My doubts and thoughts about investing in the crypto market

Author: CaptainZ

First, the confusion of investment

When I first entered the circle, I was often confused:

• Is investing in blockchain projects value investment or pure speculation?
• If it's value investing, why do many projects that are obviously SCAM also have a good money-making effect?
• If it's purely speculative, is industry research still useful?
• How to judge the value of a project for primary market investment?
• Why do SCAM projects sometimes generate higher returns than so-called "value investing" projects?
• Why do some people think that VC institutional investment is out of touch with the "market"?

Second, the origin of the stock market

It's not an easy task to answer the above questions, but before we begin, let's first understand the history of the traditional investment market - the stock market.

In the beginning, entrepreneurship was a form of partnership with unlimited liability, but with the budding of capitalism and the emergence of large-scale industry, a new form of organization was needed to encourage investment and entrepreneurship, which could limit the liability of investors. Thus the joint-stock company was born: in which the ownership of the company was divided into transferable shares, and the liability of the shareholders was limited to the value of the shares they held. **

At the same time, the shares of entrepreneurs and investors are locked in business entities, and in order to allow both to make an effective exit and new shareholders to enter, a new open market is urgently needed to trade the company's equity, and the stock exchange came into being. For example, the London Stock Exchange, founded in 1698. With the advancement of capitalism and globalization, the stock market has gradually expanded around the world and has become a major place for companies to raise funds and investors to invest.

III. Evolution of the Valuation Method

Another question arises: how should the company's stock be valued? **

**The first to emerge is the "payback cycle" valuation method, which is how long it takes to recover the cost of an investment. **Suppose an industry with a stable income and a net profit of 100 million yuan a year, if all the profits are returned to shareholders, then investing 500 million yuan to buy shares means that the cost can be recovered in about 5 years. Later, this method was fixed: it was to divide the price of the stock by the profit of a year.

**As a result, the "payback cycle" valuation method evolved into the "price-to-earnings ratio" (P/E) valuation method, from which two valuation parameters were obtained: the P/E multiple and the EPS coefficient. **

Therefore, the P/E valuation method is essentially a rough estimate of the "payback cycle". So for the Bitcoin miner community, do you feel familiar here? That's right, at present, a valuation method commonly used by miners to buy mining machines is the "payback cycle", which actually corresponds to the "price-earnings ratio" of the stock market. **

**The payback cycle, or price-to-earnings ratio valuation method, is a "static valuation method" that does not take into account future changes. **With the development of financial theories, more and more financial practitioners have begun to realize the temporal significance of "cash". For example, in the same industry, Company A's net profit this year is 100 million, and it is expected to be 200 million next year and 300 million the year after, while Company B's net profit this year is also 100 million, but it is expected to have a net profit of 100 million next year and 50 million the year after. So what's the difference between the valuations of the two companies?

Expectation is an "expectation" of the future, and this expectation is based on probability, so there must be a valuation method to reflect this expectation and risk, hence the "DCF Discounted Cash Flow". **The specific mathematical formula will not be analyzed too much here, you just need to understand that the DCF valuation method is essentially the value obtained today after the correction of the "risk-free rate" and "risk premium" with the expected profit return in the future.

**As a result, the P/E ratio and DCF are the two most important valuation methods in the capital markets. **

4. Efficient Markets and Behavioral Finance

However, how can there be such a simple thing in valuation, can it be said that a few formulas can be calculated to know which stock is undervalued and which stock is overvalued? The valuation methods mentioned above are very objective reference standards and do not take into account human subjective factors.

This brings us to behavioral finance. **

Behavioral finance is a marginal discipline at the intersection of finance, psychology, behavior, sociology and other disciplines, which strives to reveal the irrational behavior and decision-making laws of the financial market. **Behavioral finance theory believes that the market price of securities is not only determined by the intrinsic value of securities, but also largely affected by the behavior of investors, that is, investor psychology and behavior have a significant impact on the price determination and changes in the securities market. It is a doctrine corresponding to the efficient market hypothesis, and the main content can be divided into two parts: arbitrage restriction and psychology.

