Cryptocurrencies and Power Laws

Vanguard AUM

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There are dozens, maybe hundreds or thousands of cryptocurrencies out there1.

However, there are only a handful of cryptocurrencies that anyone who has some knowledge of cryptocurrencies has ever heard of:

  • Bitcoin (BTC)
  • Ethereum (ETH)
  • Litecoin (LTC)
  • Bitcoin Cash
  • Ripple2

It’s likely to stay this way forever because of something called a power law.3.

Power laws work in a “winner take all” sort of way, rewarding the winner in a kingdom, phylum, class, order, family, genus, species of whatever with the vast majority of the rewards…

Cryptocurrencies are no different.

Just as Heinz ketchup is the #1 ketchup in the world (for no good reason related to quality), Bitcoin will be the #1 cryptocurrency forever, unless it goes up in flames or is hacked to death or uses up all the world’s energy just to survive.

It’s highly unlikely that Doge, ZCash, Butthole Coin, or whatever is being launched today is going to overtake Bitcoin as the leading cryptocurrency in the world.4

Power laws have a real effect on any asset related investment that is based on scarcity, be it Bitcoin, or gold, or New York City real estate.

The more people who want the limited asset, the higher it’s price will be. The higher Bitcoin goes, more articles are written about it, the more people read about it and the further the “fear of missing out” spreads.

Internet technology and the velocity of information amplifies power laws.

The recent rapid growth of index funds is a good example.

I remember reading a book called “The Coffeehouse Investor” around 2001. The book was about index fund investing and how 99% of active mutual fund managers underperformed the stock market.

When I read it the book made a big impression on me. I wondered why so many people still invested their money with active mutual fund managers who were obviously screwing them out of serious money over time, by charging hefty “management fees” while underperforming the market majorly.

Fast forward 15 years and everyday investors are stampeding into index fund investing.

Indeed, index fund giant Vanguard recently announced that it is on track to $5 trillion in invested assets under management (AUM), with growth akin to a power law.

The following quote is from a New York Times article earlier this year about Vanguard’s outsized performance in attracting index fund capital:

“In the last three calendar years, investors sank $823 billion into Vanguard funds, the company says. The scale of that inflow becomes clear when it is compared with the rest of the mutual fund industry — more than 4,000 firms in total. All of them combined took in just a net $97 billion during that period, Morningstar data shows. Vanguard, in other words, scooped up about 8.5 times as much money as all of its competitors.”

This is insane…

But probably wouldn’t have been possible without the democratization of information via the Internet, mobile phones, etc.

In any event, cryptocurrency investment will perform similar to index funds…

Unless it craters under it’s own success, Bitcoin will probably be the outsized winner over time.

Footnotes

  1. Wikipedia lists fewer than 100. The mobile app “CoinCap” lists over 1,000… But as it gets easier to launch an ICO, the number of cryptocurrencies is increasing every day
  2. People have heard of Ripple (XRP), but it isn’t really a cryptocurrency. Ripple (XRP) is different than Bitcoin or Ethereum, etc. because it’s meant to be used by large financial organizations to help them more efficiently transfer money and asset value electronically.
  3. Also sometimes referred to as the Pareto Principle, or the 80:20 rule. The 80:20 rule suggests that 80% of winnings will go to 20% of the players, or 80% of assets will be owned by 20% of the world’s population. In reality, the numbers are more skewed… Currently it is estimated that 1% of the world’s richest own over 50% of global wealth.
  4. Ethereum and Chia are supposedly working on a solution to the energy consumption problem, which could possibly make things interesting over time.