This week, I am going to answer another question that was sent to my Ask Kim mailbox: askkim@sanecrypto.com. The gist is “What is an ICO and why don’t you invest in them?”

Dina writes…

Love your podcast. I have been in crypto for just over year. I own about eight different coins, all of them ICOs. You seem to be the only person in crypto who does not recommend alt coins. Can you explain your logic? Trying to figure out if I am making a mistake. Looking forward to your answer. Dina.

So, before we jump right into answering Dina’s question, I want to pause just a minute and define some terms she uses in the question.

Alt-coin is the term for any crypto asset other than Bitcoin. Bitcoin was the original. Everything else are referred to as alt-coins.

ICO stands for Initial Coin Offering. This is how most alt-coins, come to market. Much like a company traded on a public exchange has an initial public offering, or IPO, to raise money from the general public, many crypto assets raise money through ICOs.

What is an ICO? it’s backwards fund-raising.

Traditionally, the way fund-raising was done is an entrepreneur comes up with a product or service to fill a need or hole in the marketplace.

They establish product market fit. They build out minimum viable product. They get revenues and profit. Hire a team. Spend years building the company, possibly raising some capital along the way in various funding rounds — maybe from friends and family to start, then angel investors, and finally from venture funds.

After years of slogging and crafting and honing the product, they file paperwork with the SEC for an IPO.

There is a tremendous amount of due diligence done by the Wall Street firm underwriting the offering. Not to mention criminal penalties for misleading investors in the prospectus.

There is a road show where you pitch to investors. And finally, the day finally comes, where the company is listed on an exchange and publicly traded.

When you or I buy those shares, we actually own a percentage of the company. We have voting rights, etc.

An ICO, is a totally different kettle of fish.

Meaning, the way it works is the team publishes a white paper detailing the problem the team is planning to solve and how they propose to solve it.

This white paper may have the names of some PhD’s on it… or maybe not. But to be clear, you can buy a white paper written by a PhD for about $50K. So that is meaningless.

There is really no oversight or due diligence. At the moment, there is no registration with the SEC, although that may change soon, as we’ll discuss.

They offer coins for sale, as a way of pre-funding the project, no different than if I want to build a cool new drone and I run a Kickstarter campaign asking people to pre-fund the project.

If there is enough interest, people think it is cool, they send me money in exchange for the promise of getting my drone when and if I ship it. There is no ownership rights. No guarantees that I will actually ship my project. Nothing.

What could possibly go wrong with people raising $100’s of millions of dollars on the basis of a white paper?

When alt-coins are issued, whether through an ICO or some other means, there are really two reasons to own them.

One is because these coins, in theory, are integral to the working of the project.

If I bought Filecoin, for example, which is sort of a decentralized Dropbox, I need those Filecoins in order to transact on the Filecoin network… To store files and/or get paid for storing files.

Those are what are referred to as utility coins. They provide access to the network or the project. And I would hold them because if the project comes to fruition, I think it is cool, like the drone, and want to use it.

ORRRR… I am holding them as an investment with the expectation that they will go up in value. With me so far?

So finally, we have enough background that I can answer Dina’s original question about why I don’t invest in any alt coins other than a small allocation to Ethereum.

Specifically, I hold a market cap weighted portfolio of Bitcoin and Ethereum, periodically rebalanced. And the question is why? What is my logic?

It is very simple and boils down to risk. I believe, every single crypto asset you buy, beyond Bitcoin, incrementally increases risk without a commensurate reward for that risk.

With Bitcoin as our measuring stick, as a stand-in for what investors refer to as beta, or the market return on a risk adjusted basis …

In my mind there are three enormous uncompensated risks, relative to Bitcoin, without even considering the fact that I think a massive number of these alt coins are outright blatant money grabs.

And there is really no way for a retail investor to know which are which, I don’t care how much research you do. It’s just delusional to think otherwise.

So, to start off with, you are basically playing a game of financial Russian roulette with each coin and the odds get worse and worse every time you pull the trigger.

So you are starting there….

And then assuming, when you pull the trigger, you didn’t get your head blown off by buying a scam, the real projects have three monumental risk hurdles.

They are:

  1. Regulatory risk
  2. Wrong Wave
  3. The velocity problem
Of these, I think regulatory risk is the easiest to understand.

The SEC and CFTC, here in the States, have begun to finally clarify their positions on crypto assets.

On the one hand, the chairman for both, in testimony before Congress, have come out and said that their guiding principle is to do no harm. In other words, to try not to kill the innovation and potential benefits we could derive from a new and exciting technology. But, at the same time, live up to their mandate, which is very simply to protect investors from fraud.

They have also very clearly said that Bitcoin is not a security and its issuance has not violated any US Securities law.

On the other hand, ICO’s… they have said ARE unregistered securities, or at least were at the time they were issued and have, therefore, broken the law.

So every crypto asset, brought to market via ICO, has the cloud of uncertainty as to what, if anything, will be done retroactively and how will that affect the future viability of the project.

Next is what I call Wrong Wave.

This refers to Steve Case’s excellent book, the Third Wave, which I highly recommend you read. I think it is immensely useful in thinking through the likely path this technology will take.

