Predicting the Future Is Easy, Profiting Is Hard

A question I am often asked is how an individual can invest in the future of blockchain technology and ride the growth of this great emerging technology. The truth is, I’m not completely sure I know. However, as always, I like looking at analogies from other industries and times to see if I can glean some insights. This isn’t investment advice and my aim here isn’t really to provide investment advice. This is an opportunity to step back and think about which companies and strategies might be winners if we can generalize some good lessons from the past.

The most obvious approach to investing in the future of blockchain technology is to buy into the blockchains you believe will be successful, such as Ethereum and Bitcoin. On the surface, that may seem like a direct and simple plan but it may not be that easy. In thinking about this topic, I’ve come up with two key analogies from history and, unfortunately, they both suggest there’s no easy answer.

In the case of Ethereum, this blockchain is increasingly becoming an ecosystem of complex business networks. The network effects that drive growth and innovation are clearly visible in the way the decentralized finance ecosystem has exploded and the degree to which DeFi services interoperate with each other. Growing demand for transactions within the Ethereum ecosystem has, in turn, led to soaring transaction costs and a rising value for ether, which is needed to fund transactions on Ethereum, as people compete for a limited transaction capacity.

Superficially, it’s easy to predict the value of ether will soar as demand for transactions rises. In fact, there is no guarantee that will happen. In Ethereum, the fees that are required to process transactions are called gas, and the analogy with gas prices in the real world is a very good one: As gas prices go up, people quickly turn to engineering more efficient engines. The same is happening in Ethereum. We see multiple paths with different technologies that will likely raise the network capacity by a factor of over 1,000. That’s a lot of extra capacity.

If Ethereum does become the foundation of a new digital global economy, the value of ether will certainly appreciate relative to other currencies, but perhaps not enough to satisfy a typical investor who is used to thinking about the 7%-10% annual returns you get in the stock market. The U.S. economy surpassed Britain’s in 1916. At that time, you needed nearly five U.S. dollars to buy one British pound. Today you need fewer than two dollars. That’s appreciation, yes, but not much over the course of a century. In that context, buying U.S. dollars as an investment in the U.S. economy would not have turned out very well.

A better analogy might be to think of Ethereum as a digital version of the global economy or the internet and ether as the foundation currency. And again, that doesn’t give us a good easy answer. The U.S. economy, the world’s largest, has been growing around 2%-3% annually for decades. And while the U.S. dollar’s purchasing power has declined an average of 2.2% a year due to inflation, the U.S. stock market has risen by around 7%-9% a year (after inflation) during the same time period.

The lesson here: A stable medium of exchange (the dollar, on in this case, ether) is a necessary condition for growth and value to be created, but if you want to participate in that growth, you will need to buy into the companies that create it.

The internet gives us another take on this. In the go-go days of the late-1990s, internet startups raised money nearly as fast as blockchain startups do today. Enormous amounts of money flowed into high-risk ventures. Often these startups had great ideas about how the internet would transform our daily lives – and they were often right.

Same-day delivery of essentials? Kosmo.com. Home grocery delivery? Webvan. Social networks and streaming music: Myspace. Every single one of them was right about the future, and it didn’t save them from failure. There’s a good chance that many of the brilliant blockchain startups we see today will see the same end: being completely right about the future and frustratingly unable to cash in.

See also: Paul Brody - This Isn’t the Revolution I Signed Up For

One theme cited frequently in Silicon Valley in the 1990s was that of Levi Strauss, a local San Francisco company still in business. The original Levi Strauss set up shop selling jeans and clothing to local miners lured to California by the gold boom. Most of those gold mines went broke and nearly all the miners did, too. But those selling clothing and equipment did just fine. Applied to the internet of the 1990s, that meant investing in networking companies and servers, a bet that seemed a good one.

You can apply the same logic today to those companies looking to scale up Bitcoin and Ethereum. We don’t know how these layer 2 applications will finally be used, but we know there will be enormous demand for them. However, a quick survey of the layer 2 business suggests it’s every bit as crowded as every other segment in this space, which makes picking winners very difficult. Indeed, our view that selling jeans and tools to miners may be informed by survivor bias – we only know about the companies that survived the end of the mining boom, not all the outfitters that perished along the way.

There is one investing strategy that has stood the test of time: passive index investments. Picking winners is hard, even when you are right about what the future may look like. What you can do is pick the broad category for your investments. Decades of research has shown that it’s nearly impossible to beat the market as whole. All of that research was done on the stock market, but there’s no reason to think that blockchains as the next big digital engine of growth and innovation will be any different. As philosopher Georges Santayana said, “Those who don’t learn history are condemned to repeat it.”

The views reflected in this article are the view of the author and do not necessarily reflect the views of the global EY organization or its member firms.