The ongoing correction can turn into a nightmare for retail investors

There is something called ‘fundamentals’. In any investment space, where sanity takes precedence over-speculation, fundamentals are at the heart of all investment decisions.

Why did global stock markets fall sharply last year when the pandemic struck? Because the fundamentals weren’t promising. Economies were entering lockdowns, and with shuttered businesses, one cannot expect companies to register high returns. Shares, which represented these companies on the stock market, plummeted owing to weak fundamentals, including subdued revenue growth, deferred investments by companies in new products and markets, and negative sentiments surrounding job growth.

Absence of fundamentals in crypto investment

The primary concern in the crypto space is that the sector lacks fundamentals. Bitcoin, the most popular among the lot, aims to either replace fiat currencies with ‘quick and cheap’ money transfer advantages of the underlying blockchain technology or become a reliable constituent in the global currency realm. To this day, nothing on this count has been realized, and El Salvador’s risky bet of making bitcoin a legal tender has been largely rebuffed. Altcoins, which include the second most valuable crypto, Ether, and Elon Musk’s ‘Baby Doge’ or Dogecoin, have had anything but a stable run.

Enter FOMO or fear of missing out. The fear of missing the cryptocurrency bandwagon gripped amateur retail investors more than their cautious counterparts, seasoned institutional investors.

Retail investors in cryptocurrencies

What does a retail investor, awestruck by the legacy of a multi-billionaire CEO, do when he tweets about working with developers of a ‘potentially promising’ altcoin? The investor doubles down on that particular altcoin and hoards more of it. In today’s world, where news is consumed more on social media than on traditional avenues and where incidents like ‘Ronaldo-snub’ wipe out billions from the value of an S&P 500 Index stock, sentiments can be shaped even in the absence of fundamentals. Bitcoin and other constituents of the crypto world are often among the top trends on Google. Exchanges like Coinbase and Binance and platforms like eToro have enabled swift, ready hasty buying and selling for retail investors.

A cursory look at the trading volume on Coinbase reveals the actual picture. In the first quarter of 2018, the share of retail investors in total trading in cryptocurrencies was 80 per cent. Although this share has come down to 36 per cent by the fourth quarter of 2020, volume traded by retail investors in these three months was a whopping US$32 billion. One can blame social media platforms that track users’ browsing history and display targeted ads prompting the user to invest in a speculative asset like cryptocurrency.

Tulipmania and the greater fool theory

The greater fool theory in investment space is about how an additional buyer in the string allows the price of any asset to rise even when the asset lacks commensurate intrinsic value. Critics have begun to call the cryptocurrency mania a greater fool kind of bubble, but matters can further slide.

The Tulip Mania was a 17th-century phenomenon amid the Dutch Golden Age. The tulip flower gained prominence as a status symbol, and people doubled down on their purchase of its bulbs in the hope that the momentum will not fade. But this bubble burst in 1637. Any tradable asset’s value relies on market sentiments, which are shaped by fundamentals in the case of seasoned investors. For example, will the product or service of the company have a greater demand in the near future? A stock is bought or sold on these sentiments. In the greater fool space, however, fundamentals have little role.

The crackdown continues

China’s crackdown on cryptoassets and focus on its digital yuan has led to the global scrutiny on a major cryptocurrency exchange, Binance. From Italy to Hong Kong, financial watchdogs have been inquiring into its services, compelling it to halt operations in some regions. Recently, the exchange said users would not buy ‘stock tokens’ on the platform. This is not the first time that exchanges threw investor interest out of the window. In Turkey, Thodex, a locally popular platform, went offline in a blink of an eye, with investors losing hundreds of millions of dollars in investments. Another exchange in Turkey, Vebitcoin, also abruptly stopped operations in April 2021.

Multiple factors have added to volatility in the sector, from cryptos’ excessive power consumption to flaws in the ‘immutability’ of smart contracts created on the blockchain. Moreover, the multi-billionaire CEO, often a backer of the decentralized form of currency, has also lately backtracked on his positive stance.

In the absence of any investment opportunity in the crypto space, retail investors, with enough money despite the economic downturn brought by the pandemic, thanks to governments’ stimulus, would have built their portfolio in a relatively stable asset class, the stock market. The market comes with fundamentals, on the back of which the S&P 500 Index gave double-digit returns to investors in the last decade.

An unwinding of sorts is underway in the crypto investment space, but it will be the seasoned investors that will be the early movers with respect to booking any profits or limiting losses by taking quick selloff decisions. With little understanding of fundamentals, the amateur retail investor will have to act fast not to give away wealth to shrewd participants in the space.