In the 50s of the 20th century, Von Neumann and Morgenstern established a framework for the analysis of rational people's choices under uncertainty conditions on the basis of axiomatic assumptions, namely the expected utility function theory. Arrow and Debreu later developed and refined the theory of general equilibrium, which became the basis of economic analysis, thus establishing a unified analytical paradigm for modern economics. This paradigm has also become the basis for modern finance to analyze the decision-making of rational people. In 1952, Markowitz published his famous paper "Portfolio Selection", which established the modern portfolio theory and marked the birth of modern finance. Modigliani and Miller later established the MM theorem and pioneered corporate finance, which has become an important branch of modern finance. In the 60s of the 20th century, Sharp and Lintner, among others, established and expanded the Capital Asset Pricing Model (CAPM). In the 70s of the 20th century, Ross established a more general arbitrage pricing theory (APT) based on the principle of no arbitrage. In the 70s of the 20th century, Fama formally formulated the Efficient Market Hypothesis (EMH) and Black, Scholes, and Morton established the Option Pricing Model (OPM), and by then modern finance has become a logical discipline with a unified analytical framework.

However, in the 80s of the 20th century, a large number of empirical studies on the financial market found many anomalies that cannot be explained by modern finance, and in order to explain these anomalies, some financiers applied the research results of cognitive psychology to the analysis of investors' behavior, and by the 90s, a large number of high-quality theoretical and empirical literature emerged in this field, forming the most dynamic school of behavioral finance. Matthew Rabin, winner of the 1999 Clark Prize, and Daniel Kahne-man and Vernon Smith, winners of the 2002 Nobel Prize, are both exponents of the field and have made important contributions to the fundamental theory of the field.

**To sum up in a word, various valuation models can help you determine the intrinsic value of assets, but people are irrational, and in the face of the real investment market, investors will produce all kinds of "subjective undervaluation and overvaluation" due to various "psychological biases". **

5. Retail Investors and Market Manipulation

With these basics, we can try to analyze the blockchain digital asset trading market. **

At present, the native blockchain digital asset, unlike the traditional stock and bond markets, does not have a more unified valuation method, so it is difficult to determine the intrinsic value of a mainstream recognition.

Valuation is relatively simple and deterministic by simply using blockchain technology to "issue" coins and thus map a real world asset (RWA).

The blockchain digital asset trading market is currently dominated by retail investors, and the irrational trading behavior is extraordinarily significant, and the market supervision is not clear, so there are many market manipulation behaviors, which further exacerbates the irrational trading behavior.

There are many people who still don't understand why an investment market should be regulated, and their idea is "If someone is willing to sit in the bank, they will definitely pull the market, **How can everyone make money without pulling the market"? In fact, it is this kind of market manipulation that can seriously damage the entire valuation system of the trading market and encourage irrational speculation.

Let's look at some examples, if it is a traditional stock market, the same industry, company A is excellent, company B is poor, then according to the valuation model, company A should be higher than company B's valuation, so VCPE fund companies will take the initiative to invest in excellent entrepreneurs to help them develop their companies, so that they will get a good return on funds. Secondary market investors will also be willing to buy and hold shares of Company A, so that the company's valuation can be supported, and stock holders can also get better returns. It can be said that entrepreneurs, VC investors, and stock investors are a win-win. But if Company B is manipulated by the market, and someone sits on the bank, so that the valuation of Company B's stock is much higher than that of Company A, how will the market react? Do VCs still dare to invest in good entrepreneurs (good startups don't necessarily have good returns anyway)? Do you still dare to buy shares of good companies in the secondary market (the shares of junk companies may rise even higher anyway)? Do entrepreneurs still dare to build a good company (stock prices don't reflect the company's quality anyway)? This becomes a lose-lose market. Over time, when hard work doesn't pay off, the market dies day by day. **

