analysis

Hunt for next bitcoin to spark wilder crypto swings

When investors see extreme gains, high volatility and low nominal prices, they tend to treat assets like lottery tickets

Ben Carlson, Bloomberg
13:22 December 30, 2017

If you thought bitcoin has been on a wild ride, check what happened last week with litecoin.

The newer cryptocurrency, which is supposed to be a faster version of bitcoin with a larger supply of coins, increased from around $100 on December 8 to more than $370 by December 12, a gain of 270 per cent. The price has come down, but even after a fall from the peak, litecoin is up more than 7,000 per cent for 2017.

The question is: Why did litecoin shoot up in the span of a few days? There was no news to speak of. There were no changes in the technology or new versions of the currency. One of the biggest reasons for this price boom is that litecoin now has an exchange where investors can easily purchase it. Much as investors in the tech bubble had E-Trade to buy dot-com stocks, cryptocurrency investors now have Coinbase, which has been at the centre of bitcoin speculation because it is so easy to sign up and begin buying.

By the end of November, Coinbase announced it had more than 13 million users. To put this in perspective, Charles Schwab only has 10.2 million client accounts, though the traditional broker has a much larger asset base. At one point, the Coinbase app was the most downloaded on Apple’s App Store, showing that people are in a rush to invest in these assets and are doing so through their smartphones.

The reason mobile matters for litecoin is that investors are easily fooled by numbers when making their buy decisions. Litecoin was just added to the Coinbase line-up in May, and it has the lowest price of the three available assets on the platform. For now, Coinbase users can only trade bitcoin, the Etherum network’s ether, or litecoin. This is what the interface looks like when Coinbase customers pull up the app on their phone to check the prices of the cryptocurrencies on the platform:

A glance at the prices on the exchange would seem to indicate that litecoin is much cheaper than the other two crypto-assets. Of course, users are able to purchase fractional units of each so it doesn’t really matter what the nominal price point is. For example, Berkshire Hathaway has a price of almost $300,000 per share while Facebook’s stock price is closer to $180. But both have a market cap close to $500 billion because there are different numbers of shares available. Investors shouldn’t be concerned with the share price but rather the overall value.

Although rational people should be able to figure this out, there are times when investors are not rational and use nominal share prices to determine their buying decisions. This occurs in particular when asset prices have lottery-like features. With the huge gains in cryptocurrencies these days and the number of people rushing in with the hope of getting rich quick, this is a perfect example of how security price levels can affect investor buying impulses.

Researchers from the University of Washington studied the characteristics that cause investors to gamble and drive up prices:

Barberis et al. (2005) argue that when groups of investors concentrate their trading within a specific habitat or category of stocks, fluctuation in those investors’ sentiment can lead to nonfundamental comovement among those stocks. In addition, prior studies show that investors with a taste for gambling concentrate their trading in lottery-like stocks with high skewness and volatility and low nominal prices. Those investors with gambling preferences trade actively, and their trading activities are often correlated, perhaps due to their stronger behavioural biases and because their demographic attributes are similar. Given the observed behaviour of gambling-motivated investors, we conjecture that the lottery-like stocks favoured by these investors would exhibit excess return comovement.

When investors see extreme gains, high volatility and low nominal prices, they tend to treat assets like lottery tickets. This study also found that investors with this propensity to gamble also trade these types of securities more actively, which can make similar securities more strongly correlated to these moves as these market participants are always looking for the next big thing.

So while there were no fundamental reasons for litecoin to skyrocket in recent weeks, there is a behavioural explanation. This type of move doesn’t last forever, even in early-stage markets such as this, but you can expect to see this behaviour in other cryptocurrencies in the future as people try their best to pick the next winner.

It’s estimated there are now more than 1,000 different cryptocurrencies. Eventually more of them will find their way to Coinbase as customers demand a more diverse opportunity set to trade. You should expect to see more wild price swings as investors look for the next lottery ticket in cryptocurrencies.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ben Carlson is director of institutional asset management at Ritholtz Wealth Management. He is the author of “Organizational Alpha: How to Add Value in Institutional Asset Management.”