If you are not familiar with the name, Steve Case was the Founder and CEO of AOL, one of the poster children of the Internet and whose millions of CDs mailed to consumers across the country opened up mass adoption of the Internet.

Reading from Amazon’s description of the book:

“The first wave saw AOL and other companies lay the foundation for consumers to connect to the Internet. The second wave saw companies like Google and Facebook build on top of the Internet to create search and social networking capabilities, while apps like Snapchat and Instagram leverage the smartphone revolution. Now, Case argues, we’re entering the Third Wave: a period in which entrepreneurs will vastly transform major “real world” sectors like health, education, transportation, energy, and food-and in the process change the way we live our daily lives.”

Many, many, many of the ideas that crashed and burned after 2000, were not bad ideas. They were the wrong wave. In other words, they were too early.

There are countless examples…

Pets.com for example, kind of the poster child because of their sock puppet commercials, is the exact same idea as Chewy.com, which was bought last year by PetsMart for $3.35 billion dollars.

eToys.com was another flop… too early.

If pets.com was the most famous Internet bust, Webvan, which was grocery deliveries, was the biggest, taking down over $1.2Billion of market cap down with it … Yet, today, we use the Internet to have all sorts of things delivered, including food and groceries.

And finally, just one more example… anyone remember TheGlobe.com? They were the first social media site and also had the biggest public offering.. going up 600% on opening day.

Of course, by crypto standards, that seems downright pedantic. The company raised $27.9 million in its IPO, and its market cap was valued at $842 million. But less than two years later, in August 2001, theGlobe.com’s stock was delisted by the Nasdaq stock exchange for failing to stay above $1 per share.

Again, too early. Wrong wave!

And I just scroll down many of these projects and think, yeah, someday … but not now. This is the first wave and you are trying to build, or at least pitching, a Second or Third Wave project! It’s just so obvious that history is repeating itself.

And then finally, you have what is known as The Velocity Problem.

And this one is the most esoteric and hardest for non-professional investors to get their brain around.

I will link to quite a few articles on this. But, in a nutshell, it says that for most of these projects, the more successful they become … the most they are used, the closer the price will be to zero. Quoting from an article titled, appropriately, “On The Velocity Problem for Cryptoassets”:

“There is an emerging consensus that velocity is a confounding problem in establishing cryptoasset value for single utility tokens.

The widely accepted M = PQ / V model popularized by Chris Burniske illuminates the effect of velocity on cryptoasset value quite obviously: increasing velocity decreases the value of the asset base in a linear fashion, and, therefore, the price of utility tokens (given a fixed token supply).

As transactional costs and friction decrease, especially as the purchase and sale of these tokens becomes basically instantaneous or concurrent, velocity increases significantly and collapses the utility value of the token.

For investors, the uncertainty around this confounding variable should destroy the speculative investment opportunity for the majority of single utility tokens, unless they are depending on sustained transactional friction, irrational HODLing, or the next greater fool in those token markets.

Whether you understood any of that, or not, trust me… it’s thang. A real big thing!

Basically, it is saying velocity could make these alt-coins a bad investment, even though they are a successful technology!

And, to use their word, the confounding thing for me is, given these risks, there is no logical reason for anyone to buy these coins, unless you like playing Russian Roulette.

But why? A fundamental principle in portfolio construction is never take a risk you don’t have to. If Bitcoin is the beta … and has risk for sure. But not all these additional risks … why would you own these other coins when there is no guarantee that you will earn more than Bitcoin and it is almost certainly guaranteed that you will earn less than Bitcoin on a risk adjusted basis???

Why? In 2017 Bitcoin went up 1246%. That’s not enough for you? You see my point? I don’t get it. I’ll never get it.

I’ve said this before. I’m going to say it again. This is not some game. It’s not a competition. It’s not entertainment.

When you are dealing with having to fund potentially 40+ years in retirement with the money you have managed to accumulate, investing is deadly serious business.

Be smart! Be humble! And the markets reward you well. Get greedy and the markets will slap your face down into the dirt. That’s how it works …

As Barry Ritholtz says … “It is the markets’ job to reallocate money from the ignorant to the intelligent, from the lazy to the hard working and studious; from the naive to the educated, and from the speculator to the investor.”

Something to consider. As always, I hope you found it helpful …

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If you’d like to learn more about investing in cryptocurrency for retirement, I would encourage you to register for my free online training, How A Little, Little Bit of Bitcoin Can Make Your Retirement Savings Go A Lot, Lot Further.

As always. If you have any questions at all, about this topic, or anything else, just email me at askkim@sanecrypto.com. I read and answer every email personally. Or leave it in the comments below.

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Dive Deeper Into What Is An ICO

Cryptoassets — Tatar & Burniske (Amazon aff. link)

The Third Wave: An Entrepreneur’s Vision of the Future — Steve Case (Amazon aff. link)

Nearly Half of 2017’s Cryptocurrency ‘ICO’ Projects Have Already Died (Fortune)

Why I am a #NoAltCoiner in retirement portfolios (Snider)

SEC/CFTC Testimony to Senate Banking Cmte. (C-Span)

On the Velocity Problem for Cryptoasset Value (Wilson Lau)

Velocity could make Ethereum a bad investment, but still a great technology (Trent Eady)

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