A decade ago, a curious craze developed in game farming. Prices for rare breeds started rising ostensibly because of the demand from trophy hunters. At the height of the rare-breed game bubble, a black impala male fetched R2.5 million compared to a meagre R1 000 for a normal male impala. That was, of course, until the bubble burst and the speculators lost nearly everything. Today, hunting a black impala male will cost you around R10 000.
This example illustrates how price can be influenced by the perceived value buyers place on something, rather than the intrinsic value it has. Said another way, there can be a difference between its utility (or functional value) and the price people will pay for it. To calculate the utility value, simply consider what it is used for. The most basic utility attached to an impala is the price of impala meat. Alternatively, as a breeding animal, its utility value should include the potential value of the meat of future offspring.
What then drove up the price for rare breeds? The perception of value. This happened when people perceived that black impala were more valuable than golden impalas. The price correction that followed the bubble is evidence that there was no sustainable reason for this difference. Of course, they’re rarer and continue to fetch a premium, but not to the extent people perceived in 2015 when speculators expected prices to continue to soar at 100% per year.
When the perception of value changes, the price normalises. In this case, perhaps because the supply increases. Or the fad blows over. Or regulators catch up to the game (excuse the pun). Whatever the reason for the change, in this example the price returns to the ultimate utility - meat.
When we evaluate the potential of an asset we must judge what the difference is between the utility and the current price. If the difference is perception, apply great caution to your expectation of returns. When the expectation is that prices can only rise, apply even more caution. The downside is that the price could normalise to its utility value. Think of cryptocurrency. Think NFTs.
Understanding utility will help you understand the difference between speculating and investing. Speculating is believing the price will go up because the price has gone up. Speculating is believing that you have a rare understanding that others will still come to understand.
A healthy approach to investing is understanding that the downside could be the utility value of an asset, and willingly accepting that downside.