**So do you feel familiar with blockchain digital asset investors? Yes, the current chaos in the market is due to the high degree of market manipulation and unclear regulation. **If the market value of a so-called meme coin is higher than the market value of a so-called value coin, the unclear valuation will affect the investment of VC and the participation of entrepreneurs, and ultimately affect the holders of the secondary market: Anyway, the valuable ones may not necessarily make money, so why not stud the most beautiful boy? Of course, the outcome must be a crash, and it depends on whether the coin holder will leave the market in time when he makes money.

Sixth, token empowerment

To sum up, the clarity of blockchain digital assets in supervision is actually the biggest benefit, which can help the healthy development of the industry and enter a positive flywheel, so that VCs, entrepreneurs, and investors in the secondary market can achieve a win-win situation. **

But before that, the industry will be in a dark and disorderly exploration period, with both value investment and pure speculation: some projects are obviously scam, but the main force will sit in the bank, and some good projects do not have any empowerment of tokens (such as UNI), so everyone does not know how to value, and some projects are doing average, but the token empowerment is very good. From my personal point of view, the degree of optimism is as follows:

• The project is average, but the token empowerment is good
• The project is very good, but the token empowerment is poor
• Project Scam, but the rally is good

Some people may ask: why don't some good projects empower tokens? In fact, it is also caused by the lack of clarity in supervision. Taking UNI as an example, in general, empowerment often involves the redistribution of benefits (buybacks or dividends), which is a typical securities behavior and is bound to be strictly regulated. In order to evade supervision, the team will naturally organize some ethereal "governance coins". As for what kind of project you like, it really depends on your worldview (value investing or speculation).

Seventh, capital-driven or innovation-driven

Another typical sign of an irrational market is that it is "money driven". **As we all know, in the past 10 years, the crypto market has been about a 4-year bull-bear cycle, which corresponds to a 4-year halving cycle for Bitcoin. Why? The reason is well known: halving once in 4 years will cause a significant reduction in the amount of funds in the bank.

**The typical sign of a mature rational market is "innovation-driven", that is, the valuation of the trading market is based on the improvement of the industry by innovation. Of course, the improvements here aren't limited to efficiency gains. As I mentioned in my article "My First Principles Thoughts on the Blockchain Industry", the Internet focuses on efficiency, and the blockchain network focuses on decentralization and fairness, which is not an upgraded relationship, but a "complementarity of world views". Considering that there are 6 billion people in the world, even if only 20% of the population is concerned about equity, there are 1.2 billion, and satisfying the "correct worldview" of these 1.2 billion people also requires good technical means, which still requires a high level of innovation.

The good news is that in the last bull cycle, we finally saw some examples of innovation-driven innovators that allowed innovators, primary market VCs, and secondary market holders to reap huge financial returns, giving the entire industry a chance to enter the positive flywheel.

Many people will worry about the future macro-financial environment, such as interest rate hikes, CPI index, unemployment rate. But the advent of AI has taught us that true innovation is the one that defies the external environment of high interest rates. **Over the past two years, AI startups have not only raised huge sums of money, but secondary market leaders such as Nvidia have tripled their shares in one year. This is the market's reward for innovation. **

**By the same token, if the crypto market really enters a period of "innovation-driven", the 4-year cycle will no longer exist, and the macro environment of high interest rates will not be a problem, but will enter a long-term upward market like AI. **

This kind of "innovation-driven" is not an easy task, and it requires VCs in the primary market to be able to identify where the real innovation is. Another is the need for retail investors in the secondary market to reduce all kinds of irrational investment behaviors. There will be a certain degree of disconnect between the rationality of the primary market and the irrationality of the secondary market, we know that the vision of VC is generally ahead, but this disconnection from the "market" is not a kind of courage? After all, they are supporting the innovation of entrepreneurs. **