Legendary investors and Nobel Prize winning economists such as Warren Buffett, Ray Dalio, Jamie Dimon, Robert Shiller and Joseph Stiglitz have all declared that cryptocurrencies are a bubble.

In this article I start describing what a bubble is and whether or not we’re in one. I then look at the possible effects of a bubble, using the 2000 dotcom bubble as a case study. Finally, I look at some of the strategies we can implement as cryptocurrency investors and long term holders in order to be prepared for any eventuality.

I won’t spend too long discussing whether or not we’re in a bubble (I don’t know nor do I think anyone can know) but rather examine the effects of a possible bubble on cryptocurrency believers and long term investors as well as what a rational response might be.

What is a bubble and are we in one?

A bubble occurs when an asset’s price exceeds its intrinsic value. While the word “bubble” sounds scary, almost all new technologies tend to go through one. Evidence shows that railways, radio and obviously the internet all underwent bubbles before they became mainstream. As Fred Wilson, founder of Union Square Ventures, tells us:

“A friend of mine has a great line. He says ‘Nothing important has ever been built without irrational exuberance’. Meaning that you need some of this mania to cause investors to open up their pocketbooks and finance the building of the railroads or the automobile or aerospace industry or whatever. And in this case, much of the capital invested was lost, but also much of it was invested in a very high throughput backbone for the Internet, and lots of software that works, and databases and server structure. All that stuff has allowed what we have today, which has changed all our lives… that’s what all this speculative mania built.”

Why do new technologies tend to bubble up? Because it’s very hard to value a new technology’s intrinsic value using traditional valuation methods (present value of discounted future cashflows) as they generally don’t generate any cashflows until very far into the future. In the case of blockchain technology this becomes even more difficult as many of them will never generate cashflows and yet will nevertheless be incredibly valuable.

With no cashflows in sight to ground people’s excitement, hype and FOMO reign supreme as people begin to speculate on all the possible industries the new technology could supplant (i.e. “decentralize everything”) with little regard for feasibility and time scales of how long this could take to come to fruition. Thus, the price increases and the “social contagion” effect described by Schiller begins to take place:

“News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fueling “new era” stories, and so on, in successive feedback loops as the bubble grows.”

So are cryptocurrencies in a bubble? The reality is it’s impossible to say for sure because it’s extremely difficult to accurately calculate the intrinsic value of the technology. However, there are definitely some warnings signs to watch out for. As John Rothschild wrote in 1996:

“Joe Kennedy, a famous rich guy in his day, exited the stock market in timely fashion after a shoeshine boy gave him some stick tips. He figured that when the shoeshine boys have tips, the market is too popular for its own good.”

Looking on the news or browsing through Facebook will reveal a similar trend: cryptocurrency investing is hot right now and just about everyone (including Paris Hilton) seems to be getting in on it.

On the positive side, even if we are in a bubble, the 2000 dotcom bubble was primarily a North-American phenomenon and yet reached $3–5 trillion in size 17 years ago. Cryptocurrencies are a global phenomenon and yet are currently only worth $300 billion — meaning the bubble has a lot of room left to inflate.

Hodling through a bubble — a comparison with the 2000 dotcom bubble

There seems to be an underlying belief (faith?) among crypto investors that even if there is a bubble and this bubble pops, this won’t affect long term hodlers as the crypto market will always recover and reach new heights in the long-term.

Don’t get me wrong, a bubble bursting doesn’t necessarily matter if you’re a disciplined hodler and the asset you’re hodling has real underlying value and long term potential. Historically, most markets have recovered from these kinds of crashes and topped the peak bubble values eventually. However, if you buy at the wrong price, eventually may turn out to be a hell of a long time. For reference, here are some stats from the 2000 dotcom bubble.

The tech market took 17 years to get back to the values it was at during the 2000 tech bubble. Looking at specific companies shows a similar story. Microsoft stock price was $59/share at the peak of the tech bubble in 2000. It only surpassed this again at the end of October 2016. If you’d bought in mid 1999 (which was nowhere near peak bubble values in early to mid 2000) and decided to HODL, you’d have had to wait until August 2014 to break-even.