, or with real estate, or whatever. I made my investment decisions instead by MATHING SHIT UP.
I can’t MATH SHIT UP with crypto. So I don’t think I could ever own it again.
What do you think? Is there a way to evaluate the value of a Bitcoin that doesn’t involve just reacting to FUD or FOMO? Let’s hear it in the comments below!
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