How the Crypto and Meme Bubbles Threaten Ordinary Investors
The next market correction will inflict its worst damage on crypto and meme investors, but those saving for retirement in a diversified, disciplined manner will suffer alongside them.
A bubble occurs when the price of an asset inflates well beyond its fundamental value. Bubbles often form when the imaginations of investors are inflamed by unrealistic expectations, sharp recent price increases (and the fear of missing out), and, most importantly, a fundamental value that is opaque and subject to wild divergence of opinions.
A new article by UCLA emeritus professor Bradford Cornell takes aim at the ethereal wealth of cryptocurrencies, and the author presents an important thought experiment about the value of financial assets. Cornell asks readers to consider whether the current $1 trillion market value of crypto actually represents $1 trillion of wealth. If crypto can be sold and turned into $1 trillion of fiat currency, then there should be no argument about its value.
The article presents an example of an economy that consists of three individuals (A, B, and C). Each holds 10 units of “real” wealth. A invents a digital coin, develops a story about its value, and sells it to B for one unit of wealth. Now A has 11 units and B has 9 plus the coin, which is worth one unit, so collectively all three now have 31 units of wealth.
C wants to get in on the action and buys the coin off B for two units of wealth. Now A and B both have 11 units of wealth and C has 8 units and a coin worth two units of wealth, for a total social wealth of 32 units. Collectively, the three are now two units wealthier. But C is stuck with a coin whose value story was invented by A and accepted by A and B. If nobody believes the value story anymore, A and B still have 11 units of wealth and C (the poor sap) is stuck with 8 units of wealth and a worthless coin.